LBO 2.0

Question 1

What is an LBO, and why does it work?

Answer 1

In an LBO, a sponsor acquires a company using a combo of debt and equity, operates it for several years and then sells it to realize a return on its investment.

During ownership, the sponsor uses the company’s CFs to pay interest on the debt and repay principal.

It works because LEVERAGE AMPLIFIES RETURNS: if the deal performs well, the sponsor will realize higher returns than if it paid with 100% equity. But, introduces risks.

Question 2

Why do PE firms use leverage?

Answer 2

1. To AMPLIFY their returns, not increase them. Leverage increases the magnitude of positive or negative returns, but their direction.
2. Frees up capital for other deals

Question 3

Walk me through a basic LBO model.

Answer 3

1. Assume Purchase Price, Debt and Equity, Interest Rate on Debt and operational stuff (i.e., revenue growth, margins).
2. Create S&U - show exactly how much sponsor equity is required; make Purchase Price Allocation Schedule to calc. goodwill.
3. Make PF B/S - new debt and equity, allocate purchase price and add Goodwill to Assets.
4. Project I/S, B/S and CF/S - determine annual debt repayment based on FCF.
5. Make assumptions about exit (i.e., EBITDA Exit Multiple), and calculate IRR and Money-on-Money multiple based on end proceeds.

Question 4

Can you explain the legal structure behind an LBO and how it benefits the PE firm?

Answer 4

Sponsor forms a HoldCo., which it owns, which acquires the real company. Debt lies at HoldCo; mgmt. etc have shares in HoldCo.

Means that sponsor is not on the hook for the debt - forms a HoldCo. to borrow the money so the sponsor can do the deal.

Question 5

What assumptions impact an LBO the most?

Answer 5

1. Purchase and Exit Multiples are biggest:
   - Lower Purchase / higher Exit means higher returns
2. % Debt Used is next - if deal does well, higher leverage amplifies
3. Revenue growth, EBITDA margins, interest rates and principal repayment

Question 6

How do you select the purchase multiples and exit multiples in an LBO model?

Answer 6

Public companies - assume a share-price premium and check implied purchase multiple against 3 methods for sanity
Private companies - look at comps and DCF.

Exit multiples are typically similar to purchase but can go either way based on company’s FCF growth and end ROIC. SENSITIZE BOTH.

Question 7

What’s an ideal LBO candidate?

Answer 7

Assuming the price is right (undervalued), look for:

• Stable and predictable cash flows
• Low reinvestment needs
• Fast-growing and fragmented industry (bolt-ons)
• Opportunities to cut costs and increase margins
• Strong management team
• Assets to collateralize
• Realistic path to exit

Question 8

How do you use an LBO model to value a company, and why does it set the floor?

Answer 8

By setting a targeted IRR (i.e. 25%) and using Goal Seek in Excel to determine what purchase price could be paid.

Produces a floor b/c it tells the max you could pay to realize a target IRR.

Question 9

How does an LBO valuation differ from a DCF valuation?

Answer 9

Both are based on cash flows, but:

• DCF asks what the firm COULD BE WORTH, based on NPV of cash flows
• LBO asks WHAT COULD WE PAY if we want x% returns

Question 10

How is an LBO different from a regular M&A deal?

Answer 10

• LBO assumes sale after 3-5Y, so focus on IRR and MoM multiple
• Sponsors can only use debt/equity (cash) - no stock issuance
• Synergies and EPS accretion/dilution matter less in LBOs
• Purchase price is reverse-engineered in an LBO

Question 11

A strategic acquirer usually prefers to pay for another company with 100% cash - if that’s the cash, why would a sponsor use debt in an LBO?

Answer 11

1. Sponsor plans to sell in a few years - cares about amplifying returns via leverage than interest cost
2. Company, not sponsor, is responsible for debt - in regular M&A, strategic assumes the risk

Question 12

How could a PE firm boost its returns in an LBO?

Answer 12

1. Multiple Expansion - cut Purchase Multiple / increase Exit Multiple
2. EBITDA Growth - increase revenue growth or cut expenses to boost margins
3. Debt Paydown and Cash Generation - increase leverage, or cut reinvestment to boost FCF

Question 13

How do you calculate the IRR in an LBO model, and what does it mean?

Answer 13

IRR = effective annual compounded interest rate

1. Make sponsor equity negative, and keep dividends to sponsor plus net proceeds at end positive
2. Select all and do excel IRR function

If no dividends, annualized HPR.

Question 14

How can you quickly approximate the IRR in an LBO? Are there any rules of thumb?

Answer 14

DOUBLE YOUR MONEY - IRR ~= (100% / years) x 75%
TRIPLE YOUR MONEY - IRR ~ = (200% / years) x 65%

Rough key numbers:

• Double money in 3y = 25% IRR
• Double money in 5y = 15% IRR
• Triple money in 3y = 45% IRR
• Triple money in 5y = 25% IRR

Question 15

A PE firm acquires a $100M EBITDA company at 10x and funds the deal with 60% debt. EBITDA grows to $150M by Y5, but exit multiple drops to 9x. The company repays $250M of debt in this time and generates no extra cash. IRR?

Answer 15

• Sponsor equity = $400M
• Proceeds to sponsor = ($150 x 9) - $350M = $1B
• MoM, 5y = 2.5x
• IRR = (15% + 25%)/2 = 20%

Question 16

A PE firm acquires a $200M EBITDA company using 50% debt, at 6x. EBITDA grows to $300M at Y3, and exit multiple stays the same. Assuming the company pays its interest and required debt principal but generates no additional cash, what’s minimum IRR?

Answer 16

• Sponsor equity = $600M
• Proceeds to sponsor = ($300M x 6x) - $600M = $1.2B
• MoM = 2x
• IRR = (100% / 3) x 75% = 25%

Question 17

How does the IRR change if the company repays all its debt but nothing else changes?

Answer 17

Sponsor receives full exit EV as Equity Proceeds.

Question 18

You buy a $100 EBITDA business at 10x, and believe you can sell it in 5Y for 10x. You use 5x Debt/EBITDA to fund, and the company repays 50% of that debt over 5y. By how much does EBITDA need to grow over 5Y for you to realize a 20% IRR?

Answer 18

• MoM = 2.5x
• Upfront equity = $500
• Required exit equity = $1,250
• Required exit = $1,500
• Required 5Y EBITDA = $1,500 / 10 = $150
• 50% GROWTH.

Question 19

A PE firm acquires a business for 12x EBITDA, using 5x leverage and plans to sell in 5Y. Current EBITDA is $100, growing to $200 in Y5.

Assuming no debt repayment and no add’l cash generation, what exit multiple do we need for a 25% IRR?

Answer 19

• Required MoM = 3x
• Upfront equity = $700
• Required exit equity = $2,100
• Required exit EV = $2,600
• Required exit multiple = $2,600 / $200 = 13x

Question 20

Now assume the company repays 75% of the initial debt over 5 years. What exit multiple do we need for a 25% 5Y IRR?

Answer 20

• Required MoM = 3x
• Debt remaining = $125
• Exit EV = $2,225
• Exit multiple = $2,225 / $200 ~ 11x

Question 21

A PE firm acquires a $200 EBITDA company at 8x using 50% debt. It wants to sell it in 3Y, but it decides to take it public instead. If EBITDA increases to $240, and it repays ALL debt over 3y, and it takes it public and sells off its stake evenly in Years 3-5 at 10x, what’s the approximate IRR?

Answer 21

• Upfront equity = $800
• Exit EV = exit proceeds = $2,400
• MoM = 3x, ~4Y
• IRR = 35%

Question 22

How does the IRR change if, after going public, the company’s share price drops by approx. 10% per year in Years 4 and 5?

Answer 22

• 10% drop means exit multiple falls to 9x, then 8x
• Average EBITDA multiple now = 9x
• Exit EV / proceeds = $2,160
• MoM = 2.7x
• IRR = roughly 30%

Question 23

What’s the approximate IRR if a PE firm acquires a company using $500 of investor equity, sells it for $1,000 in equity proceeds in Y3, and receives a dividend of $250M in Y3?

Answer 23

• MoM (3y) = 2.5x

- IRR (25% + 45%) / 2 = 35%. But since dividend came earlier, between 35%-40%.

Question 24

A PE firm acquires a company with $100 in EBITDA, which grows to $150 by Y7, at which point it’s sold at 10x. Sponsor used $500 debt upfront, and the company has $300 of net debt at exit. If the PE firm realized an IRR of 10%, what was the purchase multiple?

Answer 24

Since less than 15% in 7Y, assume doubled money.

• Exit equity proceeds = $1,200
• Implied upfront equity = $600
• Implied purchase multiple = 11x

Question 25

Could a PE firm earn a 20% IRR if it buys a company for a PEV of $1B and sells for Exit EV of $1B after 5y?

Answer 25

• IRR = 20%
• Required MoM = 2.5x
• Upfront equity = $400M
• YES, IF THEY BORROW $600M AND REPAY IT ALL.

Question 26

Could a PE firm ever earn a 20%+ IRR if it buys a company using upfront equity of $1B and gets back exactly $1B in equity proceeds at the end of 5Y?

Answer 26

Theoretically, yes; practically, no.

Would require extremely high dividends and/or multiple dividend recaps.