LBO Flashcards
How do you pick purchase multiples and exit multiples in an LBO model?
The same way you do it anywhere else: you look at what comparable companies are
trading at, and what multiples similar LBO transactions have had. As always, you also
show a range of purchase and exit multiples using sensitivity tables.
Sometimes you set purchase and exit multiples based on a specific IRR target that you’re
trying to achieve – but this is just for valuation purposes if you’re using an LBO model
to value the company.
How would an asset write-up or write-down affect an LBO model? / Walk me
through how you adjust the Balance Sheet in an LBO model.
All of this is very similar to what you would see in a merger model – you calculate
Goodwill, Other Intangibles, and the rest of the write-ups in the same way, and then the
Balance Sheet adjustments (e.g. subtracting cash, adding in capitalized financing fees,
writing up assets, wiping out goodwill, adjusting the deferred tax assets / liabilities,
adding in new debt, etc.) are almost the same.
The key differences:
• In an LBO model you assume that the existing Shareholders’ Equity is wiped out
and replaced by the equity the private equity firm contributes to buy the
company; you may also add in Preferred Stock, Management Rollover, or
Rollover from Option Holders to this number as well depending on what you’re
assuming for transaction financing.
• In an LBO model you’ll usually be adding a lot more tranches of debt vs. what
you would see in a merger model.
• In an LBO model you’re not combining two companies’ Balance Sheets.
How do you use an LBO model to value a company, and why do we sometimes say
that it sets the “floor valuation” for the company?
You use it to value a company by setting a targeted IRR (for example, 25%) and then
back-solving in Excel to determine what purchase price the PE firm could pay to achieve
that IRR.
This is sometimes called a “floor valuation” because PE firms almost always pay less for
a company than strategic acquirers would.
Give an example of a “real-life” LBO.
The most common example is taking out a mortgage when you buy a house. Here’s how
the analogy works:
• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Selling the House: Selling the Company / Taking It Public in an LBO
Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?
This is completely dependent on the company, the industry, and the leverage and
coverage ratios for comparable LBO transactions.
To figure out the numbers, you would look at “debt comps” showing the types, tranches,
and terms of debt that similarly sized companies in the industry have used recently.
There are some general rules: for example, you would never lever a company at 50x
EBITDA, and even during the bubble leverage rarely exceeded 5-10x EBITDA.
Normally we care about the IRR for the equity investors in an LBO – the PE firm
that buys the company – but how do we calculate the IRR for the debt investors?
For the debt investors, you need to calculate the interest and principal payments they
receive from the company each year.
Then you simply use the IRR function in Excel and start with the negative amount of the
original debt for “Year 0,” assume that the interest and principal payments each year are
your “cash flows” and then assume that the remaining debt balance in the final year is
your “exit value.
Most of the time, returns for debt investors will be lower than returns for the equity
investors – but if the deal goes poorly or the PE firm can’t sell the company for a good
price, the reverse could easily be true.
Why might a private equity firm allot some of a company’s new equity in an LBO to
a management option pool, and how would this affect the model?
This is done for the same reason you have an Earnout in an M&A deal: the PE firm
wants to incentivize the management team and keep everyone on-board until they exit
the investment.
The difference is that there’s no technical limit on how much management might receive
from such an option pool: if they hit it out of the park, maybe they’ll all become
millionaires.
In your LBO model, you would need to calculate a per-share purchase price when the
PE firm exits the investment, and then calculate how much of the proceeds go to the
management team based on the Treasury Stock Method.
An option pool by itself would reduce the PE firm’s return, but this is offset by the fact
that the company should perform better with this incentive in place.
Why you would you use PIK (Payment In Kind) debt rather than other types of
debt, and how does it affect the debt schedules and the other statements?
Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest
payments – instead, the interest just accrues to the loan principal, which keeps going up
over time. A PIK “toggle” allows the company to choose whether to pay the interest in
cash or have it accrue to the principal (these have disappeared since the credit crunch).
PIK is more risky than other forms of debt and carries with it a higher interest rate than
traditional bank debt or high yield debt.
Adding it to the debt schedules is similar to adding high-yield debt with a bullet
maturity – except instead of assuming cash interest payments, you assume that the
interest accrues to the principal instead.
You should then include this interest on the Income Statement, but you need to add back
any PIK interest on the Cash Flow Statement because it’s a non-cash expense
Tell me about all the different kinds of debt you could use in an LBO and the
differences between everything.
Here’s a handy chart to explain all of this. Note that this chart does not cover every
single feature or every single type of debt in the universe – just the most important ones,
and what you’re likely to be asked about in finance interviews:
Debt Type Revolver Term Loan A Term Loan B Senior Notes Subordinated Notes Mezzanine
Interest Rate: Lowest Low Higher Higher Higher Highest
Floating / Fixed? Floating Fixed
Cash Interest? Yes Cash / PIK
Tenor: 3-5 years 4-6 years 4-8 years 7-10 years 8-10 years 8-12 years
Amortization: None Straight Line Minimal Bullet
Prepayment? Yes No
Investors: Conservative Banks HFs, Merchant Banks, Mezzanine Funds
Seniority Senior Secured Senior Unsecured Senior Subordinated Equity
Secured? Yes Sometimes No
Call Protection? No Sometimes Yes
Covenants: Maintenance Incurrence
“Tenor” is just the fancy word for “How many years will this loan be outstanding?”
Each type of debt is arranged in order of rising interest rates – so a revolver has the
lowest interest rate, Term Loan A is slightly higher, B is slightly higher, Senior Notes are
higher than Term Loan B, and so on.
“Seniority” refers to the order of claims on a company’s assets in a bankruptcy – the
Senior Secured holders are first in line, followed by Senior Unsecured, Senior
Subordinated, and then Equity Investors.
“Floating” or “Fixed” Interest Rates: A “floating” interest rate is tied to LIBOR. For
example, L + 100 means that the interest rate of the loan is whatever LIBOR is at
currently, plus 100 basis points (1.0%). A fixed interest rate, on the other hand, would be
11%. It doesn’t “float” with LIBOR or any other rate.
Amortization: “straight line” means the company pays off the principal in equal
installments each year, while “bullet” means that the entire principal is due at the end of
the loan’s lifecycle. “Minimal” just means a low percentage of the principal each year,
usually in the 1-5% range.
Call Protection: Is the company prohibited from “calling back” – paying off or
redeeming – the security for a certain period? This is beneficial for investors because
they are guaranteed a certain number of interest payments.
What are some examples of incurrence covenants? Maintenance covenants?
Incurrence Covenants: • Company cannot take on more than $2 billion of total debt.
• Proceeds from any asset sales must be earmarked to repay debt.
• Company cannot make acquisitions of over $200 million in size.
• Company cannot spend more than $100 million on CapEx each year.
Maintenance Covenants:
• Total Debt / EBITDA cannot exceed 3.0 x
• Senior Debt / EBITDA cannot exceed 2.0 x
• (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0 x
• EBITDA / Interest Expense cannot fall below 5.0 x
• EBITDA / Cash Interest Expense cannot fall below 3.0 x
• (EBITDA – CapEx) / Interest Expense cannot fall below 2.0 x
Just like a normal M&A deal, you can structure an LBO either as a stock purchase
or as an asset purchase. Can you also use Section 338(h)(10) election?
In most cases, no – because one of the requirements for Section 338(h)(10) is that the
buyer must be a C corporation. Most private equity firms are organized as LLCs or
Limited Partnerships, and when they acquire companies in an LBO, they create an LLC
shell company that “acquires” the company on paper.
What is meant by the “tax shield” in an LBO?
This means that the interest a firm pays on debt is tax-deductible – so they save money
on taxes and therefore increase their cash flow as a result of having debt from the LBO.
Note, however, that their cash flow is still lower than it would be without the debt –
saving on taxes helps, but the added interest expenses still reduces Net Income over
what it would be for a debt-free company.
Walk me through how you calculate optional repayments on debt in an LBO model.
First, note that you only look at optional repayments for Revolvers and Term Loans –
high-yield debt doesn’t have a prepayment option, so effectively it’s always $0.
First, you check how much cash flow you have available based on your Beginning Cash
Balance, Minimum Cash Balance, Cash Flow Available for Debt Repayment from the
Cash Flow Statement, and how much you use to make Mandatory Debt Repayments.
Then, if you’ve used your Revolver at all you pay off the maximum amount that you can
with the cash flow you have available.
Next, for Term Loan A you assume that you pay off the maximum you can, taking into
account that you’ve lost any cash flow you used to pay down the Revolver. You also
need to take into account that you might have paid off some of Term Loan A’s principal
as part of the Mandatory Repayments.
Finally, you do the same thing for Term Loan B, subtracting from the “cash flow
available for debt repayment” what you’ve already used up on the Revolver and Term
Loan A. And just like Term Loan A, you need to take into account any Mandatory
Repayments you’ve made so that you don’t pay off more than the entire Term Loan B
balance.
The formulas here get very messy and depend on how your model is set up, but this is
the basic idea for optional debt repayments.
Explain how a Revolver is used in an LBO model.
You use a Revolver when the cash required for your Mandatory Debt Repayments
exceeds the cash flow you have available to repay them.
The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment – Cash
Flow Available to Repay Debt).
The Revolver starts off “undrawn,” meaning that you don’t actually borrow money and
don’t accrue a balance unless you need it – similar to how credit cards work.
You add any required Revolver Borrowing to your running total for cash flow available
for debt repayment before you calculate Mandatory and Optional Debt Repayments.
Within the debt repayments themselves, you assume that any Revolver Borrowing from
previous years is paid off first with excess cash flow before you pay off any Term Loans.
How would you adjust the Income Statement in an LBO model?
The most common adjustments:
• Cost Savings – Often you assume the PE firm cuts costs by laying off employees,
which could affect COGS, Operating Expenses, or both.
• New Depreciation Expense – This comes from any PP&E write-ups in the
transaction.
• New Amortization Expense – This includes both the amortization from writtenup
intangibles and from capitalized financing fees.
• Interest Expense on LBO Debt – You need to include both cash and PIK interest
here.
• Sponsor Management Fees – Sometimes PE firms charge a “management fee” to
a company to account for the time and effort they spend managing it.
• Common Stock Dividend – Although private companies don’t pay dividends to
shareholders, they could pay out a dividend recap to the PE investors.
• Preferred Stock Dividend – If Preferred Stock is used as a form of financing in
the transaction, you need to account for Preferred Stock Dividends on the Income
Statement.
Cost Savings and new Depreciation / Amortization hit the Operating Income line;
Interest Expense and Sponsor Management Fees hit Pre-Tax Income; and you need to
subtract the dividend items from your Net Income number.
In an LBO model, is it possible for debt investors to get a higher return than the PE
firm? What does it tell us about the company we’re modeling?
Yes, and it happens more commonly than you’d think. Remember, high-yield debt
investors often get interest rates of 10-15% or more – which effectively guarantees an
IRR in that range for them.
So no matter what happens to the company or the market, that debt gets repaid and the
debt investors get the interest payments.
But let’s say that the median EBITDA multiples contract, or that the company fails to
grow or actually shrinks – in these cases the PE firm could easily get an IRR below what
the debt investors get.
Most of the time, increased leverage means an increased IRR. Explain how
increasing the leverage could reduce the IRR.
This scenario is admittedly rare, but it could happen if the increase leverage increases
interest payments or debt repayments to very high levels, preventing the company from
using its cash flow for other purposes.
Sometimes in LBO models, increasing the leverage increases the IRR up to a certain
point – but then after that the IRR starts falling as the interest payments or principal
repayments become “too big.”
For this scenario to happen you would need a “perfect storm” of:
1. Relative lack of cash flow / EBITDA growth.
2. High interest payments and principal repayments relative to cash flow.
3. Relatively high purchase premium or purchase multiple to make it more difficult
to get a high IRR in the first place
What is a leveraged buyout, and why does it work?
In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of debt and equity (cash), operates it for several years, possibly makes operational improvements, and then sells the company at the end of the period to realize a return on investment.
During the period of ownership, the PE firm uses the company’s cash flows to pay interest expense from the debt and to pay off debt principal.
An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns.
2. Using the company’s cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows.
3. The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to acquire it in the first place.
Why do PE firms use leverage when buying a company?
They use leverage to increase their returns.
Any debt raised for an LBO is not “your money” – so if you’re paying $5 billion for a company, it’s easier to earn a high return on $2 billion of your own money and $3 billion borrowed from other people than it is on $5 billion of your own money.
A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used debt rather than their own funds.
Walk me through a basic LBO model
“In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you might also assume something about the company’s operations, such as Revenue Growth or Margins, depending on how much information you have.
Step 2 is to create a Sources & Uses section, which shows how the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required.
Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, allocate the purchase price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
In Step 4, you project out the company’s Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest
Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.
What variables impact a leveraged buyout the most
Purchase and exit multiples (and therefore purchase and exit prices) have the greatest impact, followed by the amount of leverage (debt) used.
A lower purchase price equals a higher return, whereas a higher exit price results in a higher return; generally, more leverage also results in higher returns (as long as the company can still meet its debt obligations).
Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an impact as well, but they are less significant than those first 3 variables.
How do you pick purchase multiples and exit multiples in an LBO model?
The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have been completed at. As always, you show a range of purchase and exit multiples using sensitivity tables.
Sometimes you set purchase and exit multiples based on a specific IRR target that you’re trying to achieve – but this is just for valuation purposes if you’re using an LBO model to value the company.
What is an “ideal” candidate for an LBO?
Ideal candidates should:
• Have stable and predictable cash flows (so they can repay debt);
• Be undervalued relative to peers in the industry (lower purchase price);
• Be low-risk businesses (debt repayments);
• Not have much need for ongoing investments such as CapEx;
• Have an opportunity to cut costs and increase margins;
• Have a strong management team;
• Have a solid base of assets to use as collateral for debt.
The first point about stable cash flows is the most important one.
How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?
You use it to value a company by setting a targeted IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR.
This is sometimes called a “floor valuation” because PE firms almost always pay less for a company than strategic acquirers would.
Wait a minute, how is an LBO valuation different from a DCF valuation? Don’t they both value the company based on its cash flows?
The difference is that in a DCF you’re saying, “What could this company be worth, based on the present value of its near-future and far-future cash flows?”
But in an LBO you’re saying, “What can we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?”
So both methodologies are similar, but with the LBO valuation you’re constraining the values based on the returns you’re targeting.
Give me an example of a “real-life” LBO.
The most common example is taking out a mortgage when you buy a house. We think it’s better to think of it as, “Buying a house that you rent out to other
people” because that situation is more similar to buying a company that generates cash flow.
Here’s how the analogy works:
• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Rental Income from Tenants: Cash Flow to Pay Interest and Repay Debt in an LBO
• Selling the House: Selling the Company or Taking It Public in an LBO
A strategic acquirer usually prefers to pay for another company with 100% cash – if that’s the case, why would a PE firm want to use debt in an LBO?
It’s a different scenario because:
- The PE firm does not hold the company for the long-term – it sells it after a few years, so it is less concerned with the higher “expense” of debt over cash and is more concerned about using leverage to boost its returns by reducing the capital it contributes upfront.
- In an LBO, the company is responsible for repaying the debt, so the company assumes much of the risk. Whereas in a strategic acquisition, the buyer “owns” the debt, so it is more risky for them.
Why would a private equity firm buy a company in a “risky” industry, such as technology?
Although technology is “riskier” than other markets, remember that there are mature, cash flow-stable companies in almost every industry. There are PE firms that specialize in very specific goals, such as:
• Industry Consolidation – Buying competitors in a market and combining them to increase efficiency and win more customers.
• Turnarounds – Taking struggling companies and improving their operations.
• Divestitures – Selling off divisions of a company or turning a division into a strong stand-alone entity.
So even if a company isn’t doing well or even if it seems risky, the PE firm might buy it if it falls into one of the categories that the firm focuses on.
This whole issue of “risk” is more applicable in industries where companies truly have unstable cash flows – anything based on commodities, such as oil, gas, and mining, for example.
How could a private equity firm boost its return in an LBO?
- Reduce the Purchase Price.
- Increase the Exit Multiple and Exit Price.
- Increase the Leverage (debt) used.
- Increase the company’s growth rate (organically or via acquisitions).
- Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.).
These are all “theoretical” and refer to the model rather than reality – in practice it’s hard to actually implement these changes.
How could you determine how much debt can be raised in an LBO and how many tranches there would be?
Usually you would look at recent, similar LBOs and assess the debt terms and tranches that were used in each transaction.
You could also look at companies in a similar size range and industry, see how much debt outstanding they have, and base your own numbers on those.
Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?
This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions.
To figure out the numbers, you would look at “Debt Comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently.
There are some general rules: for example, you would never lever a company at 50x EBITDA, and even during bubbles leverage rarely exceeds 10x EBITDA.
For interest coverage ratios (e.g. EBITDA / Interest), you want a number where the company can pay for its interest without much trouble, but also not so high that the company could clearly afford to take on more debt.
For example, a 20x coverage ratio would be far too high because the company could easily pay 2-3x more in interest. But a 2x coverage ratio would be too low because a small decrease in EBITDA might result in disaster at that level.
What is the difference between Bank Debt and High-Yield Debt?
This is a simplification, but broadly speaking there are 2 “types” of Debt: “Bank Debt” and “High-Yield Debt.”
There are many differences, but here are a few of the most important ones:
• High-Yield Debt tends to have higher interest rates than Bank Debt (hence the name “high-yield”) since it’s riskier for investors.
• High-Yield Debt interest rates are usually fixed, whereas Bank Debt interest rates are “floating” – they change based on LIBOR (or the prevailing interest rates in the economy).
• High-Yield Debt has incurrence covenants while Bank Debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.) while maintenance covenants require you to maintain a minimum financial performance (for example, the Total Debt / EBITDA ratio must be below 5x at all times).
• Bank Debt is usually amortized – the principal must be paid off over time – whereas with High-Yield Debt, the entire principal is due at the end (bullet maturity) and early principal repayments are not allowed.
Usually in a sizable leveraged buyout, the PE firm uses both types of debt.
Wait a minute. If High-Yield Debt is “riskier,” why are early principal repayments not allowed? Shouldn’t investors want to reduce their risk?
This isn’t the right way to think about it – remember that investors need to be compensated for the risk they take. And now think about what happens if early repayment is allowed:
• Initially, the investors might earn $100 million in interest on $1 billion worth of debt, at a 10% interest rate.
• Without early repayment, the investors keep getting that $100 million in interest each year paid directly to them.
• With early repayment, this interest payment drops each year and the investors receive increasingly less each year – and that drops their effective return.
All else being equal, debt investors want companies to keep debt on their Balance Sheets for as long as possible.
