LBO Flashcards
What is the payback term for high yield bonds?
Is it investment grade or non investment grade?
Fixed or floating?
What is a bullet bond?
7-10 years
Non investment grade
Fixed
Instead of intermittent interest payment, all interest/debt is paid off in one lump sum
What are the 4 sources of capital in an LBO?
Senior debt
High Yield debt
Mezzanine debt
Sponsor’s equity
True or False:
High yield bonds typically have longer maturities than do bank loans.
True
Does the IRR increase 5% when selling the assets?
A financial buyer has just invested $1,500 million in a company buyout and used $4,500 million of debt financing. The buyer is planning to sell the company in 3 years for an 8x exit multiple.
If the buyer sells assets, the year 3 net debt balance will go down to $3,000 and EBITDA will be $770 million.
If the assets are not sold, year 3 EBITDA would be $800 million and net debt would be $3,500 million.
No, do not sell the assets because the change is not 5%.
What is mezzanine debt and who invests in it?
What is the payment period?
Why do PE firms turn to mezzanine debt?
Privately traded debt invested in by hedge funds, PE firms, etc
7-10 years
PE firms turn to mezzanine debt when more senior levels of debt are unavailable
Target:
EBITDA $140 million
Net debt $70 million
Acceptable leverage ratio 5.5x
- Calculate new debt
- Calculate max purchase price assuming 23% max equity investment
- Calculate dollar value of equity
- What would be the resulting EV/EBITDA multiple?
- $700 million
- $1,000 million
- $230 million
- 7.143x
How do PE investors measure their rate of return? Explain this.
What are the 3 ways PE firms realize a return on their investment?
IRR, which is the discount rate needed to get the NPV of the investment to 0. It is the discountrate that equates the PV of inflows to the PV of outflows.
Sale, IPO, or dividend recapitalization
Do PE funds want to know how much cash you have BEFORE or AFTER paying interest? Why?
How much cash AFTER paying interest, because that is the amount used to pay down the principal of the debt and thus increase the fund’s equity value
What are the 2 types of ratios applied to target company to assess credit risk? Show the formulas.
Leverage and coverage ratios.
Leverage
Total Debt/EBITDA
Senior Debt/EBITDA
Coverage
EBITDA/Interest expense
(EBITDA - CapEx)/Interest expense
Calculate the pro forma (post-deal) leverage (Total Debt/EBITDA), of the newly indebted LBO target assuming EBITDA of $100 million, a transaction purchase price multiple of 8x, and an equity contribution of 30% of purchase price.
5.6x
What is the IRR formula? Explain the inputs.
(FV/PV)^(1/n) - 1
FV= Future residual equity value (not to be confused with future value formula)
PV= Initial equity investment
n= number of periods/years
- Walk me through a basic LBO model
- a) make assumptions about purchase price, debt/equity %, interest rate on debt and other variables
b) create a sources/uses section indicating how the transaction is financed and what the capital is for
c) adjust the company’s balance sheet for incremental debt / equity and additional Goodwill
d) project forward the company’s financial statements with attention to how much debt is paid off
e) derive exit multiple and derive residual equity value
Describe an LBO.
What is LBO analysis?
Are LBO buyers strategic or financial?
Typically initiated by PE funds, it is the acquisition of a company using high amounts of debt and low equity.
LBO analysis is a set of tools used by the acquirer to determine what price it can pay for a target in order to achieve a particular return on its equity investment.
LBO buyers are financial buyers.
If the projected IRR is not what the sponsor likes, what changes could be made to increase the IRR?
Increase debt to reduce equity value (before the transaction occurs)
Negotiate lower purchase price
- Why do you use leverage when buying a company?
- Which variables impact IRR the most in an LBO model?
- How do you pick purchase and exit multiples?
- a) boost return
b) sometimes can be a cheap source of capital - a) purchase / exit multiple
b) amount of leverage
c) cash flow and its growth
d) time - Same way you do any other valuation, look at comparable companies, acquisition comparables, DCF, etc
Choose which investment has the higher IRR.
Both have current year EBITDA of $100 million. In both cases, the maximum amount of leverage allowed is 5.5x debt / current year EBITDA and the equity contribution is 30%. Investment A has an exit potential in projected year 3 with a 7.9x EBITDA exit multiple, $125 million in EBITDA and net debt of $500 million.
Investment B has an exit potential in year 5 with a 7.9x EBITDA exit multiple, $150 million in EBITDA and net debt of $450 million.
Choose investment A
What are typically the biggest cash outflows sponsors are concerned about in a LBO?
Capital Expenditures
When a PE firm purchases a target company, what happens to that company’s existing debt?
It either gets retired or refinanced.
Given that target companies already have existing debt, what happens to that existing debt? Also, what is the formula used to derive new debt?
Existing debt is typically refinanced.
New Debt = Total Debt Capacity - Refinanced existing debt
(Total debt capacity = leverage multiple x EBITDA)
What is the payback term for senior debt?
Is the interest rate lower or higher compared to other forms of debt? Why?
Fixed or floating?
Senior debt consists of what types of loans?
4-8 years
Lower, due to securitization and covenants
Floating
Term Loans A and B
- What is the main concern of lenders in an LBO?
- Who are the 2 main lenders in an LBO? Who commands a lower interest rate and why?
- Will the target company’s cash flows be able to support the repayment of principal and interest?
- Senior debt and subordinate debt lenders. Senior debt lenders command the lower interest rate due to securitizing the loan of the target company’s assets, etc. Also, it is the first to be paid back in the event of bankruptcy, liquidation, etc.
What is PIK debt?
It does not require the company to make annual interest payments
Interest accures and is paid off when debt principal is paid
It is riskier (due to not intermittent payments), thus carries a higher interest rate
What is the typical equity % of uses of funds in a PE acquisition?
25% - 50%
What is second lien debt?
Fixed or floating?
Bullet or amortizing?
Investor base of hedge funds
Floating (Libor + spread)
Bullet
What is the residual equity value formula?
What would be a selling multiple?
EV - Net Debt
Enterprise value can be the purchase price paid or the new EV based on the selling multiple.
A multiple applied to EBITDA.
Debt features:
- Interest?
- Repayment date?
- Priority of payment?
- Security
- Covenants
- Cash vs PIK
- Bullet vs amortizing
- Senior vs junior
- Secured vs unsecured
- Covenants
Assume LTM EBITDA of $140 million with $70 million in net debt. The financial sponsor can borrow up to 6x total debt to EBITDA. The sponsor is willing to own equity up to 30% of purchase price and is targeting an IRR of 25%.
The sellers want a price of $1,120.
The final year, year 5, assume:
No change in exit multiple
EBITDA $145 million
Net Debt $350 million
Will this deal work?
IRR 23.7%
Max leverage $840
Initial equity investment $280
What are criteria needed for a company to be a suitable LBO investment?
- It must be undervalued
- It must have stable cash flows
- Must have manageable investment needs (CapEx)
- Must have a viable exit strategy
- It must be in a stable industry
- It must have disciplined management
What is the max purchase price formula?
Total Debt Capacity / % Debt Contribution
What are the drivers of value in an LBO?
- Increasing FCF to pay down more debt and subsequently increasing EBITDA to lead to a higher exit value
- Improving the business to increase its multiple
- Interest tax shield, which leads to lower cash taxes paid
What is the Total Debt Capacity formula?
Total Debt Capacity = Max Leverage multiple x EBITDA
What is a non-corporate example of an LBO?
A house flipper.
A person takes out a mortgage with little equity and purchases a house. It improves the house by performining maintenance, interior design, etc. The buyer rents the house to occupants, and the buyers uses those rental payments to pay off the mortgage. Once the mortgage has been paid off, it sells the home. Thus, it generates returns on the little equity it initally put in.
What are the 3 main goals of a PE firm once a deal has been executed? Explain each goal.
De-leveraging
Essentially paying down debt.
Operational improvements to improve cash flow
- sales growth
- margin improvements
Multiple expansion
This is to increase the selling multiple when the sponsor wants to exit the investment. For example, say the purchase multiple is 7x, but due to operational efficiencies and debt reduction, the company could be acquired for 8x given market conditions.
