LBO modelling Flashcards
1
Q
How should IRR and WACC relate to each other?
A
IRR of a private equity investment should always be greater than WACC
2
Q
What is the condition that the traditional comparison of a leveraged buyout to house flipping relies on?
A
That you buy the house and rent it out, and use the rent payments to pay down the debt
3
Q
How does debt funding help a PE fund?
A
- Reduces the upfront cost of acquiring a company, making it easier for the PE firm to earn a high IRR
- It lets the PE firm use the company’s cash flows to repay the debt and make interest payments
4
Q
Does leverage boost or amplify returns?
A
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.
5
Q
In a leveraged buyout, does the private equity firm own the company?
A
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.
6
Q
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?
A
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
7
Q
Ideal characteristics for an LBO candidate?
A
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
8
Q
Is growth or stability more important in an LBO?
A
Stability - can’t have cash flows declining any 80% in one quarter and a company defaulting on its debt
9
Q
Does a company’s current capital structure affect its viability as a leveraged buyout candidate?
A
No - because in an LBO, the company’s existing capital structure is “wiped out” and replaced with a new capital structure
10
Q
What does a strong management team actually mean?
A
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”
11
Q
What industry / market factors are appealing for a potential LBO candidate?
A
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
12
Q
What credit stats are useful to look at for an LBO candidate?
A
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)
13
Q
What are the financial drivers of returns in an LBO?
A
Mostly EBITDA growth and/or debt paydown, with minimal (if any) multiple expansion
14
Q
What is the difference between buyout and growth equity?
A
Buyout take majority positions, growth equity tends to be minority positions in small and growing companies
15
Q
In a simple LBO model, what would be the three key steps?
A
- Transaction assumptions and sources and uses
- Forecasting the company’s cash flow and debt schedule
- Making exit assumptions, calculating IRR and MoM and assessing the return drivers
16
Q
How do you judge the amount of debt used in the LBO?
A
Usually look at the leverage ratio used in similar, recent deals in the industry
17
Q
What does a cash-free, debt-free deal mean?
A
The target company’s existing cash and debt both go to 0 when the deal closes, and then gets replaced immediately
18
Q
What would go in the uses part of a sources and uses? (maybe just for private companies?)
A
Purchase equity
Gross value of debt
Transaction fees
Financing fees
Minimum cash balance required
19
Q
What typically goes in the sources part of a sources and uses?
A
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
20
Q
How do you calculate the purchase price for a public company?
A
Apply the premium to the company’s undisturbed share price
21
Q
In an LBO of a public company, is it the purchase equity value or the purchase enterprise value in the sources section?
A
Equity value, as long as a premium has been applied to it
22
Q
For a public company LBO, what would be in the sources table?
A
New debt issued
Assume/replace of target’s current debt
Excess cash on balance sheet (if any)
Investor equity (used as the plug)
23
Q
For a public company LBO, what would be in the uses table?
A
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)
24
Q
Do you need a full 3-statement model for an LBO?
A
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
25
What line items are needed for a cash flow statement in an LBO?
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)
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?
Net income
+ D&A (and other non-cash expenses)
- Increases in NWC
27
In standard LBO models, would you use free cash flow to pay out dividends, or pay down debt?
Traditionally you would pay down debt, although it is important to consider the impact to returns in both cases
28
What are the four main exit options for LBO candidates?
1. Sale to strategics
2. Sale to other financial sponsors
3. IPO
4. Dividend recap
29
Which exit strategy tends to produce the highest IRR?
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
30
Why are two reasons an IPO exit sometimes used instead of a sale to a sponsor or strategic?
Any firm over a certain size can go public; sale needs a willing buyer
Can also participate in the equity upside of the company.
31
What is the main advantage of an IPO exit?
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.
32
What are some of the main disadvantages of the IPO exit?
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.
33
Why does a firm not usually sell the entire stake in an IPO?
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
34
What are the ways of issuing a dividend recap?
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
35
If the money on money multiple looks acceptable but the IRR does not, how could you increase the IRR?
Assuming earlier exit or dividends in the holding period
36
What is the formula for calculating the return attribution from EBITDA growth?
(Exit year EBITDA - Initial EBITDA) * EBITDA purchase multiple
37
What is the formula for calculating the return attribution from multiple expansion?
(EBITDA Exit multiple - EBITDA purchase multiple) * Exit year EBITDA
38
What is the formula for calculating the return attribution from debt pay down / cash generation?
Total return - returns from EBITDA growth - returns from multiple expansion (or initial debt - final debt + final cash - initial cash - transaction and financing fees)
39
What is the logic behind calculating the return from EBITDA growth?
How much value would we get solely from the company's EBITDA growing if the purchase multiple stayed the same
40
What is the logic behind calculating the returns from multiple expansion?
How much value would we get solely from the multiple increasing if the initial EBITDA were the same as its final year EBITDA
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?
72 / holding period = IRR
OR
72 / IRR = Holding period
42
What is the IRR for a 2x multiple in 3 years?
Approximately 25% IRR
43
What is the IRR for a 2x multiple in 5 years?
Approximately 15% IRR
44
What is the IRR for a 3x multiple in 3 years?
Approximately 45% IRR
45
What is the IRR for a 3x multiple in 5 years?
Approximately 25% IRR
46
What is the IRR for a 3x multiple in 4 years?
Approximately 35% IRR
47
What is the IRR for a 2x multiple in 4 years?
Approximately 20% IRR
48
The 3-year IRR in an LBO is 35%, and the exit equity proceeds are $1,000. What is the initial investor equity?
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
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.
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
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?
Approximately 16-17%
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?
Approximately $150 in EBITDA, so 50% growth
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?
Approximately 25% IRR
53
Got to page 36
Got to page 36
54
In an LBO model, what is a stub period?
PE firm enters/exits part way through a financial year
55
Stopped at 3 hour case study
Stopped at 3 hour case study
56
What is the difference between a leveraged and unleveraged dividend recap?
Leverage is funded with debt, and unleveraged is funded with cash flows of the company
57
When can a PE firm execute a dividend recap?
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
58
What are the ways that a PE firm can incentivise management to act in the PE firms best interest?
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
59
What is a management waterfall return schedule?
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
60
What is a shareholder loan in the context of an LBO?
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.
61
Does a shareholder loan affect net debt in an LBO?
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.
62
On what financial statements does PIK interest show up?
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.
63
Why do PE firms use a shareholder loan?
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.
64
What is a seller's note?
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.
65
How does the interest rate on preferred stock compare to traditional debt?
All else equal, will be lower as the debt holder retains the potential to convert into equity
66
On financial statements following an LBO, what might "cost savings" or "operating cost reductions" mean?
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
67
What are call premiums and prepayment penalties?
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"
68
What are call premiums and prepayment penalties?
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"
69
What are original issue discounts?
This is when debt is issued at a discount to its par value.
70
Why would a bond be issued at an original issue discount?
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.
71
How do the returns of an OID bond work in practice?
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.
72
What changes are there to an LBO if OID bonds are used?
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.
73
Typically, what matters more to an LBOs success - the interest rate or amount of debt outstanding?
Most of the time, leverage will determine the success more
74
How to move from EBITDA to free cash flow?
EBITDA
- Capex
- Increases in NWC
- Cash interest expense
- Cash taxes
+/- other items
+ Cash interest income
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?
Usually equity value, as this is what they are being advised on to purchase
76
How to move from net income to free cash flow?
Net income
+ D&A
+/- deferred taxes
+ Non-cash interest
- increases in NWC
- Capex
77
How to calculate cash taxes?
Difference between book taxes and deferred taxes
78
How do you calculate book taxes from cash taxes and deferred taxes?
Add both of them together
79
How is cash interest different from interest expense on income statement?
Interest expense - non-cash interest
80
What are real estate loans?
Mortgaging the real estate that a company owns?
81
Why would management run the company better after an LBO?
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.
82
What is a good ratio for operating cash flow to annual interest expense in an LBO?
2x or above. Anything less is considered ropey.
83
What is loan syndication?
Loans sold by arranging banks among a wide pool of buyers, other banks, insurers, mutual funds, and even securitised into CLOs.
84
Why is a bank underwriting debt risky?
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.
85
In a leveraged buyout, what is a "hung bridge"?
Bridge loans that could not be quickly syndicated to mutual funds and other institutional buyers
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?
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
87
What tax consequences are there of repurchasing debt that trades at a discount?
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.
88
What are placement agents?
Firms that are hired by private equity to help them connect with the pools of capital who would invest in their funds.
89
What is a rights issue/offering?
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.
90
In the context of restructuring, what is 'fraudulent conveyance'?
The idea that either assets or liabilities would be sold or transferred to benefit the shareholders of a company at the expense of creditors.
91
What is a bond indenture?
Legal contract associated with a bond
92
In the acquisition of a private company, what happens to cash in the sources and uses table?
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
93
How does the amortisation of financing fees work in an LBO?
Total financing fees / tenor
94
Which order of priority do these debt items usually have?
RCF, Term Loan A, Term Loan B, Senior Notes
RCF
TLA
TLB
Senior Notes
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
1,2,3,4
96
What is the difference between 'cash flow available for debt service' vs 'total cash available for debt service'?
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
97
Why do you use a MIN function in the amortisation of any debt?
To stop the BOP debt balance going negative.
-max(min(cash flow available to service debt tranche, starting debt balance), 0)
98
In the LBO of a private company, what do you assume for cash and debt in the uses table?
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
99
In the LBO of a private company, what items would go in the uses table?
Purchase enterprise value of target
Transaction fees
Financing Fees
Minimum cash
100
In a public company LBO, what is the purchase price based on?
A premium to the company's current share price, just as in M&A deals
101
For public company LBO, what goes in the uses table?
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)
102
For public company LBO, what goes in the sources table?
New debt issued
Replacement of target's existing debt
Excess cash on balance sheet
Investor equity
103
When you use investor equity as the plug in the sources and uses table, how do you calculate it?
Use the 'Total Uses' - sum(all other sources)
104
What features of debt are needed in a debt schedule?
x EBITDA
$ Amount
Interest rate
Floor
% Amortisation
% Sweep
% Fee
$ Fee
105
When there is management equity rollover representing 20%, what does this actually mean?
Management will plug 20% of the investor equity value that is put in the sources table of the LBO
106
Is a management earn outs or management rollover equity more likely to align management?
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.
107
What is purchase price allocation in an LBO?
Making a pro-forma balance sheet that is reflective of the assets, liabilities and equity for the company post-acquisition.
108
How does a waterfall return schedule work?
xxx
109
What is the difference in the accounting treatment of transaction fees and financing fees?
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.
110
In an LBO transaction, what will be the most basic adjustments to goodwill?
Purchase equity value
- Book value of equity
+ Existing goodwill
= Allocable Purchase Premium
111
After the basic adjustment to goodwill, what other things need to be considered to calculate pro forma goodwill?
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
112
Why do asset write ups decrease goodwill?
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.
113
When doing purchase price allocation, why do you add deferred tax liability to the purchase premium to get pro forma goodwill?
xxx
114
Difference between indefinite-lived intangibles and definite-lived intangibles?
Indefinite dont amortise, where as definite do.
115
What are some characteristics of good companies to LBO?
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
116
What are commitment letters in the context of an LBO?
Letters that promise funding for the debt portion of the purchase price on pre-agreed terms in exchange for various fees
117
What are GPs and LPs?
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.
118
In PE fundraising, what is a blind pool?
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.
119
How are GPs compensated for management of the fund?
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')
120
What is an engagement letter in the context of a private equity deal?
Letter that highlights that the sponsor engages the investment bank to underwrite any bonds intended to be included in the planned financing
121
What does flex mean in financing of an LBO?
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
122
What is a bridge loan?
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.
123
What is a management buyout?
An LBO originated and led by a target's existing management team
124
Why would management do an MBO?
The management team believes it can create more value running the company on its own than under current ownership.
125
Why are fragmented markets attractive for LBO candidates?
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
126
Why is strong cash flow generation important in the context of LBO modelling?
Cash flow generation must be able to support the periodic interest payments and debt principal repayment over the life of the loans.
127
What characteristics lend themselves to strong cash flow generation?
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
128
Why is leading and defensible market positions a good thing for a portfolio company?
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.
129
How does a financial sponsor adjudge whether a company's market positions is defensible?
Often hires strategy consultants to have assurances that the targets market positions are secure.
130
What are the two types of growth opportunities?
Organic and inorganic.
131
What are organic growth opportunities?
Growth through improved performance of existing product lines / businesses
132
What are inorganic growth opportunities?
Growth through acquiring new companies
133
Why is growth important for an eventual IPO exit?
xxx
134
What is one way of driving multiple expansion?
Robust/constant growth rate at larger levels of EBITDA, or even increasing growth rate (i.e. better future growth profile)
135
Why do larger companies command a premium to smaller peers?
Larger companies benefit from their scale, market share, purchasing power, and lower risk profile
136
Why may a sponsor not maximise the debt that could be placed on a target company?
Because they may want to use some of the cash flows to fund inorganic growth opportunities
137
What are some examples of traditional cost-saving measures for portfolio companies?
Lowering corporate overheads
Streamlining operations
Introducing lean manufacturing and six sigma processes
Reducing headcount
Rationalising the supply chain
Implementing new management information systems
138
What is the lean manufacturing philosophy that many PE firms instil at portcos?
Production practice and philosophy dedicated to eliminating waste
139
What are six sigma processes?
Production processes focused on improving output quality by identifying and elimination defects and variability
140
With cost-cutting measures implemented at portfolio companies, what do you need to be careful of?
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
141
Why are low capex requirements typically viewed as a positive thing?
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.
142
Why is it important to differentiate between growth and maintenance capex?
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.
143
For raising debt, why is a strong asset base important?
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.
144
What are considered high quality assets as collateral?
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.
145
Other than ability to sell them, what do high quality assets signify?
High barriers to entry because of the substantial capital investment required, which serves to deter new entrants in the target's markets.
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What indicates a proven/talented management team?
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.
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What happens if the target company has 'weak' management?
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.
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Why is IRR preferable to MOIC?
IRR factors in the time value of money, whereas MOIC does not
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What is the best way to interpret IRR compared to other asset classs?
Annualised return of an investment - can be used to compare against other asset classes.
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When calculating investment returns, what are the 2 things you need?
How much you pay
What the future cash flows are
You can use these to work out the returns
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Why do you use IRR over NPV?
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.
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READ: Explanation of NPV vs IRR
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.
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What can MOIC also be called?
Cash-on-cash return, MoM, Money-on-money multiple etc
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What are the three most common types of exit?
Strategic sale
Sale to another sponsor
An IPO
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Other than exiting, how can sponsors extract returns?
Issuance of dividends
Dividend recapitalisation, which is a dividend funded by the issuance of additional debt
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Why may a portfolio company purchase its own debt at a discount to par?
wAllow incremental debt reduction since the amount of the principal reduction exceeds the amount of cash used to fund it.
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Why may a portfolio company purchase its own debt at a discount to par?
Allow incremental debt reduction since the amount of the principal reduction exceeds the amount of cash used to fund it.
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Why may a financial sponsor purchase a portfolio company's debt that is trading at a discount to par?
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.
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What determines the decisions regarding when to monetise an investment?
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.
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Why may strategic acquirers be able to pay a higher price for portfolio companyies>?
Ability to ellipse synergies from the target
May also have a lower cost of capital and return thresholds than a financial sponsor
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Why is the majority of senior debt not subject to SEC regulations
Because it is issued as a loan and therefore not treated as a security
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What is the difference between contractual subordination and structural subordination?
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.
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What is a term sheet?
A summary of the key terms for the debt securities that comprise an LBO financing structure.
Typically one page in length
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Examples of sectors that typically can support higher debt / EBITDA ratios?
Cable
Healthcare
Technology
Utilities
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Examples of sectors that typically can only support lower debt / EBITDA ratios?
Cyclical industrials
Energy
Retail
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Can a revolver be drawn as part of the sources of an LBO?
Yes, although this is quite uncommon
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What are ABL facilities generally secured by?
Current assets
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For debt investors, what risk does call protection mitigate when interest rates are declining?
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.
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Throughout the life of a loan, what typically happens to the leverage and coverage ratios of a company?
Leverage ratio declines as debt is paid off, whilst coverage increases as interest payments decline/EBITDA grows
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How often do corporations typically pay bondholders interest?
Semi-annually
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From a financial engineering standpoint, what are the two ways that LBOs generate returns?
Either through debt pay down or increase in enterprise value
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What are the two ways of getting levered free cash flow from items on the income statement?
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
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In sources and uses table, should you use net or gross debt?
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.
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How do shareholder loans usually work in the entry and exit equity calculation? Are they included alongside common equity?
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.
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Why does ROIC matter less in the context of private equity investing?
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.
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