LBO

Question 1

What is an LBO? What is the buyers goal?

Answer 1

It is the acquisition of a target (can be a company, division or collection of assets) using debt to finance a large portion of the purchase price

To realise an acceptable return on its equity investment upon exit, typically through an IPO or sale of the target. Investors have historically sough a 20%+ annualised return and an investment exit within five years

Question 2

What are the pros and risks involved in an LBO?

Answer 2

Pros:
As the debt ratio increases in the leverage in the LBO financing, the equity portion shrinks, allowing for PE firms to acquire the business by just putting up 20-40% of the purchase price.

Risks:
Ability to pay interest payments. In times of recession, litigation, regulatory environment change, problems resulting in technical defaults, breaches of debt covenant or even liquidation can occur

Question 3

How do PE firms generally structure their equity investment and why?

Answer 3

Through preferred stock. Their dividend payments provide a minimum ROI while still allowing them to participated in the equity upside.

Question 4

Explain the different levels of debt typical in an LBO.

Answer 4

Bank debt - cheapest form of debt usually securitized by the targets asset base or cash flows. These are the most senior levels of debt and is paid out first in the event of default

Mezzanine debt - middle level debt, junior to bank debt and senior to lower levels of high yield debt. With a lower priority, it is compensated with higher interest payments just as each succeeding level of junior debt

Subordinated or High Yield debt/notes - known as junk bonds. Usually sold to the public and are the most junior source of debt financing and as such command the highest interest rates to compensate holders for their increased risk exposure

Question 5

What is cash sweep?

Answer 5

Is a provision of a certain debt covenant that stipulates that any excess cash ( namely free cash flows available after mandatory amortization payments have been made) generated by the target business will be used to pay down principal. For tranche of debt with provisions of a cash sweep, excess cash is paid down in order of seniority

Question 6

How does a LBO target exit and what’s the investment horizon?

Answer 6

LBO firms seek to exit their investments in 5-7 years. An exit usually involves either a sale of the portfolio company, an IPO or a recapitalization (effectively an acquisition and relevering of the company by another LBO firm)

Question 7

What are some strong characteristics of a strong LBO candidate?why?

Answer 7

• strong cash flow generation -> given highly leveraged capital structure of a LBO, need to have display that can support periodic interest payments and debt principal repayment over the life of the loans and securities (steady non cyclical cash flows)
• strong management team
• Low capex requirements
  Again relates to strength of cash generation. However high capex can still be strong candidate if strong margins, growth profile and business strategy is validated during due diligence
• leading and defensible market positions
  Reflects entrenched customer relationships, brand name recognition, superior products and services, favourable cost structure, and scale advantages among other factors-> again creates barriers to entry to increase stability and predictability of cash flows
• growth opportunities
  Both in terms of organic growth and bolt on acquisitions. -> profitable top line growth at above market rates helps drive outsized returns, generating cash for debt repayment and also increasing EBITDA and EV
• efficiency enhancement opportunities
  Opportunities for cost structure enhancement and synergies
• strong asset base
  Helps in acting as collateral and gives greater assurance to investors. Value of assets dictate the amount of bank debt available

Question 8

What is IRR formula, and in words for an LBO?

Answer 8

IRR = the discount rate for the cash inflows and outflows of the company within the investment horizon in order to produce a net present value of zero

It measures the total return in a sponsors’ equity investment, including any additional equity contributions made or dividends received, during the investment horizon

The shorter the time period, the higher the IRR

IRR = root^timeperiod (exit value/initial value) - 1

Question 9

What are the exit strategies / monetisation means for sponsors?

Answer 9

Sale to strategic buyers / other sponsor

IPO

Dividend recap

Distressed debt repurchase

Question 10

What is a dividend recap and what are it’s advantages?

Answer 10

Using the target company to issue more debt in order to pay shareholders a dividend. The incremental debt may be issued I. The form of an add on to the targets existing credit facilities and/or bonds, a new security at the holdco level or as part of a complete refinancing of the existing capital structure

It allows the sponsor to retain 100% of its ownership position in the target.

Question 11

What additional function does a revolver provide?

Answer 11

Can use it to fund a portion of the purchase price in an LBO

Question 12

What is an asset based lending facility?

Answer 12

Allows the borrow to borrow funds based on a percentage of the current asset metric
85% x AR + 60% x Inventory

Question 13

What are A, B and

Second lien type term loans?

Answer 13

TLAs are know as amortizing term loans, as they require substantial principal repayment throughout the life of the loan. These loans are perceived less risky by lenders due to shorter duration of life. Thus, they are the lowest priced in the capital structure and after have same termination as the revolver. TLAs are syndicated to commercial banks and finance companies

TLBs are known as institutional term loans and are more prevalent than TLAs in LBO financing. These loans have longer maturities, larger in size and higher coupon rates. (~7years maturity)

Prevalence of second lien term loans is a sign of a strong debt market such as the mid 2000s

Generally first lien loans are amortizable while second lines and junior debt do not amortize and just have a bullet payment at maturity

Question 14

What is mezzanine debt?

Answer 14

It is the layer of capital that lies between traditional debt and equity. It is a highly negotiated instrument between the issuer and investors that is tailored to meet the financing needs of a specific transaction and required investors return.

For sponsors, MD provides incremental capita at a cost below equity which provides higher leverage levels and purchase price when alternative capital sources are inaccessible.

MD may serve to supplement or substitute for high yield bonds esp for smaller companies where their size needs are below high yield bond market minimum thresholds - thus extremely prevalent in middle market transactions

Question 15

What is the difference between contractual and structural subordination?

Answer 15

Contractual is the priority of the debt instruments within the same legal entity

Structural is the priority of debt instruments within different legal entities within a company

Question 16

What is a call protection?

Answer 16

It is certain restrictions on voluntary prepayments (bank debt) or redemptions (bonds) during a defined period within a debt instruments term.

These restrictions outrightly prohibits or require payment of a substantial fee (cal premium) if the borrower wants to have any voluntary redemption or prepayment. This protects investors from having debt with an attractive yield refinanced long before maturity.

Call protections are usually fixed at time periods for high yield bonds NC4 for 7/8 year bonds and NC5 for 10 year fixed rate bonds

Question 17

Describe types of value creation in an LBO

Answer 17

1. Delevering - paying off the debt used to finance the LBO such that the value of equity increases and healthy returns are generated
2. Operational enhancements - this is through organic growth, cost cutting, and realisation of synergies from bolt-on acquisitions. -> as Cash flows grow, value of assets grow and equity along with it
3. Multiple expansion - buying Low and selling high. However multiple expansion is market-driven and beyond the control of the company and the sponsor. Basically higher market driven price puts more value onto the firm

Question 18

What is recapitalization in an LBO? And what is it’s use?

Answer 18

It is the accounting for the repurchase, by a corporation, of its own common stock. The price paid is booked as a decrease to shareholders equity and the repurchased shares held as treasury stock. No adjustments to the basis of assets and liabilities of the company.

In an LBO context, recaps are typically accounted for by the target company as the sale of equity securities, the issuance of new debt, the retirement of existing debt, and the purchase and retirement of treasury stock.

Benefits:
Reported earnings in the future are not burdened by a higher depreciation associated with the excess of the purchase price over the book value of the net assets acquired (goodwill/intangibles)-> this was more relevant before the FASB introduced the SFAS142 which eliminated the amortization of goodwill.

Avoids push down accounting (write up of assets) into a target company’s standalone financial statements.

Thus,

• eliminates future income statement charges for higher depreciation, resulting in Higher net income for the target company
• thus presents the target company with better ipo prospects given the P/E focus of ipos
• usually results in negative book value of equity

Question 19

Walk me through a basic LBO Model

Answer 19

Step 1 is making assumptions about the purchase price, debt to equity ratios, interest rate in 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 and uses sheet, which shows you how you finance the transaction and what you use the capital for. This also tells you how much investor equity is required

Step 3 is to adjust the company’s balance sheet for the new debt and equity figures and also add in goodwill and other intangibles on the assets side to make everything balance

Step 4 is to 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 payments

Step 5 is to finally make assumptions about the exit after several years, usually assuming an EBITDA multiple, and calculate the return based on how much equity is returned to the firm.

Question 20

We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that’s the case, why would a PE firm want to use debt in an LBO?

Answer 20

It’s a different scenario because:

1. The PE firm does not intend to hold the company for the Long term - it usually sells it after a few years, so it is less concerned with the ‘expense’ of cash vs debt and more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront.
2. In an LBO, the debt is “owned” by the company, so they assume much of the risk. Whereas in a strategic acquisition, the buyer “owns” the debt so it is more risky for them

Question 21

Why would a firm use bank debt rather than high yield debt in an LBO?

Answer 21

If the PE firm is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt; they might also use bank debt if they are planning on major expansion or capital expenditures and don’t want to be restricted by incurrence covenants

Question 22

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

Answer 22

1. Lower the purchase price in the model
2. Raise the exit multiple / exit price
3. Raise the leverage used
4. Increase the company’s growth rate
5. Increase margins by reducing expenses

These are all theoretical and refer to the model rather than reality