LBO Concepts & Overview Flashcards
What is a leveraged buyout, and why does it work?
In an LBO, a private equity firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells the company at the end of the period to a realize a return on its investment.
During the ownership period, the PE firm uses the company’s cash flows to pay for the interest expense on the Debt and to repay Debt principal.
Leverage amplifies returns, however it presents risks because it means the returns will be even worse if the deal does not perform well.
Why do PE firms use leverage when buying companies?
To amplify their returns.
Leverage makes positive returns more positive and negative returns more negative.
Walk me through a basic LBO model?
- Make assumptions for the purchase price, debt and equity, interest rate on debt, and other variables.
- Create a sources & uses schedule to show exactly how much in Investor Equity the PE firm contributes; you can also create a Purchase Price Allocation Schedule to calculate Goodwill.
- Adjust the company’s Balance Sheet for the new debt and equity figures, and add Goodwill and other tangibles to make everything balance.
- Project the company’s Income statement, balance sheet, and cash flow statement, and determine how much debt it repays each year based on it’s free cash flow.
- Make assumptions about the exit, usually assuming an EBITDA Exit multiple, and you calculate the IRR and Money-on-money multiple based on the proceeds the PE firm earns at the end.
Can you explain the legal structure behind a leveraged buyout and how it benefits the private equity firm?
The PE firm forms a “holding company”, which it owns, and then this “holding company” acquires the real company.
The banks and other lenders that provide the Debt lend to this Holding Company so that the debt is at the Holdco Level
Managers and executives at the acquired company that retain ownership after the deal closes also have shares in this holding company.
PE firm is not on the hook for the Debt it uses in the deal
What assumptions impact a leveraged buyout?
The purchase and exit assumptions, usually based on the EBITDA multiples, make the biggest impact on a leveraged buyout.
How do you select the purchase multiples and exit multiples in an LBO model?
For public companies, typically you assume a share-price premium and check the implied purchase multiple against the valuation methodologies to make sure it’s reasonable.
The exit multiple is typically similar to the purchase multiple but could go higher or lower depending on the company’s FCF growth and ROIC by the end.
You always use a range of purchase and exit multiples to analyze the transaction via sensitivity tables.
What is an ideal candidate for an LBO?
Any deal at the right price. The candidate should also have:
stable and predictable cash flows
Not much need for ongoing investments such as CapEx
Be in a fast growing and highly fragmented industry
Have opportunities to cut costs and increase margins
Strong management team
Solid base of assets to use as collateral as debt
Have a realistic path to an exit.
How do you use an LBO model to value a company, and why does it set the “floor valuation” for the company?
You use it to value a company by setting a targeted IRR, such as 25% and then using Goal seek in excel to determine the purchase price that the PE firm could pay to achieve that IRR.
This method provides a floor valuation because it tells you the maximum amount a PE firm could pay to realize a certain IRR. Other methodologies are not constrained in the same way.
How is an LBO valuation different from a DCF valuation?
DCF - what could this company be worth based on the present value of its cash flows?
LBO - what could we pay for this company if we want to achieve a certain IRR.
Both are similar, but with the LBO, you are constraining the values based on the returns you’re targeting.
How is a leveraged buyout different from a normal M&A deal?
In an LBO, you assume the company is sold after 3-5 years. As a result, you focus on the IRR and MoM multiples as the key metrics.
PE firms only use Debt and Equity to fund deals, whereas M&A deals use cash, debt, and stock
Synergies and EPS accretion / dilution matter a lot in M&A deals, not as much in LBOs
A strategic acquirer usually prefers to pay for another company with 100% Cash - if that’s the case, why would a PE firm want to use Debt in an LBO?
- A PE firm plans to sell the company in a few years - so it’s less concerned with the expense of Debt and more concerned with using leverage to amplify its returns.
- In an LBO, the company is responsible for repaying the debt, so the acquired company assumes most of the risk.
How could a private equity firm boost its returns in an LBO?
The main returns drivers are
Multiple Expansion: Reduce the purchase Multiple and/ or increase the exit multiple
EBITDA Growth: Increase the company’s revenue growth rate or boost its margins by cutting expenses.
Debt Paydown and Cash Generation: Increase the leverage used in the deal, or improve the company’s cash flow by cutting CapEx and working capital requirements.
