LBO - Advanced Flashcards
Why would you use PIK debt rather than other types of debt, and how does it affect the debt schedules and other statements?
PIK loan does not require the borrow to make certain 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.
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.
What are some examples of 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 on CapEx each year.
What are some example of maintenance covenants?
Total Debt / EBITDA cannot exceed 3.0x
Senior Debt / EBITDA cannot exceed 2.0x
Explain how a revolver is used in an LBO model?
You use a Revolver when the cash required for your Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
The 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.
In an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell you about the company we’re modeling?
Yes, it can happen.
high-yield debt investors often get interest rates of 10-15% or more - which effectively guarantees an IRR in that range for them.
So no matter what happens to the company or the market, that debt gets repaid and the debt investors get the interest payments.
But let’s say that the median EBITDA multiples contract, or that the company fails to grow or actually shrinks - in the case the PE firm could easily get an IRR below what the debt investors get.
Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.
This is 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, increaseing 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.”
