LBO - Basic

Question 1

Walk me through a basic LBO model.

Answer 1

“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 you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required.

Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, and also add in Goodwill & 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 2

Why would you use leverage when buying a company?

Answer 2

To boost your return.

Remember, any debt you use in 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 elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.

A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used leverage.

Question 3

What variables impact an LBO model the most?

Answer 3

Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margins.

Question 4

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

Answer 4

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 5

What is an “ideal” candidate for an LBO?

Answer 5

Ideal candidates should:

• Have stable and predictable cash flows (so they can repay debt);
• Be undervalued relative to peers in the industry (lower purchase price);
• Be low-risk businesses (debt repayments);
• Not have much need for ongoing investments such as CapEx;
• Have an opportunity to cut costs and increase margins;
• Have a strong management team;
• Have a solid base of assets to use as collateral for debt.

The first point about stable cash flows is the most important one.

Question 6

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 6

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 7

Give an example of a “real-life” LBO.

Answer 7

The most common example is taking out a mortgage when you buy a house. Here’s how the analogy works:

• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Selling the House: Selling the Company / Taking It Public in an LBO

Question 8

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

Answer 8

First, the Liabilities & Equities side is adjusted – the new debt is added on, and the Shareholders’ Equity is “wiped out” and replaced by however much equity the private equity firm is contributing.

On the Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Other Intangibles are used as a “plug” to make the Balance Sheet balance.

Depending on the transaction, there could be other effects as well – such as capitalized financing fees added to the Assets side.

Question 9

Why are Goodwill & Other Intangibles created in an LBO?

Answer 9

Remember, these both represent the premium paid to the “fair market value” 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.

Question 10

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

Answer 10

It’s a different scenario because:

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

Question 11

Do you need to project all 3 statements in an LBO model? Are there any “shortcuts?”

Answer 11

Yes, there are shortcuts and you don’t necessarily need to project all 3 statements.

For example, you do not need to create a full Balance Sheet – bankers sometimes skip this if they are in a rush. You do need some form of Income Statement, something to track how the Debt balances change and some type of Cash Flow Statement to show how much cash is available to repay debt.

But a full-blown Balance Sheet is not strictly required, because you can just make assumptions on the Net Change in Working Capital rather than looking at each item individually.

Question 12

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Answer 12

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

Question 13

Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?

Answer 13

This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions.

To figure out the numbers, you would look at “debt comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently.

There are some general rules: for example, you would never lever a company at 50x EBITDA, and even during the bubble leverage rarely exceeded 5-10x EBITDA.

Question 14

What is the difference between bank debt and high-yield debt?

Answer 14

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”).
• High-yield debt interest rates are usually fixed, whereas bank debt interest rates are “floating” – they change based on LIBOR or the Fed interest rate.
• 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 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).

Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt.

Again, there are many different types of debt – this is a simplification, but it’s enough for entry-level interviews.

Question 15

Why might you use bank debt rather than high-yield debt in an LBO?

Answer 15

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

Question 16

Why would a PE firm prefer high-yield debt instead?

Answer 16

If the PE firm intends to refinance the company at some point or they don’t believe their returns are too sensitive to interest payments, they might use high-yield debt. They might also use the high-yield option if they don’t have plans for major expansion or selling off the company’s assets.

Question 17

Why would a private equity firm buy a company in a “risky” industry, such as technology?

Answer 17

Although technology is more “risky” than other markets, remember that there are mature, cash flow-stable companies in almost every industry. There are some PE firms that specialize in very specific goals, such as:

• Industry consolidation – buying competitors in a similar market and combining them to increase efficiency and win more customers.
• Turnarounds – taking struggling companies and making them function properly again.
• Divestitures – selling off divisions of a company or taking a division and turning it into a strong stand-alone entity.

So even if a company isn’t doing well or seems risky, the firm might buy it if it falls into one of these categories.

Question 18

How could a private equity firm boost its return in an LBO?

Answer 18

1. Lower the Purchase Price in the model.
2. Raise the Exit Multiple / Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company’s growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.).

Note that these are all “theoretical” and refer to the model rather than reality – in practice it’s hard to actually implement these.

Question 19

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

Answer 19

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 20

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

Answer 20

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.

As you might guess, dividend recaps have developed a bad reputation, though they’re still commonly used.

Question 21

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

Answer 21

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 22

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

Answer 22

No changes to the Income Statement. On the Balance Sheet, Debt would go up and Shareholders’ Equity would go down and they would cancel each other out so that everything remained in balance.

On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change.

Question 23

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

Answer 23

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.
2. 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 24

How is an LBO valuation different from a DCF valuation? Don’t they both value the company based on its cash flows?

Answer 24

The difference is that in a DCF you’re saying, “What could this company be worth, based on the present value of its near-future and far-future cash flows?”

But in an LBO you’re saying, “What can we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?”

So both methodologies are similar, but with the LBO valuation you’re constraining the values based on the returns you’re targeting.

Question 25

If High-Yield Debt is “riskier,” why are early principal repayments not allowed? Shouldn’t investors want to reduce their risk?

Answer 25

This isn’t the right way to think about it – remember that investors need to be compensated for the risk they take. And now think about what happens if early repayment is allowed:

• Initially, the investors might earn $100 million in interest on $1 billion worth of debt, at a 10% interest rate.
• Without early repayment, the investors keep getting that $100 million in interest each year paid directly to them.
• With early repayment, this interest payment drops each year and the investors receive increasingly less each year – and that drops their effective return.

All else being equal, debt investors want companies to keep debt on their Balance Sheets for as long as possible.

Question 26

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

Answer 26

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 27

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

Answer 27

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 28

What’s the point of assuming a minimum cash balance in an LBO?

Answer 28

The point is that a company cannot use 100% of its cash flow to repay Debt each year – it always needs to maintain a minimum amount of cash to pay employees, pay for general and administrative expenses, and so on.

So you normally set up assumptions such that any extra cash flow beyond this minimum cash balance is used to repay debt.

Question 29

How do you project the financial statements and determine how much debt the company can pay off each year?

Answer 29

The same way you project the financial statements anywhere else: assume a revenue growth rate, make key expenses a percentage of revenue, and then tie Balance Sheet and Cash Flow Statement items to revenue and expenses on the Income Statement – and to historical trends.

To project the cash flow available to repay debt each year, you take Cash Flow from Operations and subtract CapEx.

Just as in the DCF analysis, you assume that other items in the Investing and Financing sections are non-recurring and therefore do not impact future cash flows.

Note that this calculation only determines how much in debt principal the company could potentially repay – interest expense has already been factored in on the Income Statement, and its impact is already reflected in the Cash Flow from Operations number.

Question 30

Is it really accurate to use Levered Free Cash Flow to determine how much debt can be repaid? Can’t you reduce CapEx spending after a leveraged buyout?

Answer 30

First off, this metric of Cash Flow from Operations – CapEx is not exactly Levered Free Cash Flow: normally with Levered FCF you subtract mandatory debt repayments as well.

Assuming that CapEx (or any other big expenses) can be reduced post-LBO is dangerous because CapEx, in theory, drives revenue growth.

So if you reduce CapEx and claim that it’s not truly necessary, can you still make the same assumptions about the company’s revenue growth?

Question 31

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

Answer 31

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 32

What’s the proper repayment order if there are multiple tranches of debt?

Answer 32

As mentioned above, normally you assume that existing debt on the Balance Sheet gets repaid first.

After that, it depends on the seniority of the debt and also whether or not the debt can even be repaid early. For example, typically you are not allowed to repay High-Yield Debt before its maturity date.

So if you have a Revolver (sort of like a “credit card” for a company) and then multiple Term Loans (Bank Debt), normally you’ll repay the Revolver first, followed by the most senior Term Loan, and then the more junior Term Loans.

In theory you should want to repay the most expensive form of Debt first – but unlike with student loans, car loans, or mortgages, it’s not always allowed.

Question 33

How do you calculate the internal rate of return (IRR) in an LBO model and what does it mean?

Answer 33

You calculate the IRR by making the amount of Investor Equity (cash) that a PE firm contributes in the beginning a negative, and then making cash flows or dividends to the PE firm, as well as the net sale proceeds (basically the Equity Value) at the end, positives.

And then you can apply the IRR function in Excel to all the numbers, making sure that you’ve entered “0” for any periods where there’s no cash received or spent. You can calculate IRR manually, but it’s very time-consuming.

Technically, the IRR is defined as “the discount rate at which the net present value of cash flows from the investment equals 0.”

It’s easier to think of it as the effective interest rate: If you invested that cash in the beginning and earned an interest rate of X% on it, compounded each year, you would earn the positive cash flows shown in the model.

Question 34

What IRR do private equity firms usually aim for?

Answer 34

It depends on the economy and fundraising climate for PE firms, but an IRR in the 20-25% range, or higher, would be “good.” It far exceeds the average annual return of the stock market, and is significantly above the yields on corporate and municipal bonds.

Sometimes PE firms will go lower and accept a 15-20% IRR, but usually they target at least 20%. Remember that private equity is a riskier and less liquid asset class than equities or bonds, so the investors in the private equity fund need to be compensated for that in the form of higher returns.

Question 35

How can you estimate the IRR in an LBO? Are there any rules of thumb?
Yes, you can use these rules of thumb to come up with a quick estimate:

Answer 35

• 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.

Remember that “money” here refers to investor equity, i.e. the amount of cash the PE firm invests and receives back, not to the total purchase price or exit price.

Question 36

Can a PE firm earn a solid return if it buys a company for $1 billion and sells it for $1 billion 5 years later?

Answer 36

Sure – because the PE firm uses a certain percentage of Debt to buy this company in the beginning. So if they raise $500 million of Debt and only pay with $500 million of cash, and then the company pays off that $500 million of Debt over 5 years and the firm receives back $1 billion in cash at the end, that’s a 15% IRR.

Question 37

What if the equity contributed (investor equity) in the beginning is the same as the net proceeds to the PE firm at the end, when it sells the company?

Answer 37

In this case it’s much tougher to earn a high IRR because the major cash inflow at the end is the same as the major cash outflow at the beginning.

If nothing else happens, the IRR would be 0% in this case. If the company issues dividends to the firm or the PE firm does a dividend recap (see the next section), then the IRR will be higher than 0%.

Question 38

How do dividends issued to the PE firm affect the IRR?

Answer 38

Any dividends issued, either in the normal course of business or as part of a dividend recap, increase IRR because they result in the PE firm receiving more cash back.

Usually dividends make less of an impact than the 3 key variables in an LBO: purchase price, exit price, and leverage.

Question 39

Wait, don’t you need to factor in interest payments and debt principal repayments somewhere in these IRR calculations? How can you just ignore them?

Answer 39

You ignore them because the company uses its own cash flow to pay interest and pay off debt principal. Since the private equity firm itself is not paying for these, neither one affects its IRR.

Question 40

Let’s say that a PE firm borrows $10 million of debt to buy out a company, and then sells the company in 5 years at the same EBITDA multiple it purchased it for. If the PE firm does not pay off any debt during those 5 years, what’s the IRR?

Answer 40

This is a trick question because you need more information to answer it.

If the purchase price were the same as the exit price here, the IRR would be 0%. But the question only says that the purchase multiple is the same as the exit multiple.

Most companies grow over a 5-year period, so EBITDA in the exit year will almost always be higher than EBITDA when the company was initially purchased.

Unless you know what the EBITDA was in both years, it’s impossible to say what the IRR was. If EBITDA was initially $100 million but only grew to $110 million, that’s a very low IRR… but if it grew to $200 million or $300 million, the exit price was 2-3x the purchase price and that implies a much higher IRR.

Question 41

How would an LBO of a private company be different?

Answer 41

The mechanics are the same. The only difference is that you think of the purchase price as a lump sum number rather than as a premium to the company’s share price times the number of shares outstanding.

Evaluating LBOs of private companies can also be trickier because information is limited.

Question 42

What about a buyout of a company where you only acquire a 30% stake?

Answer 42

This scenario is not a true leveraged buyout because a PE firm cannot “make” a company take on Debt unless it actually controls the company.

So in this case, you would model it as a simple equity investment for 30% of the company, assume that the company operates for several years, and then assume that the PE firm sells its 30% stake at the end of that period.

You would base the company’s “ending” value on an EBITDA (or other) multiple, and usually you assume that it’s less than or equal to the initial multiple in the beginning to be conservative.