LBO Flashcards
What is IRR?
Discount rate that makes the NPV of all cash flows equal to 0 in a DCF analysis.
Used to estimate profitability of potential investments
Higher IRR = Better
What are some ways we can increase our IRR in an LBO?
Increase Leverage
Shorten time horizon
Higher EBITDA Margin
Increasing sale price
3 Key Elements in an LBO
Time Horizon (years)
MoM Multiple (Equity at End + CFs / Equity at Beginning)
IRR
What are three key reasons an LBO works?
1) Debt to Purchase - Uses debt to reduce up-front cash payment boosting returns
2) CF used to Pay Debt - Uses company’s CF to repay debt principal and interest (produces better return than keeping CF)
3) Sell - Sell the company in the future allowing you to gain back a majority of your funds spent to acquire the company
How to perform an LBO (summarized)
1) Calculate the cost to acquire
2) Raise the funds from debt and investors
3) Acquire firm
4) Operate firm (receive CFs and use them to pay debt)
5) Sell firm or IPO
What are characteristics of a good LBO candidate?
1) *Stable and unpredictable CFs
2) Undervalued relative to peers
3) Low-Risk business
4) Not a large need for ongoing investments such as capex
5) Opportunity to cut costs and increase margin
6) strong management team
7) Solid base of assets
Can you give some examples of industries that may not make good candidates for LBOs?
Oil, gas, mining where commodity prices can change dramatically and push cash flows up or down drastically.
3 Key Model Assumptions in an LBO
1) Purchase price and debt/equity mix
2) Debt terms (IRs and Principal Repayments) - depend on debt types
3) Create a sources and uses table tracking where the funds are coming from and where they’re going
Bank Debt
Lower IRs and 10-20% annual principal repayment
Less risky than high yield debt
Includes Maintenance Covenants
High Yield Debt
Higher IRs and NO annual repayment
Unsecured (not protected by a guarantor in case of bankruptcy) so riskier
Investors demand higher returns as a result
Includes Incurrence Covenants
Maintenance Covenant
Component of Bank Debt
Tested on a regular basis
Example: Total Debt / Equity must be <4x or EBIDA / Interest Expense must be >2x
Incurrence Covenant
Component of High Yield Debt
Only tested when borrower wished to take a specific action
Examples: Company cannot acquire another company and cannot sell off assets
Leverage Ratio
Debt/EBITDA
Check to see if too high or too low relative to other companies
Interest Coverage Ratio
EBITDA/Interest
Check to see if too high or too low relative to other companies
Common Sources of Funding
Debt (all types)
Investor Equity (cash from PE firm)
Debt Assumed
Common Uses of Funding
*Equity Value of Company
Advisory, legal. financing, and other fees
Debt Assumed
Refinanced Debt (P/E firm must pay off seller’s existing debt when it acquires it)
What can a P/E firm do with the company’s existing debt? (2 things)
1) Assume the debt
2) Pay off the debt (Most of the time P/E firm will pay off)
Do you pay more the Equity Value or the Enterprise Value to acquire a company in an LBO?
Neither one! It depends on what you do with the seller’s debt
1) Assume the Debt - Closer to Equity Value
2) Repay the Debt - Closer to Enterprise Vale
LBO FCF
Cash Flow from Operations - CapEx
NOTE: This is different than unlevered and levered FCF from a DCF
LBO FCF = NI + Non-Cash Expenses +/- Changes in NWC - CapEx
What does LBO FCF tell us?
How much cash do we have available to repay the debt principal each year after we’ve already paid for our normal expenses and for the interest expense on the debt
How to calculate returns in an LBO? (3 Inputs)
Equity (-)
Cash/Dividends to PE (+) firm –> usually 0 b/c PE uses all available CF to pay debt
Sale Proceeds - Debt Outstanding (+)
What does the IRR tell us?
The effective IR on the investment
“If we invested this initial amount of cash and earned an IR of X%, compounded each year, you would earn the positive CFs shown in the model”
How would cash or dividends received by PE firm impact IRR?
Increase IRR b/c they boost the total amount of funds received by the firm
What 3 variables have the greatest impact on the IRR in an LBO?
1) Purchase Price
2) % Equity and % Debt used
3) Exit Price
Changes that Increase IRR?
1) Lower purchase price
2) Less equity
3) Higher revenue growth
4) Higher EBITDA margins
5) Lower Interest Rates
6) Lower CapEx
Changes that Reduce IRR?
1) Higher purchase price
2) More equity
3) Lower revenue growth
4) Lower EBITDA Margins
5) Higher Interest Rate
6) Higher CapEx
Dividend Recapitalization (Dividend Recap)
PE firm forces the company to take on additional debt and issues a big cash dividend to itself with the proceeds from that debt
Done to boost IRR - allow PE firm to get some of its initial investment back earlier on rather than waiting for the official exit
Investors don’t like b/c it reduces the credit quality of the company while saddling it with more debt
How is an LBO of a private company different to that of a public company?
Purchase price at the beginning is based on an implied value of the company rather than the premium over the company’s share price
Main obstacles of LBO of a private company? (2)
1) Company may not want to sell
2) Information is more limited
Payment-in-Kind (PIK) (option for interest)
Interest accrues to the debt principal rather than being paid in cash.
Increases interest expense (on I/S) and debt balance (on B/S)
More common with riskier forms of debt
If you acquire <50% of a company, is it still considered a true LBO?
No. Because you can’t force a company to take on debt if you don’t control it
Walk me through an LBO Model
1) Make Assumptions (Purchase Price, D/E mix, IR on debt)
2) Create Sources and Uses Section
3) Adjust B/S for new debt and equity figures (allocate purchase price, goodwill adjust)
4) Project I/S, CFS, B/S and determine how much debt paid off each year
5) Make Assumptions about exit (assuming EBITA exit multiple) and calculate returns
What variables impact an LBO the most?
1) Entry/Exit Multiples
#2) Amount of debt used
Why do we say LBO provides a “floor” in valuation?
PE (Sponsor) would almost always pay less than a strategic acquirer would (due to realizable synergies)
How is an LBO different from a DCF?
In an LBO you’re seeing what can you pay for a company based on target IRR
In a DCF we are looking at what a company is worth based on PV of future CFs and TV
Why would a PE firm not use 100% cash to acquire another company if that may be the “cheapest” option?
PE firm doesn’t hold the company for the long term
In an LBO, the company is responsible for repaying the debt
How could a PE company boost its returns in an LBO?
Decrease purchase price
Increase leverage
Increase exit EBITDA multiple and exit price
Increase company’s growth rate
Increase margins by cutting expenses
Why would a PE firm use bank debt?
Company is concerned about meeting interest payments and wants a lower cost option
Why would a PE firm use high yield debt?
If PE firm plans to refinance debt or they don’t believe the returns are sensitive to the interest payments
What is the point of assuming a minimum cash balance in an LBO?
Cannot use 100% of the CFs to repay debt each year
Need to have a minimum amount of cash to pay employees, pay for general and administrative expenses, and so on
Balance Sheet adjustments in LBO?
Assets
Cash is adjusted to reflect finance of transaction
Goodwill is used as a plug
Liabilities + SE
New Debt added
SE wiped out (replaced by how much cash PE firm is paying for company)
Additional Effects:
Asset Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing Fees
Why is Goodwill created in an LBO?
Represents the premium paid to the SE of the company
How to project financial statements?
Assume revenue growth rate
Expenses projected as a % of revenue
Tie B/S and CF items to Rev and Expenses on I/S - and to historical trends
How to determine how much debt the company can pay off each year? (FCF)
FCF = CFO - Capex
*Assume CFI and CFF are non-recurring and don’t impact future cash flows
*Only reflects how much debt principal company can repay (interest expense has already been factored into I/S and is reflected in CFO
Can CapEx spending be reduced after an LBO?
No, it is very dangerous to do so because CapEx drives revenue growth.
If the seller has existing debt, how would this impact LBO assumptions?
If PE firm refinances debt (pays it off) it is a non-factor b/c it goes away
If PE firm assumes the debt, it needs to be factored into interest and principal repayments on that debt in future years
What is the proper repayment order if there are multiple tranches of debt?
Existing debt balance on the B/S gets repaid first
After that, depends on the seniority of the debt and whether or not the debt can be repaid early
What is meant by LBO “tax shield”
Interest that a firm pays on the debt is tax-deductible - so money is saved on taxes which increases your cash flow as a result of the debt from the LBO
*Note: Firm’s CF is still lower b/c the added interest expense still reduces NI by more than the reduced taxes helps the firm
What IRR do PE firms usually aim for?
Depends on economy and fundraising climate
IRR of 20-25% would typically be considered “good”
How do dividends issued impact the IRR?
Dividends issued increase the IRR because they result in the PE firm receiving more cash back
*Usually make less of an impact than the 3 main LBO variables
Do we factor in debt interest and principal repayments into the IRR calculation?
No, because the company uses its own cash flow to pay interest and pay off the debt principal. Since the PE firm is not paying for these, neither one affects IRR.
Why would a PE firm do a dividend recap?
To boost returns (IRR); all else equal, more leverage = higher returns
Dividend Recap - PE firm is “recovering” some of its equity investment in the company (lower equity investment is better because it leads to higher returns
How would a dividend recap affect the financial statements?
Dividend Recap = Issuing dividends to raise debt
I/S: No Changes
C/F: CFF the additional debt raised would cancel out the dividends paid to investors so there is no change in cash
B/S: Debt increases and SE goes down (Cancel and balance)
How would an LBO of a private company be different?
Mechanics are the same but think of the purchase price as a lump sum number rather than as a premium to the company’s share price * shares outstanding
Why would a PE firm choose to take on high yield debt vs bank debt (even if IR lower on bank debt)?
Opportunities to refinance in the future
PE firm can’t take on 100% bank debt (very high amount)
What types of companies have steady CFs (ideal PE targets for LBO)
Utility and infrastructure companies are ideal candidates for LBOs because they have steady CFs and are not subject to cyclicality (everyone needs to use energy and power and there is a need for infrastructure)
Why would a company sell to a PE firm over a strategic acquirer (who may pay more)?
PE firm may pay less but they are more likely to keep management and pay management well (strategics are more likely to lay off employees as the synergies help them to fund the acquisition)
