LBO (Advanced) Flashcards
Tell me about the different types of debt you could use in an LBO.
• REVOLVER: Lowest Int. Rate‚ Floating Cash Int.‚ 3-5 year tenor‚ not amortized‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ No Call Protection‚ Maintenance Covenant
• TERM LOAN A: Low Int. Rate‚ Floating Cash Int.‚ 4-6 year tenor‚ straight-line amortized‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ Sometimes Call Protection‚ Maintenance Covenant
• TERM LOAN B: Higher Int. Rate‚ Floating Cash Int.‚ 4-8 year tenor‚ minimal amortization‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ Sometimes Call Protection‚ Maintenance Covenant
• SENIOR NOTES: Higher Int. Rate‚ Fixed Cash Int.‚ 7-10 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Senior Unsecured‚ Sometimes Secured‚ Yes Call Protection‚ Incurrence Covenant
• SUBORDINATED NOTES: Higher Int. Rate‚ Fixed Cash Int.‚ 8-10 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Senior Subordinated‚ Not Secured‚ Yes Call Protection‚ Incurrence Covenant
• MEZZANINE: Highest Int. Rate‚ Fixed Cash (or PIK) Int.‚ 8-12 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Equity‚ Not Secured‚ Yes Call Protection‚ Incurrence Covenant
NOTES:
• Each type of debt is arranged in order of rising interest rates - so Revolver has the lower interest rates‚ Term Loan A is slightly higher‚ B is slightly higher‚ Senior Notes are higher than Term Loan B and so on.
• “Seniority” refers to the order of claims on a company’s assets in a bankruptcy - the Senior Secured holders are first in line‚ followed by Senior Unsecured‚ Senior Subordinated‚ and then Equity Investors.
• “Floating” or “Fixed” Interest Rates: A “floating” interest rate is tied to LIBOR. For example‚ L + 100 means that the int. rate of the loan is whatever LIBOR is at currently‚ plus 100 basis point (1.00%). A fixed int. rate‚ on the other hand‚ would be 11%. It doesn’t “float” w/ LIBOR or any other rate.
• Amortization: “Straight Line” means the company pays off the principal in equal installments each year‚ while “bullet” means that the entire principal is due at the end of the loan’s lifecycle. “Minimal” just means a low percentage of the principal each year‚ usually in the 1-5% range.
• Call Protection: Is the company prohibited from “calling back” - paying off or redeeming - the security for a given period? This is beneficial for investors b/c they are guaranteed a certain number of interest payments.
How are Call Protection and “Prepayment” different? Don’t they refer to the same concept?
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.
MW: call protection is to bonds as prepayment is to loans
What are some examples of incurrence covenants? Maintenance covenants?
Incurrence Covenants - Must be met when some event, such as incurring new debt or selling an asset, occurs
• Company cannot take on more than $2B of total debt.
• Proceeds from any asset sales must be earmarked to repay debt.
• Company cannot make acquisitions of over $200M in size.
• Company cannot spend more than $100M on CapEx each year.
Maintenance Covenants: Must be met regulararly
• Total Debt / EBITDA cannot exceed 3.0x; Senior Debt / EBITDA cannot exceeds 2.0x
• (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0x
• EBITDA / Interest Expense cannot fall below 5.0x
• EBITDA / Cash Interest Expense cannot fall below 3.0x
• (EBITDA - CapEx) / Interest Expense cannot fall below 2.0x
Why would you use PIK (Payment In Kind) debt rather than other types of debt‚ and how does it affect the debt schedules and the other statements?
- Unlike “normal” debt‚ a PIK loan does not require the borrower to make cash interest payments - instead‚ the interest 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 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 w/ 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‚ b/c it’s a non-cash expense.
How does Preferred Stock fit into these different financing methods? Isn’t it a type of Debt as well?
- High cost of capital due to junior position in the capital structure
- Investors like over common because protect downside while structuring for upside (participating preferred), earning a high coupon in the process.
- May be taxed at a preferred rate compared to common stock dividends
- Downside: usually no voting rights and is not a contractual obligation
How do you treat Noncontrolling Interests (AKA minority interests) and Investments in Equity Interests (AKA Associate Companies) in an LBO model?
SOURCES AND USES
• Normally, leave alone, and they show up in BOTH the Sources AND Uses
• If assume PE firm acquires one or both ‚ show up in the USES column
FINANCIALS
1) EQUITY METHOD ACCOUNTING
- Income from affiliates shows up after tax because they have already been taxed at the unit level
- Dividends paid by company = shows up in operating cash flow as dividend * ownership
- Balance sheet account is increased by income * ownership and decreased by dividends * ownership
2) NCI
- Income statement - show revenues and expenses as if subsidiary is 100% owned, and below net income, reduce consolidated net income by NI attributable to noncontrolling interests
- Cash flow statement - if you start with NI on a consolidated level, no change. Show cash flows as if 100% owned
- Balance sheet - assets = 100% owned. Retained earnings = parent’s ownership while NCI shows NCI holders interests in the assets
What about “Excess Cash”? Why do you sometimes see that in a Sources & Uses table?
- This represents the scenario where the company itself uses its excess cash (i.e. if it only requires $10M in cash but has $50M on its B/S‚ $40M 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
Can you give a complete list of items that you might see in the Sources & Uses section and explain the less common ones?
- SOURCES: Debt and Preferred Stock (All Types)‚ Investor Equity (PE firm’s cash)‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Management Rollover
- USES: Equity Value of Company‚ Advisory and Legal Fees‚ Capitalized Financing Fees‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Debt Refinanced‚ Noncontrolling Interests Purchased.
- Debt and Debt-like items such as existing Preferred Stock and Noncontrolling Interests can always be either assumed (remain on the B/S) or refinanced/purchased (paid off and disappear).
- The “management rollover” refers to the option to let the management team reinvest their shares and options into the deal. For example‚ if the team currently owns 5% of the company‚ the PE firm might say‚ “We’ll acquire 95% of the shares‚ and then let you keep the 5% you own to incentivize you to perform well over these next few years and reap the rewards.”
Walk me through how you adjust the Balance Sheet in an LBO model.
• 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 B/S adjustments (e.g. subtracting Cash‚ adding in Capitalized Financing Fees‚ writing up Assets‚ wiping out Goodwill‚ adjusting the DTAs/DTLs‚ adding in new debt‚ etc.) are almost all the same.
• The key differences are:
1) In an LBO model you assume that the existing Shareholders’ Equity is wiped out and replaced by the value of the cash the PE 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.
2) In an LBO model you’ll usually add more tranches of debt compared to what you would see in a merger model.
3) In an LBO model‚ you’re not combining two companies’ Balance Sheets.
Why are Capitalized Financing Fees a Contra-Liability?
- Presented with debt to show the “book value” of debt after deferred financing fees and OID.
- It’s “capitalized” rather than “expensed” because the cash payment an issuer makes to banks allows it to issue debt. Borrowing this money gives you the benefit of additional capital over the “life” of the bond.
- Match / smooth this expense over the course of the bond, just as you do with capex and depreciation
How would you adjust the Income Statement in an LBO model?
- Synergies
- New Interest
- Excess Depreciation and Amortization
- Rx charges
- Sponsor management fees
Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example‚ what happens when you have Existing Debt‚ a Revolver‚ Term Loans‚ and Senior Notes?
First off‚ note that you MUST make all mandatory debt repayments on each tranche of debt before anything else. So there is no real “order” there - you simply have to repay what is required. The “order” applies only when you have extra cash flow beyond what is needed to meet these mandatory repayments:
• REVOLVER: You borrow additional funds here and add them to the balance if you don’t have enough cash flow to meet the mandatory debt repayments each year; you use any extra cash flow each year to repay this Revolver first‚ before any other debt.
• EXISTING DEBT: This comes first‚ before the new debt raised in the LBO‚ when setting aside extra cash flow to make optional repayments. [Well, depends on the docs]
• TERM LOANS: Payments on these come after paying off the Revolver and any existing debt.
• SENIOR NOTES: These come last in the hierarchy and typically optional repayment is limited or not allowed at all.
• To track this in an LBO model‚ you need to separate out the Revolver from the mandatory repayments from the optional repayments‚ and keep track of the cash flow that’s available after each stage of the process.
Explain how a Revolver is used in an LBO model.
LIkely issued with an installment or term loan
1) Cash needs / cash available for repayment of RCF
2) Availability = Commitment less BoP Availability
3) Draw = min(Availability, -min(cash for prepayment, BoP))
4) EoP
5) Average balance –> interest expense and commitment fee
6) feed the interest through the income statement and the draw through cash flows
Walk me through how you calculate optional debt repayments in an LBO model.
- First‚ note that you ONLY look at optional repayments for Revolvers and Term Loans - High-Yield Debt doesn’t have a prepayment option‚ so effectively it’s always $0.
- You start by checking how much cash flow is available based on your Beg. Cash Balance‚ Min. Cash Balance‚ Cash Flow Available for Debt Repayment from the Cash Flow Statement‚ and how much you’ve spent on Mandatory Debt Repayments so far.
- 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 possible amount‚ taking into account the fact that you have less cash flow from having paid down the Revolver. You also need to take into account the fact 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 for the Revolver and Term Loan A.
- Just like with 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.
Let’s walk through a real-life example of debt modeling now. Let’s say that we have $100M of debt w/ 5% cash interest‚ 5% PIK interest and amortization of 10% per year. How do you reflect this on the financial statements?
To simplify this scenario‚ we’ll assume that interest is based on the beg. debt balance rather than the average balance over the course of the year.
• Income Statement: There’s $5M of cash interest and $5M of PIK interest‚ for a total of $10M in interest expense‚ which reduces Pre-Tax Income by $10M and Net Income by $6M assuming a 40% tax rate.
• Cash Flow Statement: Net Income is $6M lower‚ but you add back the $5M in PIK interest b/c it was a non-cash charge. CFO is down by $1M‚ Since there’s 10% amortization per year‚ you repay $10M of debt each year (and presumably the entire remaining amount at the end of the period) in the CFF section - so cash at the bottom is down by $11M.
• Balance Sheet: Cash is down by $11M on the Assets side‚ so that entire side is down by $11M. On the other side‚ Debt is up by $5M due to the PIK interest but down by $10M due to the principal repayment‚ for a net reduction of $5M. Shareholders’ Equity is down by $6M due to the reduced Net Income‚ so both sides are down by $11M 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.
