LBO (Advanced) from BIWS 400 Flashcards
Tell me about all the different kinds of debt you could use in an LBO and the differences between everything.
In a leveraged buyout (LBO), the target company’s existing debt is usually refinanced (although it can be rolled over) and replaced with new debt to finance the transaction. Multiple tranches of debt are commonly used to finance LBOs, and may including any of the following tranches of capital listed in descending order of seniority:
Revolving Credit Facility (“Revolver”)
A revolver is a form of senior bank debt that acts like a credit card for companies and is generally used to help fund a company’s working capital needs. A company will “draw down” the revolver up to the credit limit when it needs cash, and repays the revolver when excess cash is available (there is no repayment penalty). The revolver offers companies flexibility with respect to their capital needs, allowing companies access to cash without having to seek additional debt or equity financing.
There are two costs associated with revolving lines of credit: the interest rate charged on the revolver’s drawn balance, and an undrawn commitment fee. The interest rate charged on the revolver balance is usually LIBOR plus a premium that depends on the credit characteristics of the borrowing company. The undrawn commitment fee compensates the bank for committing to lend up to the revolver’s limit, and is usually calculated as a fixed rate multiplied by the difference between the revolver’s limit and any drawn amount.
Bank Debt
Bank debt is a lower cost-of-capital (lower interest rates) security than subordinated debt, but it has more onerous covenants and limitations. Bank debt typically requires full amortization (payback) over a 5- to 8-year period. Covenants generally restrict a company’s flexibility to make further acquisitions, raise additional debt, and make payments (e.g. dividends) to equity holders. Bank debt also has financial maintenance covenants, which are quarterly performance tests, and is generally secured by the assets of the borrower. Existing bank debt of a target must typically be refinanced with new bank debt due to change-of-control covenants.
Bank debt, other than revolving credit facilities, generally takes two forms:
Term Loan A – This layer of debt is typically amortized evenly over 5 to 7 years.
Term Loan B – This layer of debt usually involves nominal amortization (repayment) over 5 to 8 years, with large bullet payments in the last year. Term Loan B allows borrowers to defer repayment of a large portion of the loan but is more costly to borrowers than Term Loan A.
The interest rate charged on bank debt is often a floating rate equal to LIBOR plus (or minus) some premium (or discount), depending on the credit characteristics of the borrower. Depending on the credit terms, bank debt may or may not be repaid early without penalty.
High-Yield Debt (“Subordinated Notes”, “Junk Bonds”)
High-yield debt is typically unsecured. High-yield debt is so named because of its characteristic high-interest rate (or large discount to par) that compensates investors for their risk in holding such debt. This layer of debt is often necessary to increase leverage levels beyond that which banks and other senior investors are willing to provide, and will likely be refinanced when the borrower can raise new debt more cheaply. Subordinated debt may be raised in the public bond market or the private institutional market, carries a bullet repayment with no amortization, and usually has a maturity of 8 to 10 years.
A company retains greater financial and operating flexibility with high-yield debt through incurrence, as opposed to maintenance, covenants and a bullet (all-at-once) repayment of the debt at maturity. Additionally, early payment options typically exist (usually after about 4 and 5 years for 7- and 10-year high-yield securities, respectively), but require repayment at a premium to face value. Interest rates for these securities are higher than they are for bank debt.
The interest on high-yield debt may be either cash-pay, payment-in-kind (“PIK”), or a combination of both. Cash-pay means that coupon is paid in cash, like the interest on bank debt. PIK means that the issuer can pay interest in the form of additional high-yield debt, so as to increase the face value of the debt that must ultimately be repaid. Sometimes, high-yield debt is structured so that the issuer may choose between cash-pay and PIK (the PIK option is usually more attractive to the issuer). Also, the mezzanine debt may be structured so that the PIK option is available for the first few years of the debt’s life, after which cash-pay becomes mandatory.
Mezzanine Debt
The mezzanine ranks last in the hierarchy of a company’s outstanding debt, and is often financed by private equity investors and hedge funds. Mezzanine debt often takes the form of high-yield debt coupled with warrants (options to purchase stock at a predetermined price), known as an “equity kicker”, to boost investor returns to acceptable levels commensurate with risk. For example, regular subordinated debt might have an interest rate of 10%, while a hedge fund investor expects a return (IRR) in the range of 18-25%. To bridge this gap and attract investment by the hedge fund investor, the borrower could attach warrants to the subordinated debt issue. The warrants increase the investor’s returns beyond what it can achieve with interest payments alone through appreciation in the equity value of the borrower.
The debt component has characteristics similar to those of other junior debt instruments, such as bullet payments, PIK, and early repayment options, but is structurally subordinate in priority of payment and claim on collateral to other forms of debt. Like subordinated notes, mezzanine debt may be required to attain leverage levels not possible with senior debt and equity alone.
Seller Notes
A portion of the purchase price in an LBO may be financed by a seller’s note. In this case, the buyer issues a promissory note to the seller that it agrees to repay (amortize) over fixed period of time. The seller’s note is attractive to the financial buyer because it is generally cheaper than other forms of junior debt and easier to negotiate terms with the seller than a bank or other investors. Also, the acceptance of a seller’s note by the seller signals the seller’s faith and confidence in the business being sold. However, seller financing may be unattractive to the seller because the seller retains the risks associated with the business without having any control over it. Moreover, the seller’s receipt of proceeds from the sale is delayed.
Securitization
Securitization of the cash flows attributable to particular assets, such as receivables or inventory, may provide another source of financing when a secondary market for securitization of such assets exists.
Common Equity
Equity capital is contributed through a [private equity] fund that pools capital raised from various sources. These sources might include pensions, endowments, insurance companies, and wealthy individuals.
How would an asset write-up or write-down affect an LBO model? / Walk me through how you adjust the Balance Sheet in an LBO model.
All of this is very similar to what you would see in a merger model – you calculate Goodwill, Other Intangibles, and the rest of the write-ups in the same way, and then the Balance Sheet adjustments (e.g. subtracting cash, adding in capitalized financing fees, writing up assets, wiping out goodwill, adjusting the deferred tax assets / liabilities, adding in new debt, etc.) are almost the same.
The key differences:
- In an LBO model you assume that the existing Shareholders’ Equity is wiped out and replaced by the equity the private equity firm contributes to buy the company; you may also add in Preferred Stock, Management Rollover, or Rollover from Option Holders to this number as well depending on what you’re assuming for transaction financing.
- In an LBO model you’ll usually be adding a lot more tranches of debt vs. what you would see in a merger model.
- In an LBO model you’re not combining two companies’ Balance Sheets.
Normally we care about the IRR for the equity investors in an LBO – the PE firm that buys the company – but how do we calculate the IRR for the debt investors?
For the debt investors, you need to calculate the interest and principal payments they receive from the company each year.
Then you simply use the IRR function in Excel and start with the negative amount of the original debt for “Year 0,” assume that the interest and principal payments each year are your “cash flows” and then assume that the remaining debt balance in the final year is your “exit value.”
Most of the time, returns for debt investors will be lower than returns for the equity investors – but if the deal goes poorly or the PE firm can’t sell the company for a good price, the reverse could easily be true.
Why might a private equity firm allot some of a company’s new equity in an LBO to a management option pool, and how would this affect the model?
This is done for the same reason you have an Earnout in an M&A deal: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment.
The difference is that there’s no technical limit on how much management might receive from such an option pool: if they hit it out of the park, maybe they’ll all become millionaires.
In your LBO model, you would need to calculate a per-share purchase price when the PE firm exits the investment, and then calculate how much of the proceeds go to the management team based on the Treasury Stock Method.
An option pool by itself would reduce the PE firm’s return, but this is offset by the fact that the company should perform better with this incentive in place.
Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?
Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest payments – instead, the interest just accrues to the loan principal, which keeps going up over time. A PIK “toggle” allows the company to choose whether to pay the interest in cash or have it accrue to the principal (these have disappeared since the credit crunch).
PIK is more risky than other forms of debt and carries with it a higher interest rate than traditional bank debt or high yield debt.
Adding it to the debt schedules is similar to adding high-yield debt with a bullet maturity – except instead of assuming cash interest payments, you assume that the interest accrues to the principal instead.
You should then include this interest on the Income Statement, but you need to add back any PIK interest on the Cash Flow Statement because it’s a non-cash expense.
What are some examples of incurrence covenants? Maintenance covenants?
Incurrence Covenants:
- Company cannot take on more than $2 billion of total debt.
- Proceeds from any asset sales must be earmarked to repay debt.
- Company cannot make acquisitions of over $200 million in size.
- Company cannot spend more than $100 million on CapEx each year.
Maintenance Covenants:
- Total Debt / EBITDA cannot exceed 3.0 x
- Senior Debt / EBITDA cannot exceed 2.0 x
- (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0 x
- EBITDA / Interest Expense cannot fall below 5.0 x
- EBITDA / Cash Interest Expense cannot fall below 3.0 x
- (EBITDA – CapEx) / Interest Expense cannot fall below 2.0 x
Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use Section 338(h)(10) election?
In most cases, no – because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC shell company that “acquires” the company on paper.
Walk me through how you calculate optional repayments on debt in an LBO model.
First, note that you only look at optional repayments for Revolvers and Term Loans, high-yield debt doesn’t have a prepayment option, so effectively it’s always $0.
First, you check how much cash flow you have available based on your Beginning Cash Balance, Minimum Cash Balance, Cash Flow Available for Debt Repayment from the Cash Flow Statement, and how much you use to make Mandatory Debt Repayments.
Then, if you’ve used your Revolver at all you pay off the maximum amount that you can with the cash flow you have available.
Next, for Term Loan A you assume that you pay off the maximum you can, taking into account that you’ve lost any cash flow you used to pay down the Revolver. You also need to take into account that you might have paid off some of Term Loan A’s principal as part of the Mandatory Repayments.
Finally, you do the same thing for Term Loan B, subtracting from the “cash flow available for debt repayment” what you’ve already used up on the Revolver and Term Loan A. And just like Term Loan A, you need to take into account any Mandatory Repayments you’ve made so that you don’t pay off more than the entire Term Loan B balance.
The formulas here get very messy and depend on how your model is set up, but this is the basic idea for optional debt repayments.
Explain how a Revolver is used in an LBO model.
You use a Revolver when the cash required for your Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment – Cash Flow Available to Repay Debt).
The Revolver starts off “undrawn,” meaning that you don’t actually borrow money and don’t accrue a balance unless you need it – similar to how credit cards work.
You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments.
Within the debt repayments themselves, you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loan
How would you adjust the Income Statement in an LBO model?
The most common adjustments:
- Cost Savings – Often you assume the PE firm cuts costs by laying off employees, which could affect COGS, Operating Expenses, or both.
- New Depreciation Expense – This comes from any PP&E write-ups in the transaction.
- New Amortization Expense – This includes both the amortization from writtenup intangibles and from capitalized financing fees.
- Interest Expense on LBO Debt – You need to include both cash and PIK interest here.
- Sponsor Management Fees – Sometimes PE firms charge a “management fee” to a company to account for the time and effort they spend managing it.
- Common Stock Dividend – Although private companies don’t pay dividends to shareholders, they could pay out a dividend recap to the PE investors.
- Preferred Stock Dividend – If Preferred Stock is used as a form of financing in the transaction, you need to account for Preferred Stock Dividends on the Income Statement.
Cost Savings and new Depreciation / Amortization hit the Operating Income line; Interest Expense and Sponsor Management Fees hit Pre-Tax Income; and you need to subtract the dividend items from your Net Income number.
In an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell us about the company we’re modeling?
Yes, and it happens more commonly than you’d think. Remember, high-yield debt investors often get interest rates of 10-15% or more – which effectively guarantees an IRR in that range for them.
So no matter what happens to the company or the market, that debt gets repaid and the debt investors get the interest payments.
But let’s say that the median EBITDA multiples contract, or that the company fails to grow or actually shrinks – in these cases the PE firm could easily get an IRR below what the debt investors get.
Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.
This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes.
Sometimes in LBO models, increasing the leverage increases the IRR up to a certain point – but then after that the IRR starts falling as the interest payments or principal repayments become “too big.”
For this scenario to happen you would need a “perfect storm” of:
- Relative lack of cash flow / EBITDA growth.
- High interest payments and principal repayments relative to cash flow.
- Relatively high purchase premium or purchase multiple to make it more difficult to get a high IRR in the first place.
