LBO Flashcards
What is a leveraged buyout (LBO)?
In a leveraged buyout, a private equity firm (often called the financial sponsor) acquires a company with most of the purchase price being funded through the use of various debt instruments such as loans, bonds. The financial sponsor will secure the financing package ahead of the closing of the transaction and then contribute the remaining amount.
Once the sponsors gain majority control of the company, they get to work on streamlining the business – which usually means operational improvements, restructuring, and asset sales intending to make the company more efficient at
generating cash flow so that the large debt burden can be quickly paid down.
The investment horizon for sponsors is 5-7 years, at which point the firm hopes to exit by either:
- Selling the company to another private equity firm or strategic acquirer.
- Taking the company public via an initial public offering (IPO)
Financial sponsors usually target returns of ~20-25% when considering an investment.
Explain the basic concept of an LBO to me using a real-life example?
One metaphor to explain an LBO is “house flipping,” using mostly borrowed money. Imagine you found a house on the market selling for a low price, in which you see an opportunity to sell it later for a higher price at a profit. You end up purchasing the house, but much of the purchase price was financed by a mortgage lender, with a small down payment that came out of your pocket. In return for the lender financing the home, you have a contractual obligation to repay the full loan amount plus interest.
But instead of purchasing the house to live there, the house was bought as a property investment with the plan to put the house back on the market in five years. Therefore, each room is rented out to tenants to generate monthly cash flow. The mortgage principal will gradually be paid off and the periodic interest payments are paid down using the rental income from the tenants. Home renovations are completed with the remaining amount and any existing property damages are fixed – again, using the rental income.
After around five years, the house is sold for a price higher than the initial purchase due to the improvements made to the house and because the house is located in an area where home values have been increasing. The remaining mortgage balance will have to be paid in full, but you pocket a greater percentage of the proceeds from the sale of the house because you consistently paid down the principal.
What is the intuition underlying the usage of debt in an LBO?
The typical transaction structure in an LBO is financed using a high percentage of borrowed funds, with a
relatively small equity contribution from the financial sponsor. As the debt principal is paid down throughout the holding period, the sponsor will realize greater returns at exit. Therefore, private equity firms attempt to maximize the amount of leverage while keeping the debt level manageable to avoid bankruptcy risk.
The logic behind why it’s beneficial for sponsors to contribute minimal equity is due to debt having a lower cost of capital than equity. One reason the cost of debt is lower is that debt is higher on the capital structure – as well as the interest expense being tax-deductible, which creates a “tax shield.” Thus, the increased leverage enables the firm to reach its returns threshold easier.
What is the typical capital structure prevalent in LBO transactions?
LBO capital structures are cyclical and fluctuate depending on the financing environment, but there has been a structural shift from D/E ratios of 80/20 in the 1980s to around 60/40 in more recent
years.
The different debt tranches include leveraged loans (revolver, term loans), senior notes, subordinated notes, high-yield bonds, and mezzanine financing. The majority of the debt raised will be senior, secured loans by banks and institutional investors before
riskier types of debt are used. In terms of equity, the contribution from the financial sponsor represents the largest source of LBO equity. Sometimes, the existing management team will rollover a portion of their equity to participate in the potential
upside alongside the sponsor.
Since most LBOs retain the existing management team, sponsors will usually reserve anywhere between 3% to 20% of the total equity to incentive the management team to meet financial targets.
What are the main levers in an LBO that drive returns?
- Debt Paydown (Deleveraging): Through deleveraging, the value of the private equity firm’s equity
grows over time as more debt principal is paid down using the acquired company’s free cash flows. - EBITDA Growth: Growth in EBITDA can be achieved by making operational improvements to the
business’s margin profile (e.g., cost-cutting, raising prices), implementing new growth strategies, and
making accretive add-on acquisitions. - Multiple Expansion: In the ideal scenario, the financial sponsor hopes to exit an investment at a higher
multiple than entry. The exit multiple can increase from improved investor sentiment, better economic
conditions, increased scale or diversification, and favorable transaction dynamics (e.g., competitive
auction led by strategics).
What attributes make a business an ideal LBO candidate?
Strong Free Cash Flow Generation: The ideal LBO candidate must have predictable, FCF generation with
high margins given the amount of debt that would be put on the business. To make the interest payments
and debt paydown, consistent FCF generation year-after-year is essential and should be reflected in the
target’s historical performance.
Recurring Revenue: Revenue with a recurring component implies there’s less risk associated with the cash flows of the company. Examples of factors that make revenue more recurring include long-term customer contracts and selling high-value products or services required by customers, meaning the product/service is necessary for business continuity (as opposed to being a discretionary, non-
essential spend).
“Economic Moat”: When a company has a “moat,” it has a differentiating factor that enables a sustainable competitive advantage, which leads to market share and profit protection from outside threats. This effectively creates a barrier against competition. Examples of deterrents include branding, patents, proprietary technology, economies of scale, network effects, and switching costs.
Favorable Unit Economics: High margins are a byproduct of good unit economics, a well-managed cost structure, low capital expenditures, and minimal working capital requirements. These factors all lead to
more FCFs being available to make interest payments, paydown debt principal (required and optional),
and re-invest more into operations of the business. In addition, when a company’s unit economics is
consistently better than the rest of the market, this is oftentimes an indication of a competitive advantage.
Strong, Committed Management Team: Qualified management teams will have a proven track record,
which can be proxied by the number of years working with one another and their past achievements. The
importance of the management team cannot be overstated, as they’re the ones executing the strategic plan.
Undervalued (Low Purchase Multiple): While finding undervalued companies has become increasingly
difficult as more capital has flooded the private capital markets, many private equity firms pursue
opportunistic buyouts where the company can be acquired for a lower price due to external factors. For
example, an industry may have fallen out of favor temporarily or come under pressure due to macro or
industry-related trends, which could allow a firm to complete the purchase at a discount. Since a lower
entry multiple was paid, the opportunity for value creation through exiting at a higher multiple (i.e.,
multiple expansion) is greater while the risk of having overpaid is reduced.
Value-Add Opportunities: For traditional LBO firms, the ideal target will be very well-run, but there
should be some areas of inefficiencies that can be improved upon. These represent opportunities for value creation such as selling non-core business assets, taking cost-cutting measures, and implementing more effective sales & marketing strategies.
What types of industries attract more deal flow from financial buyers?
Non-Cyclical/Low-Growth: Industries with stagnant to low growth tend to attract higher amounts of
interest from private equity investors, as many companies will turn to inorganic growth once organic
growth opportunities seem to have diminished. In an effort to continue growing and increase margins,
companies will turn to M&A and start acquiring smaller companies. Therefore, these strategics represent potential buyers, which means there’ll be a viable exit plan from the perspective of a private equity firm.
Usually, these industries are non-cyclical and mature with minimal disruption risk, making them the ideal
industry for private equity firms that specialize in add-ons (i.e., “buy-and-build”) and pursue fragmented
markets where the consolidation strategy is more viable.
Subscription-Based/Contractual: Industries with business models based around long-term customer
contracts are viewed favorably by private equity firms, especially if the business model is based around
subscription models, as these companies are known for having recurring, stable revenue from reliable
commercial customers. B2B enterprise software companies are valued at such high multiples consistently and sought after by private equity firms for this very reason.
High R&D Requirements: Industries involving technical products will usually have a lot of deal flow
because incumbents will prefer to acquire companies with proven technologies rather than building them
in-house, which would require significant amounts of time and resources. For that reason, many private
equity firms will pursue smaller niche players and grow them, knowing there will be strategic buyers later on interested in acquiring the company for their technology. These companies will often have significant pricing power and an established niche, making them ideal targets for PE investors.
Potential Synergies: Certain industries will have more opportunities for synergies to be realized. This can
come in the form of revenue synergies such as upselling, cross-selling, and product bundling, as well as in the form of cost synergies, such as benefiting from economies of scale and reducing redundant costs. For example, industrial technology and software is known for being two of the best industries for upselling and cross-selling to existing customers, while healthcare services such as dental clinics and psychiatry treatment centers are known for having inefficient cost-structures that can benefit significantly from cost synergies through increased scale, operational improvements, and streamlining processes.
Favorable Industry Trends: The potential investment should be well-positioned to benefit from ongoing
industry tailwinds. This means that incremental improvements are going on in the industry that could be potential add-ons that provide more value to their customers, as opposed to industry-disrupting
developments that would create the need for significant investments to adjust to the changing landscape.
What would be the ideal types of products/services of a potential LBO target?
Mission-Critical: The ideal product or service should be essential to the end markets being served and the
discontinuance of the product or service’s usage should be detrimental to business continuity. In other
words, the customer should be unable to function without this product/service due to how deeply
embedded it has become in its operations.
Recurring/Contract-Based: Revenue from long-term, contractual-agreements is highly regarded by private equity investors. For instance, enterprise software
companies are known for having predictable revenue due to their subscription-based business models and long-term contracts with commercial customers.
High-Switching Costs: The decision to switch to another provider should come with high switching costs that make customers reluctant to move to a
competitor. This would mean the costs should outweigh the benefits of moving to a lower-cost provider.
High-Tech: The more technical the product, the higher the barrier to entry and more pricing power over
its end markets due to the lack of competition. In effect, this leads to more stable, low-risk cash flows, with the optionality to increase prices if necessary. The proxy for finding companies selling technical products is high R&D expenditures, patents/IP, and industry reputation.
Location-Based Competition: Certain private equity firms will pursue companies where competition is
location-specific. This is more prevalent for service-oriented industries such as landscaping and
commercial cleaning. The primary benefit is that these are fragmented markets with less competition and
often involve long-term, contract-based customer relationships.
What is the relationship between debt and purchase price?
The relationship between debt and purchase price is another reason such large amounts of debt are being used in LBOs. The usage of debt enables a private equity firm to purchase companies of a particular size it could otherwise not purchase using equity alone or with a minimal amount of borrowed funds.
In addition, the usage of high debt leaves the firm with more unused capital (called “dry powder”) for other investments or add-on acquisitions for their existing portfolio companies.
How is the maximum leverage used in an LBO typically determined?
The debt-to-equity mix in private equity deals has hovered around 60% debt/40% equity as M&A activity stabilized since the 2008 financial crisis. However, leverage varies significantly across industries, besides being specific to the target company’s fundamental qualities.
Debt/EBITDA has hovered in the 5.0x to 7.0x range and is pressured upward as overall valuations increase. When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. But this has come down because of the risks inherent to high debt burdens.
Why might a private equity firm not raise leverage to the maximum leverage, even if it had the option to do so?
Generally, a private equity firm will want to maximize the amount of debt without endangering the company and putting it at risk of default. The reason being more leverage means less required equity and the greater the potential returns. But there are several reasons a private firm might intentionally raise less leverage than the maximum amount that can be raised from lenders:
Increased Default Risk: The firm may have doubts regarding whether the acquired company could
support the additional debt. Even if the company is in a stable industry and has healthy credit ratios, it’s a
judgment call by the firm on how much debt to use as a percentage of its total debt capacity.
Negative Perception: The firm doesn’t want to appear to be using excessive leverage at the company’s
expense. Nowadays, private equity firms pitch themselves as value-add partners and avoid having a
reputation for extracting as much value as they can from a business for their benefit.
Decreased Fund Returns/Fundraising Implications: If a firm’s portfolio company declares bankruptcy, this would not only ruin the current fund’s returns, but it would make future fundraising efforts more challenging. Lenders would also be less willing to fund the private equity firm in the future and companies (potential investments) would be reluctant to partner with them.
Planned Dividend Recap: The firm might be planning to do a dividend recapitalization later on, especially
if it forecasts lower interest rates than the present day. Therefore, there would be remaining debt capacity, and the additional debt capital would be raised under better terms.
Who determines a company’s debt capacity and what criteria do they use?
In most cases, a leveraged finance group at an investment bank and the capital markets team will guide a private equity firm looking to raise debt financing.
- First, the industry risk is typically the starting point to assess what type of financing package could be obtained. Numerous factors would be looked at, such
as the industry growth rate, past cyclicality, barriers to entry, the threat of disruption by technological advancements, and regulatory risks. - Once the industry has been looked at, the focus will narrow down on the company’s competitive position in the market and substitution risk. The objective
is to understand how this company compares to the rest of the market and if it has differentiating factors that protect its revenue and margins. - Then, the company’s historical performance will be closely examined to create a forecast model. The
forecast will focus on mostly downside scenarios and look for predictable, steady cash flows, as this
allows the company to handle a higher level of debt. - Based on scenario analysis from the forecast model, the company’s appropriate debt capacity will be determined. This leverage multiple (Total Debt/EBITDA) represents the maximum leverage multiple the debt can be raised up to with a sufficient “cushion” that enables it to meet all of its debt obligations even if it were to underperform (e.g., EBITDA drops 20-25%). Note, the leverage and interest coverage ratio parameters will vary significantly based on the industry and the prevailing lending environment.
In the context of an LBO, what is the “tax shield”?
In an LBO, the “tax shield” refers to the reduction in taxable income from the highly levered capital structure.
As interest payments on debt are tax-deductible, the tax savings provide an additional incentive for private
equity firms to maximize the amount of leverage they can get for their transactions.
Since senior debt is cheaper, why don’t financial sponsors fund the entire debt portion of the capital structure with senior debt?
Senior lenders will only lend up to a certain point (usually 2.0x to 3.0x EBITDA), beyond which only costlier debt is available because the more debt a company incurs, the higher its risk of default. The senior debt has the lowest risk due to its seniority in
the capital structure and imposes the strictest limits on the business via covenants, which require secured interests. Subordinated junior debt is less restrictive but requires higher interest rates than more senior tranches of debt.
How do financial sponsors exit their investments?
Sale to a Strategic Buyer: The sale to a strategic buyer is the least time-consuming while fetching higher
valuations as strategics will pay a premium for the potential synergies.
Secondary Buyout: The next option is the sale to another financial buyer, otherwise known as a sponsor-to-sponsor deal. However, financial buyers cannot pay a premium for synergies (unless it’s an add-on).
Initial Public Offering (IPO): The third method for a private equity firm to monetize its profits is for the
portfolio company to undergo an IPO and sell its shares to the public markets. However, this is an option exclusive to firms of larger-size such as mega-funds or club-deals.
What is the one caveat of an IPO exit?
An exit via an IPO is not necessarily an immediate exit per se. Instead, an IPO is a path towards an eventual exit, as the IPO process is very time-consuming and comes with a lock-up period in which shareholders are prohibited from selling their shares for 90 to 180 days.
What is a secondary buyout?
A secondary buyout, or sponsor-to-sponsor deal, is when a private equity firm exits an investment by selling to another private equity firm. There is substantial evidence showing that secondary buyouts have lower returns than traditional buyouts, as many of the operational improvements and value-add opportunities have been exhausted by the previous owner.
What is a dividend recapitalization?
A dividend recapitalization (or dividend recap) occurs when a financial sponsor, having acquired a company via an LBO, raises additional debt intending to pay themselves a dividend using those newly raised proceeds. In most cases, a dividend recap is completed once the sponsor has paid down a portion of the initial debt raised, which creates additional debt capacity. Therefore, dividend recaps allow for partial monetization and sponsors can de-risk some of their investment, unlike an outright exit via a sale or IPO. As a side benefit, the dividend recap would positively impact the fund’s IRR from the earlier retrieval of funds.
How might operating a highly levered company differ from operating a company with minimal or no debt?
Highly leveraged companies have a lower margin of error due to high fixed debt-related payments (interest and principal). Using leverage increases the importance of effective planning and instituting better financial controls, and forces management to become more disciplined with costs and conservative in capital spending, especially when embarking on new initiatives such as expansion plans or acquisitions.
How can a private equity firm increase the probability of achieving multiple expansion during the sale process?
Building a higher quality business via entering new markets through geographic expansion, product
development, or strategic add-ons could help a PE firm fetch higher exit valuations – and increase the odds of exiting at a higher multiple than entry. Also, exit multiples can expand due to improvements in market conditions, investor sentiment in the relevant sector, and transaction dynamics (e.g., selling to a strategic).
Why is multiple expansion viewed as a less-than-ideal lever for value creation?
The standard LBO modeling convention is to conservatively assume the firm will exit at the same EV/EBITDA multiple as the entry multiple. The reason being that the deal environment in the future is unpredictable, and relying on multiple expansion to meet the return threshold is risky, given the amount of uncertainty surrounding the exit. If meeting the return hurdles is contingent on exiting at a higher multiple in the future, the target company may be a less-than-ideal LBO candidate.
In comparison, the creation of value through EBITDA growth and debt paydown is easier to develop a plan for than reliance on exiting at a higher multiple, which has many moving pieces out of the investor’s control.
Can you name a scenario when multiple contraction is common?
For large-sized companies undergoing LBOs, it’s normal to see minor multiple contractions. The reason is that as the company grows larger, the number of potential bidders that could afford to purchase the company grows smaller (i.e., a reduced pool of prospective buyers with sufficient capital). Since there’s less competition, this usually leads to a lower purchase price. This company could undergo an IPO, but this would depend on the situation, and a minor contraction in the exit multiple would not impair returns to the fund, especially since the expanded size of the company implies there was revenue and EBITDA growth, as well as debt paydown.
What are some risks you would look out for when assessing potential investment opportunities?
Industry Cyclicality: Cyclical revenue and demand based on the prevailing economic conditions make an
investment less attractive from a risk standpoint. Traditional buyout investors prioritize stability and
predictability in revenue before all else – and cyclicality is counter-intuitive to those traits.
Customer Concentration: In general, no single customer should account for more than ~5-10% of total revenue, as the risk of losing that customer from unexpected circumstances presents too significant a risk.
Customer/Employee Churn: The circumstances will be specific to the case, but high customer and
employee churn rates are perceived negatively as customer churn creates the need for constant new
customer acquisitions, while low employee retention signals organizational structure issues.
Temporarily Inflated Valuations: A key driver of returns is a lower entry multiple than exit, which clearly becomes more difficult if the company was acquired when industry-wide valuations were inflated. For example, acquiring a healthcare IT company in 2020 would be akin to “buying at the top.” M&A in the
healthcare industry is known for having high valuations, but this was heightened by the influx of strategics during the pandemic looking to build out their digital infrastructure and virtual integrations.
Past Institutional Ownership: Considering how secondary buyouts have been shown to generate lower average returns, the PE firm’s question to itself becomes: “What resources do we have to drive value
creation that past investors were incapable of implementing?” For this reason, most PE firms avoid
companies that were previously owned by another financial sponsor or venture capital-backed.
Retiring Key Management: If the continued success of the business and brand reputation with its
customers is hinged on a particular individual (e.g., the founder) who intends to retire by the end of the
holding period, it could make the sale process more difficult when exiting. The next buyer would have to
take on the risk of replacing management while retaining existing customer relationships.
If you had to pick, would you rather invest in a company that sells B2C or B2B?
All else being equal, the revenue quality would be higher for the B2B company. There is a higher likelihood of long-term contracts for customers that are businesses than consumers. Most individual consumers opt for monthly payment plans. Simply put, businesses have significantly more spending power than consumers and are overall more reliable as customers.
Businesses also have more loyalty to a particular company with whom they partner. The primary cause of this low churn (i.e., revenue “stickiness”) is the switching costs associated with moving to another provider and overall being less sensitive to pricing changes.
Imagine that you’re performing diligence on the CIM of a potential LBO investment. Which questions would you attempt to answer?
Is there a strong management team in place and do they intend to stay on during the LBO?
What value does the company’s products/services provide to their customers?
Which factors make the company’s revenue recurring? Are there any long-term customer contracts?
Where does the team see new opportunities for growth or operational improvements?
What has been driving recent revenue growth (e.g., pricing increases, volume growth, upselling)?
How is the threat of competition? Does this company have a defensible “moat” to protect its profits?
What specific levers does the private equity firm have to pull for value creation?
Is the industry that the company operates within cyclical?
How concentrated are the company’s revenue and end markets served?
Is there a viable exit strategy? Will there be enough buyer interest when the firm looks to exit?
What is a management buyout (MBO)?
A management buyout is a leveraged buyout where a significant portion of the post-LBO equity comes from the previous management team. The typical premise behind an MBO is that the management team believes it can operate the company better and create more value under their direction. An MBO usually coincides with recent underperformance and scrutiny from a company’s shareholder base. Management will usually provide cash equity and rollover any existing equity. In addition, equity financing can also include financial sponsors or other investors. The debt financing portion of the MBO, other than the
rollover amount, is similar to that of a traditional LBO.
What is roll-over equity and why do private equity firms perceive it as a positive sign?
The existing management team will occasionally rollover some (or all) of its equity into the newly acquired company and may even contribute additional capital alongside the financial sponsor. The rollover equity is an additional source of funds, and it reduces the amount of leverage needed to be raised and the equity contribution from the financial sponsor to complete the deal.
If a management team is willing to rollover some equity into the new entity, it implies the management team is doing so under the belief that the risk they’re undertaking is worth the potential upside. It’s beneficial for all parties in the deal for management to have “skin in the game” and have closely aligned incentives.
When might a PE firm prefer to use term loans rather than subordinated notes in an LBO?
Term loans are a cheaper form of debt with lower interest rates, and most PE firms will first maximize the amount that banks and institutional lenders will provide before raising riskier forms of financing. Since
optional repayments are typically allowed with term loans, there’s greater flexibility.
In addition, if the company is expecting to be active in terms of M&A activity (e.g., add-ons, divestitures), the
restrictive incurrence covenants associated with subordinated notes should be considered.
Would a PE firm prefer high growth or stability in revenue?
The vast majority of traditional buyout firms would choose stability in revenue over rapid growth. Given the capital structure considerations and usage of high leverage, most buyout-focused PE firms would choose
consistent, predictable revenue over high growth if the decision were mutually exclusive.
Why might a higher average selling price (ASP) or average order value (AOV) not always be better?
While pricing power is a lever for revenue growth, an overly expensive product decreases the number of
potential buyers due to the product being out of their price range. Therefore, there must be a balance between having high pricing from product quality and being able to reach a large enough market for there to be opportunities for expansion and new customer acquisitions.
