LBO

Question 1

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

Answer 1

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.

Question 2

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.

Answer 2

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.

Question 3

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?

Answer 3

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

Question 4

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?

Answer 4

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

Question 5

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?

Answer 5

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.

Question 6

What are some examples of incurrence covenants? Maintenance covenants?

Answer 6

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

Question 7

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?

Answer 7

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.

Question 8

What is meant by the “tax shield” in an LBO?

Answer 8

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.

Question 9

Walk me through how you calculate optional repayments on debt in an LBO
model.

Answer 9

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.

Question 10

Explain how a Revolver is used in an LBO model.

Answer 10

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.

Question 11

How would you adjust the Income Statement in an LBO model?

Answer 11

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.

Question 12

Most of the time, increased leverage means an increased IRR. Explain how
increasing the leverage could reduce the IRR.

Answer 12

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.

Question 13

How do you calculate Free Cash Flow in an LBO

Answer 13

In the context of an LBO model, “Free Cash Flow” means Cash Flow from Operations minus CapEx. That is slightly different from the definitions used for Levered FCF and Unlevered FCF in the DCF section of the guide.
Here it really means: “How much cash do we have available to repay debt principal each year, after we’ve already paid for our normal expenses and for the interest expense on that debt?”
IF there are other recurring items in the Cash Flow from Investing and Cash Flow from Financing sections (e.g. investment purchases or sales each year), you may include those here as well – but it’s not particularly common to see them in an LBO model.

Question 14

Rule of thumb returns

Answer 14

If a PE firm doubles its money in 5 years, that’s a 15% IRR.
• If a PE firm triples its money in 5 years, that’s a 25% IRR.
• If a PE firm doubles its money in 3 years, that’s a 26% IRR.
• If a PE firm triples its money in 3 years, that’s a 44% IRR.

Question 15

What Affects the IRR in an LBO?

Answer 15

These variables make the greatest impact on IRR in a leveraged buyout:
1. Purchase Price
2. % Debt and % Equity Used
3. Exit Price
Other factors include the revenue growth rate, EBITDA margins, interest rates, and anything else that affects cash flow on the financial statements.
• Changes That Increase IRR: Lower Purchase Price, Less Equity, Higher Revenue Growth, Higher EBITDA Margins, Lower Interest Rates, Lower CapEx
• Changes That Reduce IRR: Higher Purchase Price, More Equity, Lower Revenue Growth, Lower EBITDA Margins, Higher Interest Rates, Higher CapEx

Question 16

What is a leveraged buyout, and why does it work?

Answer 16

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.
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

Question 17

Why do PE firms use leverage when buying a company?

Answer 17

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

Question 18

Walk me through a basic LBO model

Answer 18

“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 Payments.
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.”

Question 19

What variables impact a leveraged buyout the most?

Answer 19

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.

Question 20

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

Answer 20

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

Question 21

What is the difference between Bank Debt and High-Yield Debt?

Answer 21

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.

Question 22

How does refinancing vs. assuming existing debt work in an LBO model?

Answer 22

If the PE firm assumes debt when acquiring a company, that debt remains on the Balance Sheet and must be paid off (both interest and principal) over time. And it has no net effect on the funds required to acquire the company. In this case, the existing debt shows up in both the Sources and Uses columns.
If the PE firm refinances debt, it pays it off, usually replacing it with new debt that it raises to acquire the company. Refinancing debt means that additional funds are required, so the effective purchase price goes up. In this case, the existing debt shows up only in the Uses column.

Question 23

How do transaction and financing fees factor into the LBO model?

Answer 23

You pay for all of these fees upfront in cash (legal, advisory, and financing fees paid on the debt), but the accounting treatment is different:
• Legal & Advisory Fees: These come out of Cash and Retained Earnings immediately as the transaction closes.
• Financing Fees: These are amortized over time (for as long as the Debt remains outstanding), very similar to how CapEx and PP&E work: you
pay for them upfront in cash, create a new Asset on the Balance Sheet, and then reduce that Asset over time as the fees are recognized on the Income Statement.

Question 24

Can you explain how the Balance Sheet is adjusted in an LBO model?

Answer 24

First, the Liabilities & Equity side is adjusted – the new debt is added, and the Shareholders’ Equity is “wiped out” and replaced by however much Investor Equity the private equity firm is contributing (i.e. how much cash it’s paying for the company).
On the Assets side, Cash is adjusted for any cash used to finance the transaction and for transaction fees, and then Goodwill & Other Intangibles are used as a “plug” to make the Balance Sheet balance.
There will also be all the usual effects that you see in transactions: Asset Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing Fees, and so on.

Question 25

Why are Goodwill & Other Intangibles created in an LBO?

Answer 25

These both represent the premium paid to the Shareholders’ Equity of the company. In an LBO, they act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.
So if the company’s Shareholders’ Equity was originally worth $1 billion and the PE firm pays $1.5 billion to acquire the company, roughly $500 million in Goodwill & Other Intangibles will be created.

Question 26

What if the company has existing debt? How does that affect the projections?

Answer 26

If the company has existing debt and the PE firm refinances it (pays it off), it’s a non-factor because it goes away. If the PE firm assumes the debt instead, you need to factor in interest and principal repayments on that debt over future years.
Normally you do this by assuming that existing debt principal is paid off first after you’ve calculated Cash Flow from Operations minus CapEx. Then, you can use any remaining cash flow after that to pay off debt principal for new debt raised in the LBO.

Question 27

What is meant by the “tax shield” in an LBO?

Answer 27

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 the debt from the LBO.
Note, however, that the firm’s cash flow is still lower than it would have been without the debt – saving on taxes helps, but the added interest expense still reduces Net Income by more than the reduced taxes helps the firm.
A lot of people get confused about this point and think that this “tax shield” is a really big deal in an LBO, but it makes a marginal difference compared to all the other variables.

Question 28

What is a dividend recapitalization (“dividend recap”)?

Answer 28

In a dividend recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it.
It would be like if you made your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds.
Dividend recaps boost the IRR in a leveraged buyout because they help the PE firm to recover some of its initial investment early. They have developed a bad reputation among some lenders because the debt in this case does not actually benefit the company itself.

Question 29

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

Answer 29

Primarily to boost returns. Remember, all else being equal, more leverage means a higher return to the firm.
With a dividend recap, the PE firm is “recovering” some of its equity investment in the company – and as we saw earlier, the lower the equity investment, the better, since it’s easier to earn a higher return on a smaller amount of capital.

Question 30

How would a dividend recap impact the 3 financial statements in an LBO?

Answer 30

No changes to the Income Statement. On the Balance Sheet, Debt goes up and Shareholders’ Equity goes down, canceling each other out, so that everything remains in balance.
On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Cash Flow from Financing the additional Debt raised would cancel out the Dividend paid out to investors, so there would be no net change in cash.

Question 31

Wait a minute, how are Call Protection and “Prepayment” different? Don’t they refer to the same concept?

Answer 31

Call Protection refers to paying off the entire debt balance, whereas “Prepayment” refers to repaying part of the principal early, before the official maturity date.

Question 32

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?

Answer 32

`Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest payments – instead, the interest 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.
PIK is riskier 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.
You 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.

Question 33

How does Preferred Stock fit into these different financing methods? Isn’t it a type of Debt as well?

Answer 33

Preferred Stock is similar to Debt and it would match the “Mezzanine” column in the table above most closely. Just like with Mezzanine, Preferred Stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt. It’s not included in the table above due to space constraints.

Question 34

How do you treat Noncontrolling Interests (AKA Minority Interests) and Investments in Equity Interests (AKA Associate Companies) in an LBO model?

Answer 34

Normally you leave these alone and assume that nothing happens – so they show up in both the Sources and Uses columns when you make assumptions in the beginning.
You could assume that the private equity firm acquires one or both of these, in which case they would only show up in the Uses column – similar to refinancing Debt.

Question 35

What about “Excess Cash”? Why do you sometimes see that in a Sources & Uses table?

Answer 35

This represents the scenario where the company itself uses its excess cash (i.e. if it only requires $10 million in cash but has $50 million on its Balance Sheet, $40 million is the excess cash) to fund the transaction. This always shows up in the Sources column.
It’s just like how you subtract Cash when calculating Enterprise Value: an acquirer would “receive” that Cash upon buying the company.
You do not always see this item – it’s more common when the company has a huge amount of excess cash and has no real reason for having it.

Question 36

Walk me through how you adjust the Balance Sheet in an LBO model

Answer 36

This is very similar to what you see in a merger model – you calculate Goodwill, Other Intangible Assets, 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 value of the cash 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 your assumptions.
• In an LBO model you’ll usually add more tranches of debt compared to what you would see in a merger model.
• In an LBO model you’re not combining two companies’ Balance Sheets.

Question 37

Wait a second, why are Capitalized Financing Fees an Asset?

Answer 37

There are a couple ways to think about this:
• It’s just like the Prepaid Expenses item on the Assets side: paid for in cash up-front, and then recognized as an expense over many years. Since the company has already paid for it in cash, it’s not going to cost them anything more in future periods.
• An Asset represents potential future income or potential future savings; Capitalized Financing Fees have already been paid in cash, so when the expense is recognized on the Income Statement over several years it reduces the company’s taxes (similar to Prepaid Expenses).

Question 38

Explain how a Revolver is used in an LBO model.

Answer 38

You use a Revolver when the cash required for Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
• Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment – Cash Flow Available to Repay Debt)
The Revolver starts off “undrawn,” meaning that you don’t 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

Question 39

Let’s walk through a real-life example of debt modeling now… let’s say that we have $100 million of debt with 5% cash interest, 5% PIK interest, and amortization of 10% per year. How do you reflect this on the financial statements?

Answer 39

To simplify this scenario, we’ll assume that interest is based on the beginning debt balance rather than the average balance over the course of the year.
• Income Statement: There’s $5 million of cash interest and $5 million of PIK interest, for a total of $10 million in interest expense, which reduces Pre-Tax Income by $10 million and Net Income by $6 million assuming a 40% tax rate.
• Cash Flow Statement: Net Income is $6 million lower, but you add back the $5 million in PIK interest because it was a non-cash charge. Cash Flow from Operations is down by $1 million. Since there’s 10% amortization per year, you repay $10 million of debt each year (and presumably the entire remaining amount at the end of the period) in the Cash Flow from Financing section – so cash at the bottom is down by $11 million.
• Balance Sheet: Cash is down by $11 million on the Assets side, so that entire side is down by $11 million. On the other side, Debt is up by $5 million due to the PIK interest but down by $10 million due to the principal repayment, for a net reduction of $5 million. Shareholders’ Equity is down by $6 million due to the reduced Net Income, so both sides are down by $11 million and balance.
Each year after this, you base the cash and PIK interest on the new debt principal number and adjust the rest of the numbers accordingly.

Question 40

Wait a minute – why do we show PIK interest in the Cash Flow from Operations section? Isn’t it a financing activity?

Answer 40

First, note that interest expense never shows up in the Cash Flow from Financing section because it is tax-deductible and it always appears on the Income Statement. So showing anything in that section for interest expense would be double-counting.
You show PIK interest in the CFO section because it is a non-cash expense – we’re adding it back because it’s just like Depreciation or Amortization. It reduces taxes but is not actually paid out in cash.

Question 41

What if there’s a stub period in a leveraged buyout? Normally you assume full years, but what happens if the PE firm acquires a company halfway through the year instead?

Answer 41

In this case, you have to project the financial statements for this “stub period,” which is easier than it sounds because it is usually a matter of multiplying the full-year statements by 1/4, 1/2, 3/4, and so on. If you have quarterly projections you could use those and avoid the need for extra math.
Example: If the PE firm buys the company on March 31, you would multiply the line items on the full-year Income Statement and Cash Flow Statement by 3/4 to determine the numbers from April 1 to December 31, which is three-quarters of the year. You would also have to project the Balance Sheet to the March 31 close date and use those numbers when adjusting the Balance Sheet and allocating the purchase price.
The IRR calculation will also be different in this case (see the next section).
This concept is not difficult, but it creates extra work without a huge benefit so most LBO models are built based on full calendar years instead.

Question 42

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 a Section 338(h)(10) election?

Answer 42

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.

Question 43

What if there’s an option for the management team to “roll over” its existing Equity rather than receive new shares or options?

Answer 43

table and it would reduce the amount of Equity and Debt the PE firm needs to use to acquire the company – because now the PE firm only needs to acquire 90%, or 95%, or some number less than 100%, rather than the entire company.
At the end, you would also subtract some of the proceeds and allocate them to the management team rather than the PE firm when calculating returns.
If nothing else changes, this reduces the PE firm’s IRR – but the idea is that it also incentivizes the management team to perform well and deliver greater results, which helps everyone.

Question 44

Let’s say that a PE firm buys a company that’s currently 20% owned by management, and the firm wants to maintain this 20% management ownership percentage afterward. Does the PE firm need to use a certain amount of Debt to maintain this ownership percentage, or does it not impact the model?

Answer 44

No. All this business with management ownership has nothing to do with the exact percentage of Debt and Equity used.
All that changes is that if the management team owns more, the PE firm can use less Debt and Equity (cash) overall to acquire the company.
Using 80% Debt vs. 60% Debt (or any other percentage) has no impact on the management ownership percentage, which is a separate issue entirely.

Question 45

A PE firm acquires a $100 million EBITDA company for a 10x purchase multiple and funds the deal with 60% Debt. The company’s EBITDA grows to $150 million by Year 5, but the exit multiple drops to 9x. The company repays $250 million of Debt in this time and generates no extra Cash. What’s the IRR?

Answer 45

Initially, the PE firm uses 40% Equity, which means $100 million * 10x * 40% = $400 million. The Exit Enterprise Value = $150 million * 9x = $1,350 million (Mental Math: $150 million * 10x = $1.5 billion, and subtract $150 million). The initial Debt amount was $600 million, and the company repaid $250 million, so $350 million of Debt remains upon exit. The Equity Proceeds to the PE firm are $1,350 million – $350 million = $1 billion. $1 billion / $400 million = 2.5x, which is in between 2x and 3x over 5 years; since 2x over 5 years is 15% and 3x is 25%, this IRR is approximately 20%.

Question 46

A PE firm acquires a $200 million EBITDA company using 50% Debt, at an EBITDA purchase multiple of 6x. The company’s EBITDA grows to $300 million by Year 3, and the exit multiple stays the same. Assuming the company pays its interest and required Debt principal but generates no additional Cash, what is the MINIMUM IRR?

Answer 46

The Purchase Enterprise Value is $200 million * 6x = $1.2 billion, and the PE firm uses $600 million of Investor Equity and $600 million of Debt. The Exit Enterprise Value in Year 3 is $300 million * 6x = $1.8 billion. The PE firm realizes the minimum IRR when the Equity Proceeds are at their minimum level. For that to happen, the company must repay no Debt and generate no additional Cash. We already know the company generates no additional Cash, so we have to calculate the Equity Proceeds under the assumption that the company repays no Debt. $1.8 billion – $600 million = $1.2 billion, which is a 2x multiple over 3 years. That corresponds to a ~25% IRR (technically, 26%), so that is the minimum in this scenario

Question 47

How does the IRR change if the company repays ALL its Debt but nothing else changes?

Answer 47

If the company repays the full Debt balance, the PE firm gets the full Exit Enterprise Value of $1.8 billion as Equity Proceeds at the end (i.e., $1.8 billion – $0 = $1.8 billion). The firm has tripled its money in 3 years, which is a ~45% IRR (technically, 44%). These results tell us that the IRR will be between 25% and 45% depending on the Debt repayment.

Question 48

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

Answer 48

A 2x multiple in 5 years is a 15% IRR, while a 3x multiple is a 25% IRR, so a 20% IRR should be right in between: A 2.5x multiple. Initially, we buy the business for an Enterprise Value of $1,000, using $500 of Investor Equity and $500 of Debt. We need to earn back $1,250 in proceeds at the end, since 2.5 * $500 = $1,250. The company repays $250 in Debt, which means that $250 in Debt remains at the end. Therefore, we need to sell the company for an Exit Enterprise Value of $1,250 + $250 = $1,500. Since the Exit Multiple stays the same at 10x, EBITDA must grow to $150 over 5 years.

Question 49

A PE firm acquires a business for a 12x EBITDA multiple, using 5x Debt / EBITDA, and plans to sell it in 5 years. The company’s initial EBITDA is $100, and it grows to $200 by Year 5. If there’s no Debt repayment and no additional Cash generation, what exit multiple do we need for a 25% IRR?

Answer 49

Initially, we buy the company for an Enterprise Value of $1,200 using Debt of $500 and Investor Equity of $700.
To realize a 25% IRR over 5 years, we need to triple our money by earning $2,100 in proceeds at the end. No Debt is repaid, so we need to sell the company for an Exit Enterprise Value of $2,600. Therefore, if EBITDA grows to $200 by Year 5, we need an exit multiple of $2,600 / $200 = 13x.

Question 50

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

Answer 50

75% of $500 in Debt is $375, which means that $125 in Debt remains at the end. We still contributed $700 in Investor Equity at the beginning, and therefore need to earn back $2,100 in proceeds at the end. Therefore, we need to sell the company for an Exit Enterprise Value of $2,100 + $125 = $2,225. As a result, we need an exit multiple of $2,225 / $200 = 11.1x (you could round this to 11x in an interview).

Question 51

A private equity firm acquires a $200 EBITDA company for an 8x EBITDA multiple using 50% Debt. It wants to sell the company in 3 years, but it’s difficult to find buyers, so the firm decides to take the company public instead. If this company’s EBITDA increases to $240, and it repays ALL the Debt over 3 years, and the PE firm takes it public and sells off its stake evenly in Years 3 – 5 at a 10x EBITDA multiple, what’s the approximate IRR?

Answer 51

Initially, the PE firm pays $1,600 for this company and uses $800 in Investor Equity and $800 in Debt. The PE firm sells its stake in the company for an Exit Enterprise Value of $240 * 10x = $2,400, and all the Debt has been repaid by this point, so the Proceeds to the PE Firm are $2,400. Tripling our money in 3 years would be a 45% IRR, and tripling it in 5 years would be a 25% IRR. Since this is an IPO and the stake is gradually sold off between Year 3 and Year 5, the “Average Year #” for receiving the proceeds is 4.
As a result, the IRR is somewhere in between these figures – we could approximate it as a 35% IRR (it’s actually 32%).

Question 52

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

Answer 52

A 10% share price decline each year means that the EBITDA multiple falls to 9x and then 8x. The “average” EBITDA multiple at which the PE firm sells its stake is 9x rather than 10x. Therefore, the Proceeds to the PE Firm decline from $2,400 to $2,160, since $2,400 – $240 = $2,160. The multiple is $2,160 / $800 = 2.7x. A 2.5x multiple over 5 years is a 20% IRR, while a 2.5x multiple over 3 years is a ~35% IRR, so we’d expect an IRR in between those. But it will be closer to 35% since 2.7x is above 2.5x. We could approximate this IRR as 30%; in real life, it is exactly 30%.

Question 53

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 Year 3, and receives a Dividend of $250 in Year 2?

Answer 53

Doubling our money in 3 years normally corresponds to a ~25% IRR. But the Dividend turns this into $1,250 / $500 = 2.5x, which is halfway between doubling and tripling our money. You’d think, based on “3x in 3 years = ~45% IRR” that the IRR would be around 35% here. But the Dividends arrived in Year 2 instead of Year 3, so it’s higher than that. We would approximate it as “Between 35% and 40%” – in real life, it is 39%.

Question 54

A PE firm acquires a company with $100 in EBITDA, which grows to $150 by the end of 7 years, at which point the PE firm sells the company for a 10x EBITDA multiple. The PE firm uses $500 of Debt initially, and the company has $300 of Net Debt remaining upon exit.
If the PE firm realizes an approximate IRR of 10% on this investment, what was the purchase multiple?

Answer 54

The Exit Equity Proceeds to the PE Firm are 10x * $150 – $300 = $1,200. We don’t know what multiple a 10% IRR over 7 years corresponds to, but we can estimate it as: • 2x  100% / 7 * 75% = ~14% * 75% = Between 10% and 11%. • 3x  200% / 7 * 65% = ~28% * 65% = Between 18% and 19%. Therefore, we can say the multiple is approximately 2x. This means that the PE firm must have used $600 in Investor Equity in the beginning. Since the PE firm used $500 of Debt, the Purchase Enterprise Value was $500 + $600 = $1,100, and the purchase multiple was $1,100 / $100 = 11x.

Question 55

Could a private equity firm earn a 20% IRR if it buys a company for a Purchase Enterprise Value of $1 billion and sells it for an Exit Enterprise Value of $1 billion after 5 years?

Answer 55

Yes, this is possible. A 20% 5-year IRR corresponds to a 2.5x multiple, so the PE firm needs to earn back 2.5x its Investor Equity. It can do this if it uses $600 million in Debt and $400 million in Investor Equity, and the company repays all the Debt and generates no excess Cash. In that case, the PE firm receives all $1 billion in proceeds at the end, since $1 billion / $400 million = 2.5x.

Question 56

Could a private equity firm ever earn a 20%+ IRR if it buys a company using Investor Equity of $1 billion and gets back exactly $1 billion in Equity Proceeds at the end of 5 years?

Answer 56

Mathematically, this is possible, but in reality, it is nearly impossible. For the PE firm to earn a 20% IRR in this scenario, the acquired company would have to issue extremely high Dividends and/or do multiple Dividend Recaps during the 5-year holding period. Most companies cannot pay anything close to a 20% Dividend Yield, so this scenario is exceptionally unlikely.

Question 57

What’s the true purchase price in a leveraged buyout?

Answer 57

Just as in a merger model, you always start with the Equity Purchase Price – the cost of acquiring all the company’s common shares. Then, depending on the treatment of Cash, Debt, Transaction Fees, and Equity Rollovers, the “true price” may be different, which is why you create a Sources & Uses schedule. For example, if existing Debt is “assumed” (kept in placed or replaced with new Debt that’s the same), it won’t affect the purchase price. But if the PE firm repays the existing Debt with its Investor Equity or a combination of Debt and Investor Equity, that increases the effective price. Using Excess Cash to fund the deal reduces the true price, as do Equity Rollovers. The true price is often close to the Purchase Enterprise Value, but it won’t be the same because of these issues.

Question 58

How can you determine how much Debt a PE firm might use in an LBO and how many tranches there would be?

Answer 58

You look at recent, similar LBOs and use the median Debt / EBITDA levels from them as references; you could also look at highly leveraged public companies in the industry and check their Debt / EBITDA levels. For example, if the median Debt / EBITDA for LBOs has been 5x, with 2x Term Loans and 3x Subordinated Notes, you might assume those same figures. Then, you would test these assumptions by projecting the company’s leverage (Debt / EBITDA) and coverage (EBITDA / Interest) ratios over time.
If they hold up reasonably well – e.g., the company’s coverage ratio always stays above 2x – then you might stick with the original numbers. If not, you have to try different assumptions.

Question 59

Can you describe the different types of Debt a PE firm might use in a leveraged buyout, and why it might use them?

Answer 59

Broadly speaking, Debt is split into Secured Debt and Unsecured Debt, which some people also label “Bank Debt” and “High-Yield Debt” or “Senior Debt” and “Junior Debt.” Secured Debt consists of Term Loans and Revolvers, is backed by collateral, tends to have lower, floating interest rates, may have amortization, and uses maintenance covenants such as restrictions on the company’s EBITDA, Debt / EBITDA, and EBITDA / Interest. Early repayment of principal is allowed, maturity periods tend to be shorter (~5 years up to 10 years), and the investors tend to be conservative banks. Unsecured Debt consists of Senior Notes, Subordinated Notes, and Mezzanine, and is not backed by collateral; interest rates tend to be higher and fixed rather than floating, there is no amortization, and it uses incurrence covenants (e.g., The company can’t sell Assets above a certain dollar amount). Early repayment is not allowed, maturity periods tend to be longer (8-10 years, and sometimes much longer or even indefinite), and the investors tend to be hedge funds, merchant banks, and mezzanine funds

Question 60

Why do the less risky, lower-yielding forms of Debt amortize? Shouldn’t amortization be a feature of riskier Debt to reduce the risk?

Answer 60

Amortization reduces credit risk but also reduces the potential returns. Since risk and potential returns are correlated, amortization should be a feature of less risky Debt. If $100 million of 10% interest bonds stay outstanding for 10 years, and the company repays them, in full, after 10 years, the investors earn a 10% IRR on those bonds. But if there’s amortization or optional repayment, that balance will decline to less than $100 million by the end, so the investors earn less than a 10% IRR. But the investors also take on less risk because more capital is returned earlier on.

Question 61

Why might a PE firm choose to use Term Loans rather than Subordinated Notes in an LBO, if it has the choice between two capital structures with similar levels of leverage?

Answer 61

Term Loans are less expensive than Subordinated Notes since interest rates are lower, and they give the company more flexibility with its cash flows since optional repayments are allowed in most cases. Also, since Term Loans have maintenance covenants, they might be better if the company is planning to divest assets, make acquisitions, or spend a huge amount on CapEx, any of which might be forbidden with incurrence covenants found in Subordinated Notes.

Question 62

Why might a PE firm do the opposite and use Subordinated Notes instead?

Answer 62

On the surface, this doesn’t make much sense because Subordinated Notes are more expensive than Term Loans. However, a PE firm might prefer Subordinated Notes if they doubt a company’s ability to comply with the maintenance covenants found in Term Loans (e.g., if the company’s EBITDA is projected to decline for a few years). Also, if the company wants to avoid paying cash interest (or the PE firm has doubts about its ability to do so), it may opt for Subordinated Notes with Payment-in-Kind (PIK) Interest so that the interest accrues to the loan principal

Question 63

Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause controversy

Answer 63

Excess Cash might act as a funding source in an LBO if a company uses its Cash to repurchase its shares, reducing the number of shares that a PE firm has to purchase. It’s not that the PE firm “gets” the company’s Excess Cash before the deal takes place – it’s that the company uses its Cash to reduce the purchase price for the PE firm. Pre-deal shareholders often object to such moves, saying that the company should have issued a Special Dividend to them or used the cash in a more productive way. Using Excess Cash to fund a deal also increases the ownership stakes of existing investors that choose to roll over their shares – since Excess Cash reduces the Investor Equity the PE firm needs to contribute

Question 64

What’s the point of assuming a Minimum Cash Balance in an LBO?

Answer 64

The point is that all companies need some minimum amount of cash to continue running their businesses and delivering products to customers. You can’t just assume that all the company’s Cash can be used to fund the deal or repay Debt after the deal takes place. You must keep this Minimum Cash Balance in mind if you assume that Excess Cash is used to fund an LBO, and you must factor it in when calculating how much Debt principal a company could potentially repay each year.

Question 65

How might you estimate this Minimum Cash Balance if the company doesn’t disclose it?

Answer 65

You might look at how low its Cash balance has fallen historically, or you might look at Cash as a % of Total Expenses and see how that figure has trended in the past. For example, if Cash has always been between 5% and 10% of (COGS + OpEx), you might make the Minimum Cash Balance between 5% and 10% of (COGS + OpEx).

Question 66

How does an Equity Rollover affect the Sources & Uses schedule in an LBO?

Answer 66

The Equity Rollover counts as a Source of Funds because it reduces the amount of Debt and Investor Equity that are required to do the deal. For example, if a company’s existing investors are rolling over 10 million out of 50 million shares, the PE firm only needs to purchase 40 million shares instead of all 50 million. The Equity Rollover also results in reduced ownership for the PE firm after the deal takes place.

Question 67

setting up the Transaction Assumptions for an LBO, but you don’t have any information on the Debt Comps. How might you estimate the interest rates on Debt?

Answer 67

You could also estimate the Interest Rate on Debt by using default spreads, similar to the method you sometimes use with Cost of Debt in the WACC calculation.
Start with the yields of 10-Year Bonds issued by the central bank of the country you’re in, and then calculate the company’s interest coverage ratio and leverage ratio to get a sense of its credit rating (or use its actual credit rating). Then, look up the company’s default spread based on this credit rating and add that to the 10-Year Bond rate. For example, if the company’s leverage ratio will be 5x after the deal takes place, and that corresponds to a BB+ credit rating, you might look up BB+-rated companies and find that most of them have spreads of 4.0%. If the 10-Year Government Bond Rate is 3.0%, then the interest rate might be 3.0% + 4.0% = 7.0%.

Question 68

What does “assuming” or “refinancing” Debt mean, and how do these two options affect an LBO model?

Answer 68

The terms of most Debt state that in a “change of control” scenario, the Debt must be repaid. In LBO scenarios, PE firms must repay it with either Investor Equity (their cash) or new Debt. In practice, most PE firms usually choose to “replace” a company’s existing Debt with new Debt in the same amount; using Investor Equity would reduce their returns. “Assuming” Debt means that the PE firm keeps the existing Debt in place, or that it replaces it with new, identical Debt: In both cases, there’s no net impact on the Investor Equity required. “Debt Assumed” shows up under both Sources and Uses in the S&U schedule. “Refinancing” Debt means that the PE firm repays it using Investor Equity or some combination of Investor Equity and New Debt; in these cases, more Investor Equity (and, possibly, additional Debt) is required for the deal. “Debt Refinanced” shows up only on the Uses side of the S&U schedule.

Question 69

How do the transaction and financing fees factor into the LBO model?

Answer 69

The company or PE firm must pay for these fees upfront in Cash, thereby increasing the purchase price, but the accounting treatment of the fees differs
Legal & Advisory Fees (e.g., fees paid to investment bankers, lawyers, accountants, etc.) are deducted from Cash and Retained Earnings. Financing Fees (e.g., fees paid to lenders to arrange for the Debt), as of 2016 under both U.S. GAAP and IFRS, are deducted from the carrying value of the Debt and Cash on the other side of the Balance Sheet. Even though the book value of Debt declines as a result of these fees, the company pays interest on the face value of the Debt, i.e. what it was before fees. For a $100 million Debt issuance with $3 million in financing fees, the company pays interest on $100 million rather than $97 million.

Question 70

Can you explain how to adjust the Balance Sheet in an LBO model?

Answer 70

The adjustments are similar to those in an M&A deal, but in an LBO, you don’t “combine” the Seller’s Balance Sheet with the Buyer’s since the “Buyer” is an empty shell corporation. You still write down the company’s Shareholders’ Equity and replace it with the Investor Equity the PE firm is contributing, you still create Goodwill and Other Intangible Assets, and you might adjust the Deferred Tax-related items as well. You also add the new Debt and possibly adjust the existing Debt on the L&E side of the Balance Sheet; you adjust Cash on the Assets side for deal funding and transaction fees. You may also write up or down Asset values. You deduct one-time Transaction Fees from Retained Earnings and Financing Fees from the book value of the new Debt issued.

Question 71

How is Purchase Price Allocation different in LBO models? Does it matter more or less than in M&A deals?

Answer 71

It’s the same process as in M&A deals, but it tends to matter far less because leveraged buyouts are based on cash flow, Debt repayment, and the IRR from acquiring and then selling a company. Many of the new items that get created in the PPA process, such as D&A on Asset Write-Ups, affect the company’s EPS but barely make an impact on its cash flow, which is why many LBO models leave out this schedule

Question 72

How do you project Free Cash Flow and Cash Flow Available for Debt Repayment in an LBO model?

Answer 72

You start with Net Income, add back D&A, factor in the Change in Working Capital, and subtract CapEx to determine a company’s FCF in a leveraged buyout. You should not add back Stock-Based Compensation because it creates additional shares, reducing the PE firm’s ownership in the company; it’s easier to treat SBC as a cash expense. You might factor in other items such as Deferred Taxes, but these should not make a huge difference for FCF. Cash Flow Available for Debt Repayment is similar to FCF, but also adds the company’s Beginning Cash Balance and subtracts its Minimum Cash Balance and other obligations such as repayments of assumed Debt.

Question 73

How is the “Free Cash Flow” in an LBO model different from the FCF in a DCF?

Answer 73

First, the purpose is quite different since FCF in an LBO model determines a company’s ability to repay Debt, not the implied value of the entire company. Second, FCF in an LBO model starts with Net Income, not NOPAT, and so it includes the Net Interest Expense. But it’s also not Levered FCF since it does not include Debt principal repayments. Finally, while FCF is the end point in a DCF, you have to go beyond it in an LBO model because of the company’s Beginning Cash Balance, Minimum Cash, and, potentially, other obligations such as repayments of Existing Debt.

Question 74

Why might a company’s FCF in an LBO model differ from its Cash Flow Available for Debt Repayment?

Answer 74

It might differ because of the additional components that go into Cash Flow Available for Debt Repayment: The Beginning Cash, Minimum Cash, and Other Obligations. For example, if a company generates $100 in FCF in the first year following an LBO, it won’t necessarily be able to repay exactly $100 of Debt; it might be more or less than that. If it starts out with $100 in Cash that year, it might be able to repay $200 instead. But if its Minimum Cash Balance is $50, it can repay only $150.

Question 75

What does the “tax shield” in an LBO mean?

Answer 75

All it means is that Interest on Debt reduces a company’s taxes because the Interest is tax-deductible. However, the company’s cash flow is still lower than it would have been WITHOUT the Debt – the tax savings helps, but the additional Interest Expense still reduces Net Income. Some people think this “tax shield” makes a huge difference in an LBO, but it makes a marginal impact next to key drivers such as the purchase and exit multiples

Question 76

How do you set up the formulas for Mandatory and Optional Debt Repayments in an LBO model?

Answer 76

Mandatory Principal Repayment for a tranche of Debt is based on the percentage that amortizes each year, the initial amount of Debt raised, and the amount of Debt remaining. You should take the minimum between Amortization % * Initial Amount and Debt Remaining because you never want to repay more than the total remaining Debt (e.g., 20% * $100 million = $20 million per year, but if only $10 million is left, repay just the $10 million). The Optional Debt Repayment formula is similar, but it’s based on the minimum between the Cash Flow Available at the current point and amount of Debt remaining at the current point. For example, if, after Mandatory Repayments, the company has $100 million in cash flow and $250 million of Debt remaining, it would repay $100 million.
But if it had only $50 million remaining, it would repay that entire remaining $50 million

Question 77

How do you use a Revolver in an LBO model?

Answer 77

You draw on the Revolver when the company doesn’t have enough cash flow to meet its Mandatory Debt Repayments. For example, if the company needs to repay $150 million in Debt principal, but it has only $100 million in Cash Flow Available for Debt Repayment, it would draw on $50 million from its Revolver to make up for the deficit and repay the full amount. The company will then pay interest and fees on this additional borrowing, and it will repay the Revolver balance as soon as it can do so. The Revolver is similar to a personal overdraft account at a bank.

Question 78

Which Key Metrics and Ratios might you calculate in an LBO, and what do they tell you?

Answer 78

You calculate key metrics and ratios such as Debt / EBITDA, EBITDA / Interest, and FCF Conversion because they give you better insight into how a deal performs over time. They can also indicate how risky a deal is, what the key risks are, and if the PE firm can do anything to boost returns. For example, if the company goes from 5x Debt / EBITDA to 3x in 1-2 years, perhaps the PE firm could use more Debt in the beginning, or it could do a Dividend Recap at that stage to boost its returns. And if the company’s FCF Conversion increases from 10% to 30%, the deal is more attractive because it’s a sign that more of the returns come from Debt Paydown and Cash Generation

Question 79

Since an LBO is based on Free Cash Flow, why do you focus on EBITDA and EV / EBITDA in the assumptions?

Answer 79

EBITDA is quick to calculate, and it’s sometimes a reasonable approximation for Cash Flow from Operations, so lenders and potential acquirers focus on it. But the other reason is that EV / EBITDA tends to be more stable over time than Equity Value-based multiples
If we used P / E or Equity Value / FCF multiples, they might change dramatically as the company repays Debt. If we used one of those, we might have to adjust the exit multiple rather than starting out at a figure close to the purchase multiple. Finally, you can use EBITDA and EV / EBITDA even if the company has negative Net Income (due to high interest expense, for example).

Question 80

What are the different exit strategies available to a private equity firm in a leveraged buyout, and what are the advantages and disadvantages of each one?

Answer 80

The main exit strategies are an M&A deal, an initial public offering (IPO), and a dividend recapitalization. In an M&A Deal, the PE firm sells the company to another company or PE firm. It’s a clean and simple break where the firm earns all the deal proceeds in one fell swoop. In an IPO Exit, the PE firm takes the company public and sells off its shares gradually over time; sometimes companies that can’t be acquired can go public, which is the main advantage. But the disadvantage is that the sale of the PE firm’s stake takes much longer, so there’s also more risk (e.g., if the company’s share price drops). The firm can’t sell its entire stake all at once because it sends a negative signal to other investors. In a Dividend Recapitalization, the company issues Dividends to the PE firm continually or takes on additional Debt to issue Dividends, and the PE firm earns the deal proceeds gradually over time.It is very tough to earn an acceptable IRR with the Dividend Recap, but sometimes it is the only option if the M&A or IPO markets are underdeveloped or the company has legal or PR issues that prevent it from using those strategies

Question 81

What IRR and MoM multiple do PE firms typically target?

Answer 81

Most private equity firms aim for an IRR of at least 20%, about twice what public equity markets in developed countries have returned historically. The targeted multiple depends on the time frame of each investment, but a 20% IRR over 5 years equates to a 2.5x multiple, so many firms target at least that much. If the firm holds companies for longer periods – say, 7 years on average – then it may need to target a higher multiple, such as 3.5x (a ~20% IRR over 7 years). Most firms also target different numbers for Base, Upside, and Downside cases, and aim to avoid losing money no matter what happens

Question 82

Would you rather achieve a high IRR or a high MoM multiple in a leveraged buyout?

Answer 82

It’s completely dependent on the time frame. Over a short period, such as 6 months, a high IRR, such as 50%, is meaningless because you’ve barely made money (~1.25x multiple). But over a long period – say, 10 years – a high MoM multiple such as 3x is meaningless because it corresponds to a ~12% IRR. Limited Partners judge private equity funds by their IRRs, but they also don’t want the money to be returned to them too quickly. The best answer to this question is: “PE firms care more about IRR because that’s how they’re measured, but over short time frames, it’s better to earn a high multiple, and over longer time frames, it’s better to earn a high IRR. Also, if the PE firm has already exceeded its hurdle rate, it will focus more on MoM multiples.”

Question 83

Why might a PE firm have to use an IPO rather than an M&A deal to exit an LBO?

Answer 83

One problem is that the company might be too big to be sold in a traditional M&A deal: For example, maybe it’s the biggest company in the industry already
Another problem is that acquirers may not be interested in 100% of the company, at least at the price the PE firm is seeking. If the industry is stagnant or declining, it may also be difficult to find an acquirer for the entire business.

Question 84

Why might a PE firm have to resort to a Dividend Recapitalization for its exit in an LBO?

Answer 84

A firm would do this only if M&A and IPO exits are completely impossible. This scenario often happens in emerging and frontier markets, where capital markets are small and undeveloped, and also when the company is too small to go public (e.g., a $20 million revenue business). It can also happen when the company has regulatory or “public relations” obstacles that prevent it from going public or getting acquired – for example, if the company operates in tobacco or adult entertainment, it might be difficult to find willing acquirers or investors.

Question 85

What are the main differences in an IPO Exit vs. an M&A Exit?

Answer 85

The main difference is that in an IPO exit, the PE firm cannot sell its entire stake at once. Instead, it sells a much smaller percentage, such as 20-30%, in the initial deal, and then sells the rest of its shares over time. If the company’s share price increases after the IPO, the PE firm could capture some of the upside – but if the company’s share price decreases, the PE firm loses out. IPOs also tend to be priced based on forward P / E multiples rather than trailing EV / EBITDA multiples, which could be better or worse depending on the company. Sometimes, portions of the company’s remaining Debt are kept in place in an IPO, which typically helps the PE firm since it doesn’t have to repay all the Debt. It’s arguably easier to earn a higher IRR in an M&A exit; a firm might achieve a similar MoM multiple in an IPO exit, but the IRR might be very different depending on the timing.

Question 86

What are the advantages and disadvantages of a Dividend Recapitalization for the exit?

Answer 86

There is no real “advantage” other than the fact that any company with sufficient cash flow could issue Dividends to the PE firm to support this strategy; unlike with M&A and IPO exits, there are no specific industry, regulatory, or size criteria. But the disadvantage is that it will be extremely difficult for the PE firm to realize anything close to a 20% IRR solely with Dividends – think about how few public companies have Dividend yields that exceed even 5%.

Question 87

In an LBO, is it better for the company to repay Debt principal with its excess cash flow or for it to issue Dividends to the PE firm?

Answer 87

There won’t be much difference in terms of MoM multiples: Any cash flow that the company does not use to repay Debt goes to Dividends instead. For example, $100 million in Dividends in Year 3 means that in Year 5, the remaining Debt balance will be $100 million higher and the Equity Proceeds will be $100 million lower. However, issuing Dividends will almost always result in a higher IRR because money today is worth more than money tomorrow. The PE firm earns its proceeds earlier, so the IRR is higher. This might not be true in scenarios with PIK (Paid-in-Kind) Interest, where the Interest accrues to the Debt principal, but companies typically can’t repay PIK Debt early.

Question 88

What might trigger “Multiple Expansion” in an LBO, and is this assumption ever justified?

Answer 88

A valuation multiple is shorthand for valuation: It’s an abbreviated way of expressing a company’s Discount Rate, FCF, and FCF Growth Rate. So, yes, Multiple Expansion is possible in an LBO: For example, if a company’s Return on Invested Capital (ROIC) improves and its WACC stays the same, then its FCF and FCF Growth should both increase, which should, theoretically, boost its exit multiple. Some PE firms aim for Multiple Expansion in deals, but it’s very tough to predict and depends heavily on market conditions as well. Even if a PE firm improves a company’s ROIC significantly, the exit multiple might stay the same or fall if the overall market has declined

Question 89

If there’s an Equity Rollover in an LBO, could the IRR to management/existing investors ever be different than the IRR to the PE firm?

Answer 89

The management/existing investors could realize a different IRR only if they rolled over their shares at a different purchase price or something else changed their ownership – such as options, incentive plans, or early distributions of their proceeds. But if the PE firm acquired 80% of the company, existing investors rolled over their shares for 20% of the company, and nothing else changed in between, the IRRs should be the same.

Question 90

Is it always accurate to add Cash and subtract Debt when calculating the Proceeds to Equity Investors at the end of an LBO?

Answer 90

No, but this is the most common assumption in LBO models – at least for deals with assumed M&A exits. While it’s safe to assume that the PE firm must repay the Debt it used to acquire the company, you can’t necessarily assume that it will “take” all the company’s Cash upon exit. For example, if the company hasn’t generated any extra Cash and still has only its Minimum Cash Balance at the end, in all likelihood, the PE firm will have to leave it in place. Some models account for this problem by adding only extra Cash generated during the holding period in the exit calculations at the end

Question 91

Would you rather have an extra dollar of Debt paydown or an extra dollar of EBITDA in an LBO?

Answer 91

An extra dollar of EBITDA is more beneficial because not only does extra EBITDA pay for Debt paydown, but it also increases the company’s Exit Enterprise Value by a multiple of that dollar. A simple way to think about is that $1 of Debt paydown increases the Equity Proceeds to the PE firm at the end by $1, but $1 of extra EBITDA increases the Equity Proceeds by at least $1 * [A multiple such as 5-6x].

Question 92

Can you walk me through how you might make an investment decision based on the output from an LBO model?

Answer 92

You start by determining the investment criteria: For example, maybe you’re aiming for a 20% IRR and 2.5x-3.0x multiple in the Base Case and a 1.5x minimum multiple in the Downside Case. Then, you build projections and look at the LBO model output in the Base Case. If the numbers don’t work at this point, it’s an easy “No”; if they do work, you build the projections for the Downside Case and start testing everything there. If it seems like you could easily lose money in the Downside Case, you might say “No”; but if the worst-case multiple is above, say, 1x, the deal might still work. Finally, you make a decision and back it up with qualitative criteria. If the numbers tell you “Yes,” you find the qualitative points to support your argument; if they tell you “No,” you find the qualitative reasons to go against the deal.

Question 93

Why might you recommend AGAINST a deal even if the IRRs and MoM multiples are favorable in the Downside, Base, and Upside cases?

Answer 93

You might recommend against a deal if there’s a problem with the industry, such as a lack of good exit strategies, or credit markets that won’t support the deal. For example, if it seems impossible for the company to go public and there are no likely buyers, the PE firm might conclude that it’s impossible to realize anything close to the returns predicted by the LBO model

Question 94

Why might you decide IN FAVOR of a deal even if the IRRs and MoM multiples are NOT favorable across the different cases

Answer 94

You might recommend a deal if the numbers are “borderline,” and you believe there’s an easy way to boost them above the thresholds For example, if the Base Case IRR is 18%, and the MoM multiple is 1.3x in the Downside Case, you might look at the projections, realize the company generates a huge amount of Excess Cash, and argue that the company could distribute this Excess Cash or do a Dividend Recap to boost the IRR above 18%. You could also argue that a different capital structure that lets the company repay more of the Debt would result in a higher IRR, making the deal math more favorable as well.

Question 95

How does a Returns Attribution Analysis for an LBO affect your investment decision?

Answer 95

This analysis makes an impact because certain returns sources are considered more favorable than others. Specifically, if a deal is predicated on Multiple Expansion, you should be very skeptical because Multiple Expansion is highly speculative and often fails to materialize in real life. But if a deal depends mostly on EBITDA Growth, it’s more credible because it’s easier to grow a company’s business than to increase its multiple. Debt Paydown and Cash Generation is somewhere in the middle; it’s less speculative than Multiple Expansion, but it’s worse than EBITDA Growth because it indicates that the deal depends on financial engineering more than core business growth.

Question 96

What makes an industry more appealing or less appealing to invest in?

Answer 96

An industry is more appealing if it’s growing quickly and highly fragmented, and the company is a clear leader (in the top 2-3 positions) in the industry. These qualities make it appealing because the PE firm can use its funds to acquire other companies and make the original company bigger, resulting in higher market share and, presumably, a higher valuation. Strong barriers to entry also help, but those are less likely in fragmented markets. An industry is less appealing if it’s highly consolidated (e.g., 2-3 companies own 80% of the market), if it’s in decline (e.g., newspapers), or if it’s highly speculative (e.g., asteroid mining). A high rate of technological change and low barriers to entry also make an industry less appealing because cash flows are unlikely to be stable

Question 97

a company has $10 million in revenue and $5 million in EBITDA, is it most appealing as an investment candidate if it plans to grow by selling 20% more units, raising its prices by 20%, or cutting its expenses by 20%?

Answer 97

It’s most appealing if it grows by raising prices by 20%. If the company does this, everything will “flow through” to EBITDA: The $2 million in extra revenue will result in an additional $2 million of EBITDA. If the company sells 20% more units, it will incur higher variable costs, and its EBITDA will increase by less than $2 million. Expense reduction of 20% will result in only $1 million of additional EBITDA, which makes less of an impact than the price increase. Investors tend to favor companies with significant pricing power because it means they have less serious competition and can grow with less friction.

Question 98

How might a PE firm reduce its downside risk if a leveraged buyout does not perform well?

Answer 98

Much of the risk in leveraged buyouts comes from multiple contraction: The Exit Multiple might be lower than the Purchase Multiple. The best way to reduce this risk is to avoid acquiring companies trading at relatively high multiples and to focus on companies that are undervalued in some way. Using more Debt can also boost returns, and acquiring a smaller stake (i.e., something less than 100%) helps in extreme Downside cases where the IRR turns negative. Acquiring companies with significant Tangible Assets that could be sold off, or non-core divisions that could be sold off, also reduces risk: In the worst-case scenario, the PE firm could recover some of its capital from selling those. A PE firm could also improve a company’s operations to reduce risk – for example, it could push management to shut down underperforming divisions or cut costs. But most of these strategies for mitigating risk depend on acquiring the right company in the first place – the PE firm can’t do much if the acquired company’s sales plummet because of a market downturn.

Question 99

How would you review a Confidential Information Memorandum (CIM) or other marketing materials and decide whether to pursue an acquisition of a company

Answer 99

You might start by reading the first few pages of the Executive Summary in the beginning to assess the company’s industry, size, and possible valuation. Then, you would skip to the historical and projected financial statements toward the end to see if the LBO math works at all: If it seems impossible to earn a 20% IRR, even with these optimistic projections, you might reject the company right away. But if the math seems plausible, you might keep reading and go to the market/industry overview section, look at the industry growth rates, the competitors, and assess how this company stands out from others. If all that checks out, then you might read through the entire document, including the management team, the customers and suppliers, and the products and services.

Question 100

After reading a company’s CIM, you decide to meet with the CEO. What are the top 3 questions you would ask him/her?

Answer 100

You’d focus on questions that are not answered in the CIM, so the best questions depend heavily on the company, its industry, and how much information is disclosed in the CIM. For example, if the CIM provides financial projections but little detail behind the revenue and expense numbers, and it seems like the deal might be dependent on add-on acquisitions, you might ask the following questions: 1) “What’s driving these assumptions for revenue growth of XX% and operating margins of YY%?” (Especially if they differ from the historical numbers)

2) “What’s your company’s big-picture strategy, and what do you see as the best sources of growth?”
3) “Can you tell us about your competitors and smaller companies in the market that might be open to acquisitions?”

Question 101

When might a PE firm use a leveraged dividend recap in a leveraged buyout?

Answer 101

A PE firm might do this if the company pays off a significant amount of Debt midway through the holding period or becomes able to support more Debt at that point (e.g., its EBITDA increases significantly and it can support another 1-2x of Debt). If a deal performs well, a dividend recap will boost the IRR because it allows the PE firm to earn proceeds from the deal earlier on; the MoM multiple won’t change by as much.

Question 102

Walk me through how the Balance Sheet and IRR in an LBO change with a $100 leveraged dividend recap and $2 in financing fees

Answer 102

On the Assets side of the Balance Sheet, you deduct the $2 in financing fees from Cash, so the Assets side is down by $2. On the L&E side, you record $100 – $2 = $98 for the new Debt because you deduct financing fees directly from the book value of the Debt. You also deduct $100 from Retained Earnings to reflect the Dividends issued to the PE firm, so the L&E side is down by $2 and both sides balance. In the IRR calculation, you reflect this $100 in Dividends to the PE firm, which boosts the IRR.

Question 103

How would you model a “waterfall returns” structure where different Equity investors in an LBO receive different percentages of the returns based on the overall IRR? For example, let’s say that Investor Group A receives 10% of the returns up to a 15% IRR (Investor Group B receives 90%), but then receives 15% of the returns (with Investor Group B receiving 85%) beyond a 15% IRR. How does that work?

Answer 103

The exact Excel formulas get tricky, but here is the basic idea: • First, you check to see what the IRR is for the Equity Proceeds generated in the deal. For example, let’s say the deal generates $500 million in Equity Proceeds; you do the calculations and find that $500 million equates to an 18% IRR for this period.
• Next, you determine the Equity Proceeds that represent a 15% IRR. Here, you run the numbers and find that $450 million equates to a 15% IRR.
• You allocate 10% of this $450 million, or $45 million, to Investor Group A, and 90%, or $405 million, to Investor Group B.
Then, you allocate 15% of the remaining $50 million ($500 million minus $450 million) to Investor Group A and 85% to Investor Group B.

Question 104

Why might a private equity firm create a management option pool in an LBO, and how does it affect the model?

Answer 104

The PE firm does this to incentivize the management team to perform while giving up relatively little in exchange. If a deal performs well and the Exit Equity Value exceeds the initial Investor Equity, a small percentage of the Equity Proceeds will go to management, barely reducing the IRR for the PE firm while greatly increasing the IRR for the management team. If the deal does not perform well, and the Exit Equity Value is below the initial Investor Equity, nothing is paid out to management and the PE firm loses nothing

Question 105

Walk me through the impact of a 10% option pool in an LBO if the initial Investor Equity is $500 and the Exit Equity Value is $1,000.

Answer 105

The options are in-the-money because the Exit Equity Value exceeds the initial Investor Equity. The Cash Payment to the PE firm for the exercise of these options is 10% * $500 = $50. Proceeds to Management are: (10% / (100% + 10%)) * ($1,000 + $50) = ~9% * $1,050 = ~$95. The PE firm receives: Exit Equity Value of $1,000 + $50 in Cash – $95 in Proceeds to Management, which equals $955. As a result, its IRR and MoM multiple will decline slightly, but the difference is very small.

Question 106

How do add-on acquisitions affect the IRR and financial statements in an LBO?

Answer 106

With add-on acquisitions, you assume that the PE firm uses additional Debt and Equity to acquire other companies and combines them with the original company. You’ll see additional Debt and Equity on the Combined Balance Sheet and the acquired companies’ revenue, expense, and cash flow contributions on the statements
The IRR could increase or decrease depending on the numbers; higher-yielding add-on acquisitions (e.g., the EBITDA / Purchase Enterprise Value is high and above the original company’s) tend to increase IRR, while lower-yielding ones tend to decrease it. But it depends on the funding method as well: It’s easier to make add-on acquisitions work, mathematically, with 100% Debt funding because the PE firm won’t have to use additional Investor Equity.

Question 107

How does a stub period affect all the calculations in an LBO model?

Answer 107

A “stub period” means that the deal closes not at the end of the company’s fiscal year, but in between fiscal years (e.g., at the end of a quarter or a month). If there’s a stub period, you have to “roll forward” the company’s last Balance Sheet to the transaction close date and make all the adjustments based on that Balance Sheet instead. You also have to project the company’s financial statements, or at least its cash flow and Debt repayment and Cash generation, for the months that comprise this stub period, and use the Balance Sheet figures from the end of the stub period for the first full year in the model. You also have to use XIRR rather than IRR to calculate the deal’s IRR because of this irregular period in the beginning

Question 108

Walk me through the impact of a $1,000 Shareholder Loan with 10% PIK Interest, and explain why PE firms use Shareholder Loans in leveraged buyouts.

Answer 108

A Shareholder Loan lets a PE firm label its Investor Equity “Debt” and use it to reduce the company’s taxes. 10% PIK Interest lets a PE firm “deduct” for tax purposes a 10% IRR per year. On the Income Statement, you record 10% * $1,000 = $100 in PIK Interest initially, and add back that $100 on the CFS since it is non-cash. This $100 in PIK Interest accrues to the Shareholder Loan’s principal. The Shareholder Loan keeps increasing each year, as does the PIK Interest shown on the Income Statement. The company’s taxes decrease because this PIK Interest is a tax-deductible non-cash expense. Upon exit, this “Shareholder Loan” still counts as Equity, so the PE firm must repay all the real Debt first, and it still earns the Equity Proceeds. The only difference is that you’ll allocate a portion of the Equity Proceeds to this Shareholder Loan.

Question 109

In an LBO scenario, are the Preferred Stock investors better off with a 12% coupon rate and no equity participation or a 10% coupon rate and 1% of the company’s Equity upon exit?

Answer 109

In most cases, the investors will be better off with the 10% coupon rate and 1% of the company’s Equity upon exit. This is because the Preferred Stock investors do not contribute any Equity in the beginning to get this 1% stake. The 1% equity participation option would be worse only if the Exit Equity Proceeds correspond to an IRR of less than 2%, which is possible but unlikely.

Question 110

How do Subordinated Notes with Call Premiums affect a PE firm’s exit strategy in a leveraged buyout?

Answer 110

Call Premiums make it more expensive to repay Debt principal early – for example, the company might have to repay 105% or 103% of the principal rather than 100%. These Premiums are higher in the early years after the Debt is issued and decline over time. As a result, they incentivize a PE firm to hold onto a company for a longer period rather than selling it for a “quick flip” – as doing so would result in higher Call Premium Fees and less in Equity Proceeds to the PE firm.

Question 111

Explain what happens on the financial statements when a 10-year Subordinated Note with a par value of $1,000 is issued for $950. Assume no principal repayments.

Answer 111

You must recognize an Original Issue Discount (OID) in this case. Initially, you record the Subordinated Notes on the Balance Sheet at a value of $950. Then, you amortize the OID over 10 years, so that there’s $5 in amortization each year on the Income Statement (which gets added back on the CFS), and so that the Subordinated Notes increase by $5 each year ($955, $960, etc.). The company pays interest expense based on the Subordinated Note’s constant face value of $1,000, so the OID amortization does not affect the company’s true cash expenses at all.

Question 112

What if a $1,000 par-value Term Loan A is issued for $950 and there are 20% annual principal repayments and no optional repayments?

Answer 112

You record the Term Loan A on the Balance Sheet at an initial value of $950, and its face value is $1,000, which decreases by $200 per year as the company repays the principal. With principal repayments, you amortize the OID more quickly, based on the % of the Beginning Debt Principal that is repaid each year. In the first year, for example, you amortize $50 / 5 = $10 of the OID since the initial OID balance is $50 and the remaining term of the Term Loan is 5 years at the start of that year. But you also have to recognize a “Loss on Unamortized OID on Repayment” equal to the $200 Repayment / $1,000 Beginning Balance times the OID balance after the amortization above. This number equals 20% * ($50 – $10), or 20% * $40 = $8. As a result, the OID Ending Balance is $50 – $10 – $8 = $32, and the ending book value of the Debt this first year is $1,000 – $200 + $10 + 8 = $818. You record both these components of OID Amortization on the Income Statement and also add them back as non-cash expenses on the Cash Flow Statement. This process continues, with less and less of the OID amortizing each year, until the Term Loan A is repaid in full in Year 5. The Interest Expense is always based on the face value of the Debt, not the book value – so it would be based on $1,000, $800, $600, $400, and $200 in this case.

Question 113

How do Cash Flow Sweeps affect Debt repayment in an LBO?

Answer 113

A Cash Flow Sweep specifies that a certain percentage of the company’s excess cash flow must be used to repay Debt in a given year. If there’s a 50% Cash Flow Sweep for Term Loan A, for example, it means that after the company has made its mandatory repayments on the Term Loan, it must also use 50% of its excess cash flow to repay even more of Term Loan A. Cash Flow Sweeps rarely make a big impact on the model, but they complicate the optional Debt repayment formulas because you use some smaller percentage of the company’s excess cash flow, rather than everything, to repay Debt