LBO - Basic Flashcards
Walk me through a basic LBO model.
- Make 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.
- 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.
- Adjust the company’s balance sheet for the new debt and equity figures, and also add in goodwill and other intangibles on the assets side to make everything balance.
- 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.
- 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.
Why would you use leverage when buying a company?
To amplify your returns.
Also, the firm has more capital to do other deals
What variables impact an LBO model the most?
Purchase price 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
How do you pick purchase multiples and exit multiples in an LBO model?
You look at what comparable companies are trading at, and what multiples are 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 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.
What is an “ideal” candidate for an LBO?
Stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as capital expenditures, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt.
How do you use an LBO model to value a company, and why do we sometimes say it sets the “floor valuation” for the company?
You use it to value a company by setting a targeted IRR 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.
Can you explain how the balance sheet is adjusted in an LBO model?
- L&E side is adjusted - the new debt is added on, and the shareholder’s equity is wiped out and replaced by however much equity the private equity firm is contributing.
Assets, 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.
Why are Goodwill & other intangibles created in an LBO?
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.
Do you need to project all 3 statements in an LBO model? Are there any “shortcuts?”
Yes, there are shortcuts and you don’t necessarily need to project all 3 statements.
You do not need to create a full balance sheet. 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.
How would you determine how much debt can be raised in an LBO and how many tranches there would be?
You 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.
Why might you use bank debt rather than high-yield debt in an LBO?
If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, 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.
Why would a PE firm prefer high-yield debt instead?
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.
How could a private equity firm boost its return in an LBO?
Lower the purchase price in the model.
Raise the exit multiple / exit price
Increase the leverage used
Increase the company’s growth rate
Increase margins by reducing expenses.
What is meant by the tax shield in an LBO?
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.
What is a dividend recapitalization?
The company recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it.
