LBO Model

Question 1

What is a leveraged buyout and why does it work?

Answer 1

• In an LBO‚ a PE 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:
• By using debt‚ the PE firm reduces the up-front cash payment for the company‚ which boosts returns.
• Using the company’s cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows.
• 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 2

Why do PE firms use leverage when buying a company?

Answer 2

• They use leverage to increase their returns.
• Any debt raised for an LBO is not “your money”‚ so if you’re paying $5B for a company‚ it’s easier to earn a high return on $2B of your own money and $3B borrowed from other people than it is on $5B of your own money.
• A secondary benefit is that the firm also has more capital available to purchase other companies b/c they’ve used debt rather than their own funds.

Question 3

Walk me through a basic LBO model.

Answer 3

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 the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required.
• Step 3: is to adjust the company’s Balance Sheet for the new Debt and Equity figures‚ allocate the purchase price‚ and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
• 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.
• 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 4

What variables impact a leveraged buyout the most?

Answer 4

• Purchase and exit multiples (and therefore purchase and exit prices) have the greatest impact‚ followed by the amount of leverage (debt) used.
• A lower purchase price equals a higher return‚ whereas a higher exit price results in a higher return; generally‚ more leverage also results in higher returns (as long as the company can still meet its debt obligations).
• Revenue growth‚ EBITDA margins‚ interest rate and principal repayment on Debt all make an impact as well‚ but they are less significant than those first 3 variables.

Question 5

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

Answer 5

• The same way you do it anywhere else: you look at what comparable companies are trading at‚ and at what multiples similar LBO transactions have been completed at. As always‚ you 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 6

What is an “ideal” candidate for an LBO?

Answer 6

Ideal candidates should:
• Have stable and predictable cash flows so they can repay debt (the most important)
• Be undervalued relative to peers in the industry (lower purchase price)
• Be a low-risk business (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

Question 7

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 7

• 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” b/c PE firms almost always pay less for a company than strategic acquirers (no synergies to be realized).

Question 8

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

Answer 8

• The difference is that in 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 w/ the LBO valuation‚ you’re constraining the values based on the returns you’re targeting.

Question 9

Give me an example of a “real-life” LBO?

Answer 9

The most common example is taking out a mortgage when you buy a house. We think it’s better to think of it as “buying a house that you rent out to other people‚” b/c that situation is more similar to buying a company that generates cash flow. 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
• Rental Income from Rentals - Cash Flow to Pay Interest and Repay Debt in an LBO

Question 10

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?

Answer 10

It’s a different scenario because:

1. The PE firm does not hold the company for the long-term - it sells it after a few years‚ so it is less concerned with the higher “expense” of debt over cash and is more concerned about using leverage to boost its returns by reducing the capital it contributes upfront.
2. In an LBO‚ the company is responsible for repaying the debt‚ so the company assumes much of the risk. Whereas in a strategic acquisition‚ the buyer “owns” the debt‚ so it is more risky for them.

Question 11

Why would a PE firm buy a company in a “risky” industry‚ such as technology?

Answer 11

Although technology is “riskier” than other markets‚ remember that there are mature‚ cash flow-stable companies in almost every industry. There are PE firms that specialize in very specific goals‚ such as:
• Industry Consolidation: Buying competitors in a market and combining them to increase efficiency and win more customers.
• Turnarounds: Taking struggling companies and improving their operations
• Divestitures: Selling off divisions of a company or turning a division into a strong stand-alone entity.

• So even if a company isn’t doing well or even if it seems risky‚ the PE firm might buy it if it falls into one of the categories that the firm focuses on.
• This whole issue of “risk” is more applicable in industries where companies truly have unstable cash flows - anything based on commodities‚ such as oil‚ gas‚ and mining‚ for example.

Question 12

How could a PE firm boost its return in an LBO?

Answer 12

1. Reduce the Purchase Price.
2. Increase the Exit Multiple and 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.)
   • These are all “theoretical” and refer to the model rather than reality - in practice it’s hard to actually implement these changes.

Question 13

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

Answer 13

• Usually you look at recent‚ similar LBOs and assess the debt terms and tranches that were used in each transaction.
• You could also look at companies in a similar size range and industry‚ see how much debt outstanding they have‚ and base your own numbers on those.

Question 14

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 14

• 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 bubbles‚ leverage rarely exceeds 10x EBITDA.
• For interest coverage ratios (e.g. EBITDA/Interest)‚ you want a number where the company can pay for its interest w/o much trouble‚ but also not so high that the company could clearly afford to take on more debt.
• For example a 20x coverage ratio would be far too high b/c the company could easily pay 2-3x more in interest. But a 2x coverage ratio would be too low‚ b/c a small decrease in EBITDA might result in a disaster at that level.

Question 15

What is the difference between Bank Debt and High-Yield Debt?

Answer 15

This is a simplification‚ but broadly speaking there are 2 “types” of Debt: “Bank Debt” and “High-Yield Debt.” Usually in a sizable LBO‚ the PE firm uses both types of 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”) since it’s riskier for investors.
• High-Yield Debt interest rates are usually fixed‚ whereas Bank Debt interest rates are floating (they change based on LIBOR or the prevailing interest rates in the economy).
• 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 minimum financial performance (for example‚ the Total Debt / EBITDA ratio must be below 5x at all times).
• Bank Debt is usually amortized - the principal must be paid off over time - whereas High-Yield Debt‚ the entire principal is due at the end (bullet maturity) and early principal repayments are not allowed.

Question 16

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

Answer 16

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 $100M in interest on $1B worth of debt‚ at a 10% interest rate.
• Without early repayment‚ the investors keep getting that $100M 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 as long as possible.

Question 17

Why might you use Bank Debt rather than High-Yield Debt in an LBO?

Answer 17

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

Question 18

Why would a PE firm prefer High-Yield Debt instead?

Answer 18

• If the PE firm intends to refinance the debt 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 High-Yield Debt if they don’t have plans for a major expansion effort or acquisitions‚ or if they don’t plan to sell off the company’s assets.

Question 19

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

Answer 19

• 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 the debt‚ it pays it off‚ usually replacing it w/ 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 20

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

Answer 20

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 21

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

Answer 21

• 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 22

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

Answer 22

• First‚ the Liabilities & Equity side is adjusted - the new debt is added‚ and the Shareholders’ Equity is “wiped out” and replaced by however much Investor Equity the PE firm is contributing (i.e. how much cash it’s paying for the company).
• On the Assets side‚ Cash is adjusted for any cash used to finance the transaction and for transaction fees‚ and then Goodwill & Other Intangibles are used as a “plug” to make the B/S balance.
• There will also be all the usual effects that you see in transactions: Asset Write-Ups and Write-Downs‚ DTLs‚ DTAs‚ Capitalized Financing Fees‚ and so on.

Question 23

Why are Goodwill & Other Intangibles created in an LBO?

Answer 23

• These both represent the premium paid to Shareholders’ Equity 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 Asset side.
• So if the company’s Shareholders’ Equity was originally worth $1B and the PE firm pays $1.5B to acquire the company‚ roughly $500M in goodwill & Other Intangibles will be created.

Question 24

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

Answer 24

• 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 25

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

Answer 25

• First off‚ this metric of Cash Flow from Operations - CapEx is not exactly Levered FCF: normally w/ Levered FCF you subtract mandatory debt repayments as well.
• Assuming that CapEx (or any other big expenses) can be reduced post-LBO is dangerous b/c 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 26

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

Answer 26

• If the company has existing debt and the PE firm refinances it (pays it off)‚ it’s a non-factor b/c 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 interest 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 27

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

Answer 27

• 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 w/ student loans‚ car loans‚ or mortgages‚ it’s not always allowed.

Question 28

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

Answer 28

• 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 B/S - bankers sometimes skip this if they are in a rush. You do need some form of I/S‚ something to track how the Debt balance changes and some type of SCF to show how much cash is available to repay debt.
• But a full-blown B/S is not strictly required b/c you can make an assumption for the overall Change in Operating Assets and Liabilities rather than projecting each one separately.

Question 29

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

Answer 29

• 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 the debt from the LBO.
• Note‚ however‚ that the firm’s cash flow is still lower than it would have been w/o the debt - saving on taxes helps‚ but the added interest expense still reduces Net Income by more than the reduced taxes helps the firm.
• A lot of people get confused about this point and think that this “tax shield” is a really big deal in an LBO‚ but it makes marginal difference compared to all the other variables.

Question 30

How do you calculate the IRR in an LBO model and what does it mean?

Answer 30

• 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’ve 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 31

What IRR do PE firms usually aim for?

Answer 31

• 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 PE is a riskier and less liquid asset class than equities or bonds‚ so the investors in the PE fund need to be compensated for that in the form of higher returns.

Question 32

How can you estimate the IRR in an LBO? Are there are any rules of thumb?

Answer 32

Yes‚ you can use these rules of thumb to come up with a quick estimate:
• 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 33

So can the PE firm earn a solid return if it buys a company for $1B and sells it for $1B 5 years later?

Answer 33

Sure - b/c the PE firm uses a certain percentage of Debt to buy this company in the beginning. So if they raise $500M of Debt and only pay w/ $500M in cash‚ and then the company pays off that $500M of Debt over 5 years and the firm receives back $1B in cash at the end‚ that’s a 15% IRR.

Question 34

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 34

• In this case‚ it’s much tougher to earn a high IRR b/c 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‚ then the IRR will be higher than 0%.

Question 35

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

Answer 35

• Any dividends issued‚ either in the normal course of business or as part of a dividend recap‚ increase IRR b/c 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 36

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 36

You ignore them b/c the company uses its own cash flow to pay interest and pay off debt principal. Since the PE firm itself is not paying for these‚ neither one affects its IRR.

Question 37

Let’s just say that a PE firm borrows $10M 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 37

• 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 $100M but only grew to $110M‚ that’s a very low IRR‚ but if it grew to $200M or $300M‚ the exit price was 2-3x the purchase price and that implies a much higher IRR.

Question 38

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

Answer 38

• 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.
• Dividend recaps boost the IRR in a LBO b/c they help the PE firm to recover some of its initial investment early. They have developed a bad reputation among some lenders b/c the debt in this case does not actually benefit the company itself.

Question 39

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

Answer 39

• 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 40

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

Answer 40

• No changes to the Income Statement. On the Balance Sheet‚ Debt goes up and Shareholders’ Equity goes down‚ canceling each other out‚ so that everything remains in balance.
• On the Cash Flow Statement‚ there would be no changes to Cash Flow from Operations or Investing‚ but under Cash Flow from Financing‚ the additional Debt raised would cancel out the Dividend paid out to investors‚ so there would be no net change in cash.

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 b/c 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 LBO b/c 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.

Question 43

Tell me about the different types of debt you could use in an LBO.

Answer 43

• 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.

Question 44

How are Call Protection and “Prepayment” different? Don’t they refer to the same concept?

Answer 44

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.

Question 45

What are some examples of incurrence covenants? Maintenance covenants?

Answer 45

Incurrence Covenants:
• 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:
• 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

Question 46

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?

Answer 46

• 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.

Question 47

How does Preferred Stock fit into these different financing methods? Isn’t it a type of Debt as well?

Answer 47

• Preferred Stock is similar to Debt and it would match the “Mezzanine” column in the table (on p. 43) most closely.
• Just like w/ Mezzanine‚ Preferred stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt.

Question 48

How do you treat Noncontrolling Interests (AKA minority interests) and Investments in Equity Interests (AKA Associate Companies) in an LBO model?

Answer 48

• Normally you leave these alone and assume that nothing happens - so they show up in BOTH the Sources AND Uses columns when you make assumptions in the beginning.
• You could assume that the PE firm acquires one or both of these‚ in which case they would ONLY show up in the Uses column - similar to refinancing existing Debt.

Question 49

What about “Excess Cash”? Why do you sometimes see that in a Sources & Uses table?

Answer 49

• 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 and has no real reason for having it.

Question 50

Can you give a complete list of items that you might see in the Sources & Uses section and explain the less common ones?

Answer 50

• 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.”

Question 51

Walk me through how you adjust the Balance Sheet in an LBO model.

Answer 51

• 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.

Question 52

Why are Capitalized Financing Fees an Asset?

Answer 52

There are a couple ways to think about this:
• It’s just like Prepaid Expenses items on the Assets side: paid for in cash up-front and then recognized as an expense over many years. Since the company has already paid for it in cash‚ its not going to cost them anything more in future periods.
• An Asset represents potential future income or potential future savings; Capitalized Financing Fees have already been paid in cash‚ so when the expense is recognized on the Income Statement over several years it reduces the company’s taxes (similar to Prepaid Expenses).

Question 53

How would you adjust the Income Statement in an LBO model?

Answer 53

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 written-up 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 they spend managing it.
NOTES:
• Cost Savings and new D&A hit the Operating Income line; Int. Expense and Sponsor Management Fees affect Pre-Tax Income.
• Common and Preferred Stock Dividends (e.g. from a Dividend Recap‚ or just a normal preferred stock issuance) are not on this list b/c theoretically‚ Dividends should always be listed on the SCF.
• In many cases‚ however‚ they will actually be shown on the I/S in an LBO and will impact the Net Income line item only (no tax impact - they get subtracted after you’ve calculated Pre-Tax Income * (1 - Tax Rate)). Just be aware of this b/c you will see it from time to time‚ and remember that neither one is tax-deductible.

Question 54

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?

Answer 54

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.
• 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.

Question 55

Explain how a Revolver is used in an LBO model.

Answer 55

• You use a Revolver when the cash required for Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
• REVOLVER BORROWING = MAX(0‚ Total Mandatory Debt Repayment - Cash Flow Available to Repay Debt)
• The Revolver starts off “undrawn‚” meaning that you don’t 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 Loans.

Question 56

Walk me through how you calculate optional debt repayments in an LBO model.

Answer 56

• 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.

Question 57

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?

Answer 57

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.

Question 58

Why do we show PIK interest in the Cash Flow from Operations section? Isn’t it a financing activity?

Answer 58

• First‚ note that interest expense NEVER shows up in the CFF section b/c it is tax-deductible and it always appears on the I/S. So showing anything in that section for interest expense would be double-counting.
• You show PIK interest in the CFO section b/c it is a non-cash expense - we’re adding it back b/c it’s just like D&A. It reduces taxes but is not actually paid out in cash.

Question 59

What if there’s a stub period in a leveraged buyout? Normally you assume full years‚ but what happens if the PE firm acquires a company halfway through the year instead?

Answer 59

• In this case‚ you have to project the financial statements for this “stub period‚” which is easier than it sounds b/c it is usually a matter of multiplying the full-year statements by 1/4‚ 1/2‚ 3/4‚ and so on. If you have quarterly projections‚ you could use those and avoid the need for extra math.
• Example: If the PE firm buys the company on Mar. 31‚ you would multiply the line items on the full-year I/S and SCF by 3/4 to determine the numbers from Apr. 1 to Dec. 31‚ which is three-quarters of the year. You would also have to project the B/S to the Mar. 31 close date and use those numbers when adjusting the B/S and allocating the purchase price.
• The IRR calculation will also be different in this case.
• This concept is not difficult‚ but it creates extra work w/o a huge benefit so most LBO models are built based on full calendar years instead.

Question 60

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?

Answer 60

• For the debt investors‚ you need to calculate the interest and principal payments that 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.

Question 61

• How would you model a “waterfall return” structure where different equity investors in an LBO receive different percentages of the returns‚ depending on the overall IRR?
• For example‚ let’s say that Investor Group A receives 10% of the returns up to a 15% IRR (Investor Group B receives 90%) but then receives 15% of the returns (with Investor Group B receiving 85%) beyond a 15% IRR. How does that work?

Answer 61

The exact Excel formulas for doing this get tricky‚ but here is the basic idea with simple numbers to make it easier to understand:
• First‚ you do a check to see what the IRR is with the amount of net sale proceeds you’ve assumed. For example‚ let’s say you get back $500M at the end and calculate that $500M equates to an 18% IRR.
• Next‚ you determine what amount of those proceeds equals a 15% IRR. So let’s say you run the numbers and find that $450M would equal a 15% IRR.
• You allocate 10% of this $450M to Investor Group A and 90% to Investor Group B.
• Then‚ you allocate 15% of the remaining $50M ($500M minus $450M) to Investor Group A and 85% to Investor Group B.
• This scenario is common in real estate development‚ where multiple groups of equity investors are commonplace‚ but you do see it in some LBOs as well.

Question 62

In an LBO model‚ is it possible for debt investors to earn a higher return than the PE firm? What does it tell us about the company we’re modeling?

Answer 62

• Yes‚ and it happens more often 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 receive their 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 lower than what the debt investors get.

Question 63

Most of the time‚ increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

Answer 63

• Increased leverage‚ past a certain point could easily reduce IRR:
• If interest payments and principal repayments exceed the company’s cash flow‚ the IRR will drop.
• If there’s declining growth or margins‚ you could also get a scenario where increasing debt past a certain point results in a lower IRR.
• Most of the time increasing the Debt balance increases the IRR - but not always. The trick with an LBO is to find the “sweet spot” that maximizes the IRR for the PE firm but which also doesn’t make it difficult for the company to repay debt.

Question 64

how do different types of Debt and interest options affect the IRR? For example‚ does it benefit the PE firm to use a higher percentage of Term Loans or higher percentage of Senior or Subordinated Notes? What about cash vs. PIK interest?

Answer 64

• It is almost always better to use Debt with lower interest rates and Debt that can be repaid early. Otherwise‚ the company’s cash flows are being “wasted” b/c it’s generating cash but the PE firm is not using this cash in any way.
• So all else being equal‚ having Term Loans rather than Senior or Subordinated Notes or Mezzanine will boost IRR; cash interest will boost IRR over PIK interest b/c the debt principal doesn’t “balloon” over time; and lower interest rates will also boost IRR.
• However‚ this doesn’t tell the whole story: sometimes a PE firm will use High-Yield Debt or debt w/ PIK interest anyway if the company is having cash flow issues or if it’s too difficult to raise the funds via Term Loans.

Question 65

Let’s say that we have a stub period in an LBO and that the PE firm initially acquires the company midway through the year (assume June 30). How does that impact the returns calculation?

Answer 65

• In this case you have to use the XIRR function in Excel rather than the IRR function‚ and you enter the dates of all the cash flows in addition to the amounts.
• The impact on IRR depends on the length of the holding period. If this “stub period” results in a longer holding period (5.5 years or 5.75 years rather than 5 years)‚ IRR will decrease because a longer time period means a lower effective interest rate.
• If this “stub period” results in a shorter holding period (4.5 years or 4.75 years rather than 5 years)‚ IRR will increase b/c a shorter time period = a higher effective interest rate.

Question 66

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 a Section 338(h)(10) election?

Answer 66

In most cases‚ no - b/c one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most PE 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.

Question 67

Why might a PE firm allot some of a company’s new equity in an LBO to a management option pool‚ and how would this affect the model?

Answer 67

• This is done for the same reason that buyers use Earnouts in M&A deals: 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: their proceeds will be a percentage of the company’s final sale value.
• 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.

Question 68

What if there’s an option for the management team to “roll over” its existing Equity rather than receive new shares or options?

Answer 68

• An Equity Rollover would show up in the Sources column in the Sources & Uses table and it would reduce the amount of Equity and Debt the PE firm needs to use to acquire the company - b/c now the PE firm only needs to acquire 90%‚ or 95%‚ or some number less than 100%‚ rather than the entire company.
• At the end‚ you would also subtract some of the proceeds and allocate them to the management team rather than the PE firm when calculating returns.
• If nothing else changes‚ this reduces the PE firm’s IRR - but the idea is that it also incentivizes the management team to perform well and deliver greater results‚ which helps everyone.

Question 69

Let’s say that a PE firm buys a company that’s currently 20% owned by management‚ and the firm wants to maintain this 20% management ownership percentage afterward. Does the PE firm need to use a certain amount of Debt to maintain this ownership percentage‚ or does it not impact the model?

Answer 69

• No. All this business w/ management ownership has nothing to do with the exact percentage of Debt and Equity used.
• All that changes is that if the management team owns more‚ the PE firm can use less Debt and Equity (cash) overall to acquire the company.
• Using 80% Debt vs. 60% Debt (or any other percentage) has no impact on the management ownership percentage‚ which is a separate issue entirely.