LBO modelling

Question 1

How should IRR and WACC relate to each other?

Answer 1

IRR of a private equity investment should always be greater than WACC

Question 2

What is the condition that the traditional comparison of a leveraged buyout to house flipping relies on?

Answer 2

That you buy the house and rent it out, and use the rent payments to pay down the debt

Question 3

How does debt funding help a PE fund?

Answer 3

1. Reduces the upfront cost of acquiring a company, making it easier for the PE firm to earn a high IRR
2. It lets the PE firm use the company’s cash flows to repay the debt and make interest payments

Question 4

Does leverage boost or amplify returns?

Answer 4

Only amplifies - if a deal does well, leverage increases how well it does. However, if a deal does badly, leverage increases how badly it does.

Question 5

In a leveraged buyout, does the private equity firm own the company?

Answer 5

No - it forms a holding company (which it owns) and this holding company acquires the real company.

If pre-takeover management rollover their equity, they will also own equity in this holdco, rather than equity in the PE firm.

Question 6

When banks issue debt for a PE firm to do a leveraged buyout, does the private equity firm take the debt onto their balance sheet?

Answer 6

No - it goes on the balance sheet of the HoldCo.

This is important as it means the private equity firm is not on the hook for the debt - it is the holding company that is

Question 7

Ideal characteristics for an LBO candidate?

Answer 7

Price seen as ‘cheap’ either vs peers, or industry itself viewed as undervalued
Stable cash flows so that the company can consistently service its debt
Significant fixed assets such as PP&E fir use as debt collateral
Minimal CapEx is ideal (e.g. mature company with lots of assets, but not spending much on new assets)
Minimal working capital requirements also help, but tend to matter less
Lower to mid range EBITDA multiple vs peers, meaning the multiple is unlikely to come down further

Question 8

Is growth or stability more important in an LBO?

Answer 8

Stability - can’t have cash flows declining any 80% in one quarter and a company defaulting on its debt

Question 9

Does a company’s current capital structure affect its viability as a leveraged buyout candidate?

Answer 9

No - because in an LBO, the company’s existing capital structure is “wiped out” and replaced with a new capital structure

Question 10

What does a strong management team actually mean?

Answer 10

Both CEO and CFO are experienced and have worked together for a long time, ideally participating in the LBO by rolling over equity to get “skin in the game”

Question 11

What industry / market factors are appealing for a potential LBO candidate?

Answer 11

High barriers to entry or strong brand ‘stickiness’
Strong competitive advantage
Ideally, market is very fragmented so it is easier for PE firms to find attractive bolt-on acquisitions

Question 12

What credit stats are useful to look at for an LBO candidate?

Answer 12

EBITDA / Net interest expense > 2,0x, (EBITDA - Capex) > 1.5x, Total debt / EBITDA >5-6x (unusual to go over this, often can be much less)

Question 13

What are the financial drivers of returns in an LBO?

Answer 13

Mostly EBITDA growth and/or debt paydown, with minimal (if any) multiple expansion

Question 14

What is the difference between buyout and growth equity?

Answer 14

Buyout take majority positions, growth equity tends to be minority positions in small and growing companies

Question 15

In a simple LBO model, what would be the three key steps?

Answer 15

1. Transaction assumptions and sources and uses
2. Forecasting the company’s cash flow and debt schedule
3. Making exit assumptions, calculating IRR and MoM and assessing the return drivers

Question 16

How do you judge the amount of debt used in the LBO?

Answer 16

Usually look at the leverage ratio used in similar, recent deals in the industry

Question 17

What does a cash-free, debt-free deal mean?

Answer 17

The target company’s existing cash and debt both go to 0 when the deal closes, and then gets replaced immediately

Question 18

What would go in the uses part of a sources and uses? (maybe just for private companies?)

Answer 18

Purchase equity
Gross value of debt
Transaction fees
Financing fees
Minimum cash balance required

Question 19

What typically goes in the sources part of a sources and uses?

Answer 19

Debt
Investor equity (which acts as the plug in the sources and uses)

Also, sometimes management may rollover their own equity which can also be a source

Question 20

How do you calculate the purchase price for a public company?

Answer 20

Apply the premium to the company’s undisturbed share price

Question 21

In an LBO of a public company, is it the purchase equity value or the purchase enterprise value in the sources section?

Answer 21

Equity value, as long as a premium has been applied to it

Question 22

For a public company LBO, what would be in the sources table?

Answer 22

New debt issued
Assume/replace of target’s current debt
Excess cash on balance sheet (if any)
Investor equity (used as the plug)

Question 23

For a public company LBO, what would be in the uses table?

Answer 23

Equity purchase price (including premium)
Assume / replace target debt
Transaction fees
Financing fees
Minimum cash balance (may not be needed if you use excess cash in the sources table, rather than total cash)

Question 24

Do you need a full 3-statement model for an LBO?

Answer 24

No, only need an income statement and partial cash flow statement so that you can estimate the company’s recurring cash flow from its core business operations

Question 25

What line items are needed for a cash flow statement in an LBO?

Answer 25

Net income (levered, but not initially including interest expense)
+ Depreciation & amortisation
- Increases in NWC
- Capex

+ Beginning cash balance
- Minimum cash balance
+ Free cash flow (Cash flow from operations - Capex, NOT LFCF or UFCF)

Question 26

In a simple LBO, you calculate free cash flow using the formula ‘Cash flow from operations - Capex’. How would you calculate cash flow from operations?

Answer 26

Net income
+ D&A (and other non-cash expenses)
- Increases in NWC

Question 27

In standard LBO models, would you use free cash flow to pay out dividends, or pay down debt?

Answer 27

Traditionally you would pay down debt, although it is important to consider the impact to returns in both cases

Question 28

What are the four main exit options for LBO candidates?

Answer 28

1. Sale to strategics
2. Sale to other financial sponsors
3. IPO
4. Dividend recap

Question 29

Which exit strategy tends to produce the highest IRR?

Answer 29

M&A exit because the sponsor cal sell its entire stake at once and does not have to wait for years to sell its shares to recover its initial investment

Question 30

Why are two reasons an IPO exit sometimes used instead of a sale to a sponsor or strategic?

Answer 30

Any firm over a certain size can go public; sale needs a willing buyer

Can also participate in the equity upside of the company.

Question 31

What is the main advantage of an IPO exit?

Answer 31

Any firm over a certain size can go public

You get to retain a significant portion of the equity, which is required because investors need reassurance that the sponsor/mgmt believe in the company’s equity story. Therefore, you can also participate in any future upside, although this may decrease IRR.

Question 32

What are some of the main disadvantages of the IPO exit?

Answer 32

Unlikely that the PE firm can sell its entire stake at once, which prolongs the time in the investment. This is because if the PE firm sells the entire stake, it sends a very bad message to the market (i.e. selling entire stake because see this as the high point for the stock)

Also, because IPO loses the control premium, the initial multiple at exit will likely be less than sale to a strategic/sponsor, although if the share price increases over time, this may help the multiple over long run.

Question 33

Why does a firm not usually sell the entire stake in an IPO?

Answer 33

Sends a bad message - management / owners dont believe in the future prospect of the business raising the valuation further

Instead, the firm may sell 20-30% in the immediate deal, but it would have to sell the remaining 70-80% quietly over time

Question 34

What are the ways of issuing a dividend recap?

Answer 34

Taking on more debt and paying proceeds out as dividends rather than to buy anythign

Using the target company’s FCF to pay out yearly dividends

Question 35

If the money on money multiple looks acceptable but the IRR does not, how could you increase the IRR?

Answer 35

Assuming earlier exit or dividends in the holding period

Question 36

What is the formula for calculating the return attribution from EBITDA growth?

Answer 36

(Exit year EBITDA - Initial EBITDA) * EBITDA purchase multiple

Question 37

What is the formula for calculating the return attribution from multiple expansion?

Answer 37

(EBITDA Exit multiple - EBITDA purchase multiple) * Exit year EBITDA

Question 38

What is the formula for calculating the return attribution from debt pay down / cash generation?

Answer 38

Total return - returns from EBITDA growth - returns from multiple expansion (or initial debt - final debt + final cash - initial cash - transaction and financing fees)

Question 39

What is the logic behind calculating the return from EBITDA growth?

Answer 39

How much value would we get solely from the company’s EBITDA growing if the purchase multiple stayed the same

Question 40

What is the logic behind calculating the returns from multiple expansion?

Answer 40

How much value would we get solely from the multiple increasing if the initial EBITDA were the same as its final year EBITDA

Question 41

What is the formula for working out a quick approximation of IRR if you know the money on money multiple as well as the holding period?

Answer 41

72 / holding period = IRR
OR
72 / IRR = Holding period

Question 42

What is the IRR for a 2x multiple in 3 years?

Answer 42

Approximately 25% IRR

Question 43

What is the IRR for a 2x multiple in 5 years?

Answer 43

Approximately 15% IRR

Question 44

What is the IRR for a 3x multiple in 3 years?

Answer 44

Approximately 45% IRR

Question 45

What is the IRR for a 3x multiple in 5 years?

Answer 45

Approximately 25% IRR

Question 46

What is the IRR for a 3x multiple in 4 years?

Answer 46

Approximately 35% IRR

Question 47

What is the IRR for a 2x multiple in 4 years?

Answer 47

Approximately 20% IRR

Question 48

The 3-year IRR in an LBO is 35%, and the exit equity proceeds are $1,000. What is the initial investor equity?

Answer 48

A 3x multiple over 3 years is c.45% IRR, and 2x over 3 years is c.25% IRR, so a 35% IRR is around a 2.5x multiple

Using 2.5x multiple, Investor equity would be 1,000 / 2.5x, so initial equity would be $400

Question 49

A PE firm invests $50 in a leveraged buyout in Year 0 and takes the company public in Year 3. It sells 1/3 of its stake each year in Years 3 – 5, and its total stake is worth $100 in Year 3. Assume no changes in the value of the stake and estimate the IRR.

Answer 49

2x MoM multiple (100/50), with the average exit year being year 4.

A 2x multiple in 3 years is a 25% IRR, a 2x multiple in 5 years is 15% IRR, so a 2x multiple in 4 years should be around 20% IRR

Question 50

A PE firm acquires a $100 million EBITDA company for a 12x multiple using 50% Debt.
The company’s EBITDA grows to $150 million by Year 5, but the exit multiple drops to 10x. The company repays $300 million of Debt and generates $100 million of additional Cash in this period. What’s the approximate IRR?

Answer 50

Approximately 16-17%

Question 51

A PE firm acquires a $100 EBITDA business for a 10x multiple, and it believes it can sell it again in 5 years for the same 10x multiple.
It funds the deal using 6x Debt / EBITDA, and the company repays 50% of this Debt over the 5 years, generating no extra Cash. How much EBITDA Growth is required to realize a 25% IRR?

Answer 51

Approximately $150 in EBITDA, so 50% growth

Question 52

A PE firm acquires a $500 EBITDA company for a 6x multiple using 50% Debt.
The company’s EBITDA increases to $600 in Year 3, and it repays 75% of the Debt. The PE firm takes the company public and sells its stake evenly over Years 4 – 7 at a 9x multiple of the Year 3 EBITDA. What’s the approximate IRR?

Answer 52

Approximately 25% IRR

Question 53

Got to page 36

Answer 53

Got to page 36

Question 54

In an LBO model, what is a stub period?

Answer 54

PE firm enters/exits part way through a financial year

Question 55

Stopped at 3 hour case study

Answer 55

Stopped at 3 hour case study

Question 56

What is the difference between a leveraged and unleveraged dividend recap?

Answer 56

Leverage is funded with debt, and unleveraged is funded with cash flows of the company

Question 57

When can a PE firm execute a dividend recap?

Answer 57

It can be used as a exit strategy, but a PE firm can also execute dividend recaps midway through the holding period to boost their returns

Question 58

What are the ways that a PE firm can incentivise management to act in the PE firms best interest?

Answer 58

Allowing the management team to roll over their shares, offering an options pool, or by offering earn-out payments

There could also be waterfall returns

Question 59

What is a management waterfall return schedule?

Answer 59

Dependent on the IRR for the PE firm, the management teams rolled-over equity would represent a higher % of the company

The important part of a waterfall schedule is that there will be a small reduction in IRR to the private equity firm, but a quite drastic increase in IRR to the management team, greatly boosting their alignment with the transaction

Question 60

What is a shareholder loan in the context of an LBO?

Answer 60

The idea is that a PE firm can call a portion of its investor equity a “shareholder loan” and then record “interest” each year. This interest is almost always paid-in-kind, so it accrues to the shareholder loan principal and does not represent an additional cash expense.

Question 61

Does a shareholder loan affect net debt in an LBO?

Answer 61

No, it counts as equity from the PE firm, and doesn’t count as ‘debt’ in the transaction - only difference is that the interest can be expensed on the income statement.

The shareholder loan then being repaid with the exit equity proceeds after calculating the exit enterprise value and subtracting the net debt.

Question 62

On what financial statements does PIK interest show up?

Answer 62

On the income statement and cash flow statement. The interest on this shareholder loan is tax deductible, even though it is non-cash.

Therefore, on the cash flow statement, you can add back the shareholder loan interest since it is non-cash; as a result, the company’s FCF increases due to the tax savings.

In addition, the interest accrues to the shareholder loan balance each year.

Question 63

Why do PE firms use a shareholder loan?

Answer 63

Sometimes you can get tax savings: the firm effectively “deducts: a portion of its IRR each year. But shareholder loans are still treated like equity, so that the exit calculations remain the same, but you show the proceeds separately. The end result of this shareholder loan is that the MoM and IRR increase slightly because of the tax saving.

However, even if there are no tax savings, it is a guaranteed way of achieving a base IRR, usually trying to get to the hurdle rate of 8-12%. There will also be priority over management equity, in case the deal goes bad.

Question 64

What is a seller’s note?

Answer 64

In this case, the buyer issues a promissory note to the seller that it agrees to repay (amortize) over fixed period of time.

A seller note is commonly used to bridge a gap between the amount a seller is seeking in a sale transaction and the amount a buyer is willing or able to pay.

Question 65

How does the interest rate on preferred stock compare to traditional debt?

Answer 65

All else equal, will be lower as the debt holder retains the potential to convert into equity

Question 66

On financial statements following an LBO, what might “cost savings” or “operating cost reductions” mean?

Answer 66

PE firm might look at an underperforming business division, conclude that it generates marginal revenue while costing too much to operate, and shut it down

Question 67

What are call premiums and prepayment penalties?

Answer 67

Often more junior forms of debt, such as subordinated notes and mezzanine debt, partial optional repayments are not allowed because the debt has “bullet maturity”

However, if the company has sufficient cash flow, it can sometimes repay the entire balance early if it is willing to pay a penalty fee too do so.

These penalty fees go by names such as “prepayment premiums”, “prepayment penalties”, “take-out premiums”, and “call premiums”

Question 68

What are call premiums and prepayment penalties?

Answer 68

Often more junior forms of debt, such as subordinated notes and mezzanine debt, partial optional repayments are not allowed because the debt has “bullet maturity”

However, if the company has sufficient cash flow, it can sometimes repay the entire balance early if it is willing to pay a penalty fee too do so.

These penalty fees go by names such as “prepayment premiums”, “prepayment penalties”, “take-out premiums”, and “call premiums”

Question 69

What are original issue discounts?

Answer 69

This is when debt is issued at a discount to its par value.

Question 70

Why would a bond be issued at an original issue discount?

Answer 70

Often happens when a bond’s coupon rate is below the rates to other, similar bonds, and the company needs to offer an incentive to investors.

Question 71

How do the returns of an OID bond work in practice?

Answer 71

Investors still earn $1,000 * coupon rate in interest and still receive back all $1,000 upon maturity, even though they paid only $990 or $950 upfront.

Question 72

What changes are there to an LBO if OID bonds are used?

Answer 72

Included on the uses of funds as PE firms must pay extra to cover them (as OID represents ledners buying the new debt at a discount).

You can then amortise the OID over the debt’s maturity, deducting it on the income statement and adding it back ads a non-cash expense on the cash flow statement.

Question 73

Typically, what matters more to an LBOs success - the interest rate or amount of debt outstanding?

Answer 73

Most of the time, leverage will determine the success more

Question 74

How to move from EBITDA to free cash flow?

Answer 74

EBITDA
- Capex
- Increases in NWC
- Cash interest expense
- Cash taxes
+/- other items
+ Cash interest income

Question 75

In a public company LBO, if you have the advisory fees as a %, what do you multiply this by to get the nominal advisory fees?

Answer 75

Usually equity value, as this is what they are being advised on to purchase

Question 76

How to move from net income to free cash flow?

Answer 76

Net income
+ D&A
+/- deferred taxes
+ Non-cash interest
- increases in NWC
- Capex

Question 77

How to calculate cash taxes?

Answer 77

Difference between book taxes and deferred taxes

Question 78

How do you calculate book taxes from cash taxes and deferred taxes?

Answer 78

Add both of them together

Question 79

How is cash interest different from interest expense on income statement?

Answer 79

Interest expense - non-cash interest

Question 80

What are real estate loans?

Answer 80

Mortgaging the real estate that a company owns?

Question 81

Why would management run the company better after an LBO?

Answer 81

Greater equity stake, therefore more aligned with the business’s long-term prospects

Does not have to place so much focus on EPS, which sell-side analysts and short-term investors pay a lot of attention to.

Question 82

What is a good ratio for operating cash flow to annual interest expense in an LBO?

Answer 82

2x or above. Anything less is considered ropey.

Question 83

What is loan syndication?

Answer 83

Loans sold by arranging banks among a wide pool of buyers, other banks, insurers, mutual funds, and even securitised into CLOs.

Question 84

Why is a bank underwriting debt risky?

Answer 84

Can be months between signing a deal and closing it months later. If interest rates move upwards materially, the price of the loan needs to fall for the yield to be comparable. Thus, banks will lose money.

Question 85

In a leveraged buyout, what is a “hung bridge”?

Answer 85

Bridge loans that could not be quickly syndicated to mutual funds and other institutional buyers

Question 86

Why is it economically efficient for PE firms to buy-back debt that is trading at heavily discounted levels in the context of LBO models?

Answer 86

If you buy back a bond at fifty cents, this reduces debt by one dollar of principal, which immediately created fifty cents of equity value

Question 87

What tax consequences are there of repurchasing debt that trades at a discount?

Answer 87

If you repurchase debt trading at a discount, the difference between the principal and the value for which you repurchase is classed as taxable income. This creates a cash tax liability which may be payable if the company does not have other losses or deductions that can be used to offset this income.

Question 88

What are placement agents?

Answer 88

Firms that are hired by private equity to help them connect with the pools of capital who would invest in their funds.

Question 89

What is a rights issue/offering?

Answer 89

The company sells additional shares to its existing investors, and the shares are allocated according to each investor’s “subscription rights” – this deal allows investors to maintain their ownership stakes as the company raises capital.

Question 90

In the context of restructuring, what is ‘fraudulent conveyance’?

Answer 90

The idea that either assets or liabilities would be sold or transferred to benefit the shareholders of a company at the expense of creditors.

Question 91

What is a bond indenture?

Answer 91

Legal contract associated with a bond

Question 92

In the acquisition of a private company, what happens to cash in the sources and uses table?

Answer 92

Only includes a minimum cash balance in the uses side - the cash / debt for the company before the sale is irrelevant, as we are doing a purchase enterprise value which accounts for these already

Question 93

How does the amortisation of financing fees work in an LBO?

Answer 93

Total financing fees / tenor

Question 94

Which order of priority do these debt items usually have?

RCF, Term Loan A, Term Loan B, Senior Notes

Answer 94

RCF
TLA
TLB
Senior Notes

Question 95

What order should these come in on the LBO?

Cash flow available for debt service
Total cash available for debt service
Cash flow available for revolver repayment
Cash flow available for sweep

Answer 95

1,2,3,4

Question 96

What is the difference between ‘cash flow available for debt service’ vs ‘total cash available for debt service’?

Answer 96

Cash flow is from current periods cash flow, whereas total cash includes cash flow from current period as well as the built up cash from previous periods/excess cash

Question 97

Why do you use a MIN function in the amortisation of any debt?

Answer 97

To stop the BOP debt balance going negative.

-max(min(cash flow available to service debt tranche, starting debt balance), 0)

Question 98

In the LBO of a private company, what do you assume for cash and debt in the uses table?

Answer 98

All goes to 0, as you assume that the Enterprise value you pay (derived from the EBITDA multiple) is sufficient to purchase the whole company.

So, you do not need to think about whether the target’s existing debt is assumed, replaced, or completely repaid…. because it always goes to 0 and is effectively replaced with new debt

Question 99

In the LBO of a private company, what items would go in the uses table?

Answer 99

Purchase enterprise value of target
Transaction fees
Financing Fees
Minimum cash

Question 100

In a public company LBO, what is the purchase price based on?

Answer 100

A premium to the company’s current share price, just as in M&A deals

Question 101

For public company LBO, what goes in the uses table?

Answer 101

Equity purchase price of target
Replacement of target’s existing debt
Transaction fees
Financing Fees
(Minimum cash balance isn’t needed because we use excess cash on the sources side)

Question 102

For public company LBO, what goes in the sources table?

Answer 102

New debt issued
Replacement of target’s existing debt
Excess cash on balance sheet
Investor equity

Question 103

When you use investor equity as the plug in the sources and uses table, how do you calculate it?

Answer 103

Use the ‘Total Uses’ - sum(all other sources)

Question 104

What features of debt are needed in a debt schedule?

Answer 104

x EBITDA
$ Amount
Interest rate
Floor
% Amortisation
% Sweep
% Fee
$ Fee

Question 105

When there is management equity rollover representing 20%, what does this actually mean?

Answer 105

Management will plug 20% of the investor equity value that is put in the sources table of the LBO

Question 106

Is a management earn outs or management rollover equity more likely to align management?

Answer 106

Rollover equity, because is based on a similar metric to the PE firm. With earn outs, they are usually on metrics like revenue or EBITDA for 1-2 years time, which is very short term focused and management may not aim for the same goals as the PE firm.

In addition, management rollover equity is a positive sign, as management believe the same growth story as the PE fund.

Question 107

What is purchase price allocation in an LBO?

Answer 107

Making a pro-forma balance sheet that is reflective of the assets, liabilities and equity for the company post-acquisition.

Question 108

How does a waterfall return schedule work?

Answer 108

xxx

Question 109

What is the difference in the accounting treatment of transaction fees and financing fees?

Answer 109

Transaction fees are expensed immediately as one-time costs.

However, financing fees are capitalised onto the balance sheet, and then are amortised over a period.

Question 110

In an LBO transaction, what will be the most basic adjustments to goodwill?

Answer 110

Purchase equity value
- Book value of equity
+ Existing goodwill
= Allocable Purchase Premium

Question 111

After the basic adjustment to goodwill, what other things need to be considered to calculate pro forma goodwill?

Answer 111

Write-ups/downs for assets to their fair market value.

Examples include:
- Writing up intangible assets
- PPE write-up
- Write-down of existing DTL
+ New Deferred tax liability

Question 112

Why do asset write ups decrease goodwill?

Answer 112

Because goodwill represents the premium paid over the ‘fair’ value of equity, as determined by the book value. Therefore, as assets have increased in value, technically you are overpaying less, and hence goodwill comes down.

Question 113

When doing purchase price allocation, why do you add deferred tax liability to the purchase premium to get pro forma goodwill?

Answer 113

xxx

Question 114

Difference between indefinite-lived intangibles and definite-lived intangibles?

Answer 114

Indefinite dont amortise, where as definite do.

Question 115

What are some characteristics of good companies to LBO?

Answer 115

Stable free cash flows
Good cash flows (usually indicated by significant EBITDA margin)
Good industry outlook with moats
Good ability to raise debt
Strong asset base that can be used for collateral, reducing interest expense
Growth opportunities
Low Capex requirements

Question 116

What are commitment letters in the context of an LBO?

Answer 116

Letters that promise funding for the debt portion of the purchase price on pre-agreed terms in exchange for various fees

Question 117

What are GPs and LPs?

Answer 117

GPs stand for general partner, and is usually the financial sponsor that manages the fund on a day-to-day basis.

LPs stand for limited partners are the passive financial investors into a fund, who have subscribed to fund a specific portion of the total fund’s capital.

Question 118

In PE fundraising, what is a blind pool?

Answer 118

When LPs subsricbe capital, they contribute to a blind pool, which means that LPs commit capital without specific knowledge of the investments that the sponsor plans to make.

Question 119

How are GPs compensated for management of the fund?

Answer 119

LPs typically pay a management fee of 1-2% per annum on committed funds. In addition, once the LPs have received the return of their entire equity investment, plus an agreed minimum investment profit, the sponsor typically receives a 20% carry on every dollar of investment profit (which is known as ‘carried interest’)

Question 120

What is an engagement letter in the context of a private equity deal?

Answer 120

Letter that highlights that the sponsor engages the investment bank to underwrite any bonds intended to be included in the planned financing

Question 121

What does flex mean in financing of an LBO?

Answer 121

Flex allows the underwriter to modify the terms of the debt during syndication to make it more attractive to potential debt investors, often including changes to covenants, increases to the interest rate “caps”, changes to prepayment premiums etc

Question 122

What is a bridge loan?

Answer 122

Used to provide assurance that sufficient funding will be available to finance and close the acquisition even if the banks cannot sell the entire bond offering to investors.

Question 123

What is a management buyout?

Answer 123

An LBO originated and led by a target’s existing management team

Question 124

Why would management do an MBO?

Answer 124

The management team believes it can create more value running the company on its own than under current ownership.

Question 125

Why are fragmented markets attractive for LBO candidates?

Answer 125

You can employ a roll-up strategy that consolidates multiples companies to create an entity with increased size, scale, and efificiency

Usually leads to multiple expansion

Question 126

Why is strong cash flow generation important in the context of LBO modelling?

Answer 126

Cash flow generation must be able to support the periodic interest payments and debt principal repayment over the life of the loans.

Question 127

What characteristics lend themselves to strong cash flow generation?

Answer 127

Mature or niche business with stable customer demand and end markets
Often freature strong brand name, established customer base, and/or long-term sales contracts

Question 128

Why is leading and defensible market positions a good thing for a portfolio company?

Answer 128

Generally reflect entrenched customer relationships, brand name recognition, superior prudcrts and services, a favourable cost structure, and scale advantages.

These qualities create barriers to entry and increase the stability and precitabilityi of a company’s cash flow.

Question 129

How does a financial sponsor adjudge whether a company’s market positions is defensible?

Answer 129

Often hires strategy consultants to have assurances that the targets market positions are secure.

Question 130

What are the two types of growth opportunities?

Answer 130

Organic and inorganic.

Question 131

What are organic growth opportunities?

Answer 131

Growth through improved performance of existing product lines / businesses

Question 132

What are inorganic growth opportunities?

Answer 132

Growth through acquiring new companies

Question 133

Why is growth important for an eventual IPO exit?

Answer 133

xxx

Question 134

What is one way of driving multiple expansion?

Answer 134

Robust/constant growth rate at larger levels of EBITDA, or even increasing growth rate (i.e. better future growth profile)

Question 135

Why do larger companies command a premium to smaller peers?

Answer 135

Larger companies benefit from their scale, market share, purchasing power, and lower risk profile

Question 136

Why may a sponsor not maximise the debt that could be placed on a target company?

Answer 136

Because they may want to use some of the cash flows to fund inorganic growth opportunities

Question 137

What are some examples of traditional cost-saving measures for portfolio companies?

Answer 137

Lowering corporate overheads
Streamlining operations
Introducing lean manufacturing and six sigma processes
Reducing headcount
Rationalising the supply chain
Implementing new management information systems

Question 138

What is the lean manufacturing philosophy that many PE firms instil at portcos?

Answer 138

Production practice and philosophy dedicated to eliminating waste

Question 139

What are six sigma processes?

Answer 139

Production processes focused on improving output quality by identifying and elimination defects and variability

Question 140

With cost-cutting measures implemented at portfolio companies, what do you need to be careful of?

Answer 140

Jeopardising sales or attractive growth opportunities by starving the business of necessary capital

Extensive cuts in marketing, capex, or R&D may hurt customer retention, new product development, or other growth initiatives

Question 141

Why are low capex requirements typically viewed as a positive thing?

Answer 141

Low capex requirements enhance a company’s cash flow generation capabilities. As a result, the best LBO candidates tend to have limited capital investment needs.

However, a company with substantial capex requirements may still represent an attractive investment opportunity if they are consistent with a strong growth profile, high profit margins, and the business strategy is validated during due diligence.

Question 142

Why is it important to differentiate between growth and maintenance capex?

Answer 142

Maintenance capex is capital required to sustain existing assets (typically PP&E) at their current output levels.

Growth capex is used to purchase new assets, thereby expanding the existing asset base. In the event that economic conditions or operating performance decline, growth capex can potentially be reduced or eliminated.

Question 143

For raising debt, why is a strong asset base important?

Answer 143

Can be pledged as collateral against a loan benefit lenders by increasing the likelihood of principal recovery in the event of bankruptcy (and liquidation).

This increases their willingness to provide debt to the target.

Question 144

What are considered high quality assets as collateral?

Answer 144

High accounts recievable and inventory are considered high quality assets given their liquidity. As opposed to long-term assets such as PP&E, they can be converted into cash easily and quickly.

Question 145

Other than ability to sell them, what do high quality assets signify?

Answer 145

High barriers to entry because of the substantial capital investment required, which serves to deter new entrants in the target’s markets.

Question 146

What indicates a proven/talented management team?

Answer 146

Prior experience operating under highly levered conditions, as well as success in integrating acquisitions or implementing restructuring initiatives, is highly regarded by sponsors.

For LBO candidates with strong management, the sponsor usually seeks to keep the existing team in place post-acquisition.

Question 147

What happens if the target company has ‘weak’ management?

Answer 147

Financial sponsor will seek to add value by making key changes to the existing team or installing a new team altogether to run the company.

Question 148

Why is IRR preferable to MOIC?

Answer 148

IRR factors in the time value of money, whereas MOIC does not

Question 149

What is the best way to interpret IRR compared to other asset classs?

Answer 149

Annualised return of an investment - can be used to compare against other asset classes.

Question 150

When calculating investment returns, what are the 2 things you need?

Answer 150

How much you pay
What the future cash flows are

You can use these to work out the returns

Question 151

Why do you use IRR over NPV?

Answer 151

IRR tells you the returns, whilst NPV tells you how much you can pay. Given that most people have an idea of what they want to pay, it is often more useful to calculate returns, rather than how much you should pay.

In addition, you need a growth / discount rate for NPV. You could use your targeted fund returns, but given this will only tell you whether the investment has an NPV of less than, equal to, or more than 0, it is more effective to calculate the exact returns and then compare to your fund’s targeted returns.

Question 152

READ: Explanation of NPV vs IRR

Answer 152

IRR and NPV are simply different parts of the same equation. After all there are really three components to any investment: (1) how much I pay today (or, similarly, what it’s worth today), (2) what the future cash flows are, and (3) the returns. In an NPV analysis, you give your model #2 and #3, and it tells you #1…how much you can pay. In an IRR analysis, you use the same future cash flow inputs (#2), but give the model a purchase price assumption (#1) so that it tells you your returns (#3) rather than the other way around. The sensitivity of short time horizons is irrelevant if you’re consistent in your methodology for projecting future cash flows.

The relative dominance of IRR can be traced to a number of factors. Perhaps the most meaningful reason is you often have a given price you intend to bid for a property, so it makes sense that price (factor #1 in our example above) be an input rather than an output…after all it’s the returns that are in question, not the price. The next main reason is that IRR is a number that is meaningful ex post, and one of the main benchmark against which fund managers are judged. NPV has no meaning at the conclusion of an investment, only at its inception.

The reason why NPV matters in public market investing is because you have a market that can re-price assets on an instantaneous basis. So if you find an asset that’s mispriced and deserves a lower discount rate, you can buy it and hope to realize your calculated NPV in the short-run if the market corrects. Even a 5% discount to NPV is meaningful if you have reason to believe a short-term catalyst will close that gap in the next few months. You don’t have that kind of real-time pricing in real estate, so you need to be comfortable with your projected IRR, not the mere fact that you’re buying at a discount.

Question 153

What can MOIC also be called?

Answer 153

Cash-on-cash return, MoM, Money-on-money multiple etc

Question 154

What are the three most common types of exit?

Answer 154

Strategic sale
Sale to another sponsor
An IPO

Question 155

Other than exiting, how can sponsors extract returns?

Answer 155

Issuance of dividends
Dividend recapitalisation, which is a dividend funded by the issuance of additional debt

Question 156

Why may a portfolio company purchase its own debt at a discount to par?

Answer 156

wAllow incremental debt reduction since the amount of the principal reduction exceeds the amount of cash used to fund it.

Question 157

Why may a portfolio company purchase its own debt at a discount to par?

Answer 157

Allow incremental debt reduction since the amount of the principal reduction exceeds the amount of cash used to fund it.

Question 158

Why may a financial sponsor purchase a portfolio company’s debt that is trading at a discount to par?

Answer 158

The sponsor can realise an attractive return on their capital as markets normalise and the debt increase in price.

They also gain leverage over the creditors in a future restructuring.

Question 159

What determines the decisions regarding when to monetise an investment?

Answer 159

Depends on the performance of the target, as well as prevailing market conditions.

In some cases, the sponsor may be forced to hold an investment longer than desired as dictated by company performance or the overall market.

Question 160

Why may strategic acquirers be able to pay a higher price for portfolio companyies>?

Answer 160

Ability to ellipse synergies from the target
May also have a lower cost of capital and return thresholds than a financial sponsor

Question 161

Why is the majority of senior debt not subject to SEC regulations

Answer 161

Because it is issued as a loan and therefore not treated as a security

Question 162

What is the difference between contractual subordination and structural subordination?

Answer 162

Contractual subordination looks at the seniority ranking of debt instruments at a single legal entity.

Structural subordination is the priority status of debt instruments at different legal entities. For example, all creditors at an OpCo must be paid back before even senior creditors at the HoldCo level can be.

Question 163

What is a term sheet?

Answer 163

A summary of the key terms for the debt securities that comprise an LBO financing structure.

Typically one page in length

Question 164

Examples of sectors that typically can support higher debt / EBITDA ratios?

Answer 164

Cable
Healthcare
Technology
Utilities

Question 165

Examples of sectors that typically can only support lower debt / EBITDA ratios?

Answer 165

Cyclical industrials
Energy
Retail

Question 166

Can a revolver be drawn as part of the sources of an LBO?

Answer 166

Yes, although this is quite uncommon

Question 167

What are ABL facilities generally secured by?

Answer 167

Current assets

Question 168

For debt investors, what risk does call protection mitigate when interest rates are declining?

Answer 168

Reinvestment risk - who interest rates are going down, companies may want to refinance their debt, to capitalise on the lower coupons being offered. Call protections mitigate the risk of this, as the companies will have to pay a fee to repurchase their debt ahead of the agreed schedule.

Question 169

Throughout the life of a loan, what typically happens to the leverage and coverage ratios of a company?

Answer 169

Leverage ratio declines as debt is paid off, whilst coverage increases as interest payments decline/EBITDA grows

Question 170

How often do corporations typically pay bondholders interest?

Answer 170

Semi-annually

Question 171

From a financial engineering standpoint, what are the two ways that LBOs generate returns?

Answer 171

Either through debt pay down or increase in enterprise value

Question 172

What are the two ways of getting levered free cash flow from items on the income statement?

Answer 172

Starting from EBITDA, you would deduct capex, increases in NWC, interest and taxes

Starting from Levered Net Income, you would add back D&A, deduct capex, deduct increases in NWC

Question 173

In sources and uses table, should you use net or gross debt?

Answer 173

You should include gross debt in the uses table, and then put excess cash in the sources table. This is the less confusing way of laying it out.

Question 174

How do shareholder loans usually work in the entry and exit equity calculation? Are they included alongside common equity?

Answer 174

Usually, yes. The MOIC and IRR should be based off of common equity which is owned by the PE fund and management, as well as the shareholder loan.

Question 175

Why does ROIC matter less in the context of private equity investing?

Answer 175

PE’s are usually more involved in the operational side, so can have an influence on how assets are being employed and hence can improve the ROIC’s themselves.

In public markets, passive investors very rarely can influence the day-to-day operations of a firm, and hence care more about how efficient the company is at reinvesting capital.