LBO Qs Flashcards
What is a LBO fund? What are its characteristics?
A financial buyer that raises capital from investors to purchase companies with a small amount
of equity and uses a significant amount of borrowed money (loans and bonds) to fund the
remainder of the acquisition cost in order to boost IRR
(1) Short-term investment (intend to exit 3-7 years)
(2) High level of debt
(3) Assets of the target company are used as collateral for loans
(4) Delever (pay down) with target company’s cash flow
(5) Exit the investment ideally with little or no debt leftover; LBO fund collects higher
percentage of exit sale price and/or uses the excess cash flow to pay themselves a dividend
What does a PE firm do?
There are 6 steps to the PE process Create fund Find target Structure deal Obtain financing Unlock value Exit the investment
Why lever up a firm?
(1) By using leverage to help finance the purchase price, private equity fund reduces the amount
of money that must be contributed, which can substantially boost returns upon exit
(2) Frees up remaining capital to be used to make other investments
(3) Interest payments on debt are tax deductible - can substantially reduce effective tax rate
Strategic acquirers tend to prefer to pay for acquisitions with cash. If that is the case, why
would a private equity fund want to use debt in a LBO?
(1) Private equity funds do not intend to hold the company for the long-term and thus, are less
concerned with the “expense” of cash versus debt. They are more concerned with using leverage
to boost its returns by reducing the amount of capital it has to contribute up front
(2) In a LBO, the “debt” is owned by the company so they assume the majority of the risk (i.e.
the target company’s assets are used as collateral). In a strategic acquisition, the buyer owns the
debt so it is more risky for them
What are the main differences between private equity and hedge funds?
-Time horizon. Private equity firms typically invest in longer-term, illiquid assets with the
intent to buy, grow and exit these portfolio companies in three to seven years. Hedge fund
investments are typically much more liquid and shorter in duration, lasting anywhere from
milliseconds to years.
-Control. Private equity funds typically make highly concentrated investments by purchasing
whole companies. Hedge funds typically make a broader set of short-term investments by
purchasing minority stakes in securities (e.g. equities, bonds, derivatives, futures, commodities,
foreign exchange, swaps, etc)
-Strategy. Private equity funds generally work closely with management to improve
operations in order to make the company more valuable. Although hedge funds use many
different strategies (long/short equity, credit, macro, arbitrage, etc), many hedge funds prefer to
in relatively liquid securities so that they can trade out at any point in time in order to lock
their profits
-Fee structure. The main difference is that hedge funds tend to take out their performance fees
every quarter or every year, whereas private equity funds do not get paid until their investments
exited. This can mean that no performance fees are taken for 5 years or more
What is the hurdle rate?
Minimum required IRR. Historically, the hurdle rate for most private equity funds was around
30% but it may be as low as 15% to 20% in adverse economic conditions
What is IRR? What is the formula for calculating the IRR of a LBO?
IRR is the discount rate that makes the net present value of all cash flows from a particular
project equal to zero. IRR is a measure of the return on a fund’s invested equity.
Run me through the changes between the existing balance sheet and the pro forma balance
sheet in an LBO model.
(1) Deduct cash used in transaction
(2) PP&E Step-up
(3) Newly Identified Intangibles
(4) New Goodwill
(5) Capitalized financing fees
(6) New debt + repayment of old debt if any
(7) Deferred tax liability
(8) New common equity
Walk me through an LBO analysis.
1) Transaction assumptions (sources and uses)
- Entry multiple and purchase price
- Financing (leverage levels / cap structure)
- Interest rates on debt tranches
- Equity contribution (uses less other sources of financing)
2) Pro-forma target balance sheet to reflect transaction and new cap structure
- Add new debt, wipe out shareholders’ equity
- Replace with equity contribution
- Adjust cash
- Capitalize financing fees
- Plug goodwill / intangibles
3) Integrated cash flow model
- Operating assumptions (e.g. revenue growth, margins)
- Pro-forma income statement, balance sheet, statement of cash flows
- Projected available FCF per year
- Required debt repayment each year
(4) Exit assumptions
- Time horizon of investment
- EBITDA exit multiple
- Dividend recapitalization
- Calculate equity returns
- Sensitize results
Let’s say you run an LBO analysis and the private equity firm’s return is too low.
What drivers to the model will increase the return?**
Some of the key ways to increase the PE firm’s return (in theory, at least) include:
(1) EBITDA/Earnings Growth – links to value creation by creating a higher implied exit price
and higher cash flow, which can lead to higher dividends and quicker debt repayment
-Organic revenue growth
-Acquisitive revenue growth
-Cost cutting (thus, improved margins)
-Reduced taxation
-Reduce operating leverage (lower fixed costs, higher variable costs)
(2) FCF Generation / Debt Paydown – quick debt paydown with excess cash decreases risk and
increases proceeds to equity holders
*Note: operational improvements (e.g. working capital management) increases cash flow
available for debt repayment
(3) Multiple uplift – simple arbitrage between the purchase multiple and sale multiple
-Negotiate lower entry multiple
-Increase exit multiple (even with the same earnings, if market conditions become favorable
and/or risk decreases, a higher sale price results from a higher multiple)
(4) Increased Gearing – increase in interest-bearing debt, which can amplify the gains (and
losses) to equity holders
-Conservative leverage reduces equity contribution and boosts returns
What are ways to increase the exit multiple?
While we cannot always rely on multiple expansion because it is difficult to control the market,
decreased risk results from
(1) Reaching a greater size
(2) Reducing debt
(3) Diversifying the offering
(4) Increasing customer/supplier fragmentation
(5) Implementing exclusive arrangements and contracts
(6) Anything else that may lead to more stable earnings.
What are some characteristics of a company that is a good LBO candidate?
(1) Strong/predictable CFs – used to pay down acquisition debt
(2) Profitability and limited business risk (e.g. mature, steady, non-cyclical industry; strong,
defensible market position w/ high barriers to entry to make cash flows less risky)
(3) Strong management team
(4) Clean balance sheet with low gearing
(5) Low ongoing investments (e.g. capex and R&D requirements)
(6) Limited working capital requirements
(7) Synergies and potential for cost structure reductions
(8) Strong tangible asset that can be used as collateral to raise more debt
(9) Undervalued
(10) Viable exit strategy
(11) Divestible assets
What is a good due diligence framework?
(1) Industry Analysis
-Porter’s Five Forces
Customer
(1) What is the unmet need?
(2) Which segment is being targeted?
(3) Price sensitivity
(4) Motivated by quality or service
-Market growth
-External factors
(2) Company Analysis
-Competitive advantage/SWOT analysis
-Management
-Supply chain analysis
-Profitability analysis
-Operating Performance
-Opportunities
What are Porter’s Five Forces?
Porter’s Five Forces
(1) Competitive rivalry
-Perfect competition, oligopoly, or monopoly
-What is the primary strategy for product competition (brand, quality, price)?
-What is market share / fragmentation (# of comps)?
-High fixed costs & low variable costs
-High barriers to exit
(2) Threat of new entry
-Barriers to entry high or low (e.g. capital equipment, technology protection, labor unions, time,
cost advantage, specialist knowledge)
-Economies of scale?
-Market fragmentation?
(3) Threat of substitutes
-Is substitution easy and viable?
-Low switching costs
(4) Supplier power
-How many suppliers are there for each key input? Size of each?
-How easy is it for suppliers to drive up prices?
-What is the uniqueness of their product or service, their strength and control over you, the cost
of switching from one to another, and so on?
(5) Buyer power
-How many customers are there? Size of each order?
-Differences between services?
Due Diligence: What firm specific questions would you ask?
(1) Competitive Advantage / SWOT Analysis
-Pricing
-Differentiation (performance, reliability, durability, features, perceived quality and brand)
-Niche / specialty
-Leveragability of skills / technology for entry
(2) Management team and Culture
-Experience and competence (length of tenure, backgrounds)
-Industry connections (strength with buyers / suppliers)
-Equity stake in the business / founders?
-Rigid or fluid culture
-HR issues like union or labor problems?
(3) Supply chain analysis
-Primary activities: R&D -> Inbound logistics -> Operations -> Distribution -> Sales &
Marketing -> Services
-Support activities: Co. infrastructure, human resources, info tech
(4) Profitability analysis
-Zero in on growth: How much growth is projected and how much is attributed to growth of the
industry versus market share gains? Realistic projections?
-What are the projected financials?
-Opportunities to increase revenue?
(a) Increase prices (differentiation, customer service, brand strength, demand elasticity)
(b) Increase volume (increase market share, move products, improve technology, fundamental
growth)
-Opportunities to decrease costs? (concentrate purchasing, overhead reduction, outsource noncore
competencies, identify cost drivers, eliminate fixed or variable costs, efficient supply
channels, increase economies of scale)
(5) Operating Performance
-What is the resilience of this company to downturns?
-What demographics is the revenue focused in, and how will these demographics change?
-What is the cost structure, how efficient are the supply and distribution chains?
-What’s the proportion of fixed to variable costs?
-How well do you utilize assets?
-Ask about capital expenditures, growth versus maintenance.
-Also ask about how working capital is managed.
-How well do you collect on account receivables or manage accounts payable?
-How much cash is available right now?
-Are there any material, undisclosed off-balance sheet liabilities?
(6) Opportunities:
-Are there non-core or unprofitable assets or business lines?
-Is there opportunity for improvement or rationalization?
-What’s your exit strategy here?
-Is the industry consolidating so that a sale might be made easier?
-What impact will an acquisition and financial leverage have on the operations of the business?
Will key customers be spooked?
What is a good framework for an investment memorandum?
(1) Investment thesis / recommendation (make a decision either way)
(2) Investment positives / major risks
- Five major points
- Mitigating factors
(3) Industry analysis
(4) Company analysis
(5) Key model drivers
(6) Financial summary
- Deal structure
- FCF
- Credit stats
- Multiples
- Returns
- Sensitivities
(7) Areas for further due diligence
If I handed you an offering memorandum, what are some of the things you’d think
about?
(1) Industry analysis: You’d examine at the industry, look for growth opportunities and question
whether the sponsor and/or management could capitalize on those opportunities.
(2) Company analysis: You’d try to understand the business as much as possible, especially in
operational points like capex, working capital needs, margins, customers, etc.
(3) Valuation: You would think about how you would value the company; areas to unlock value?
(4) Good investment? You would consider if the target meets your criteria for a good LBO
candidate
(5) Deal structure: You would wonder what would be appropriate capital structure, and whether
it is achievable in the current markets.
(6)Most importantly, you’d think about all the potential risks.
What is a revolving credit facility and what are its characteristics?
-Unfunded Revolver = form of senior bank debt that acts like a credit card for companies and is
generally used to help fund a company’s working capital needs
-A company will “draw down” the revolver up to the credit limit when it needs cash, and repays -
the revolver when excess cash is available (there is no repayment penalty).
-Offers companies flexibility with respect to their capital needs, allowing companies access to
cash without having to seek additional debt or equity financing.
Costs:
(1) Interest rate charged on the revolver’s drawn balance
-LIBOR plus a premium that depends on the credit characteristics of the borrowing company.
(2) Undrawn commitment fee
-Compensates the bank for committing to lend up to the revolver’s limit
-Usually calculated as a fixed rate multiplied by the difference between the revolver’s limit and
any drawn amount
What is bank debt and what are its characteristics?
Bank debt is a lower cost-of-capital (lower interest rates) security than subordinated debt, but it
has more onerous covenants and limitations.
(1) Typically 30-50% of cap structure
(2) Based on asset value as well as cash flow
(3) LIBOR based (i.e. floating rate) term loan depending on credit characteristics of borrower
(4) 5-8 year payback or maturity with annual amortization often in excess of that which is
required (4-5 years)
(5) 2x – 3x LTM EBITDA (varies w/ industry, ratings, and economic conditions)
(6) Secured by all assets and pledge of stock
(7) Maintenance and incurrence covenants
What forms does bank debt usually take?
(1) Revolver
(2) Term Loan A – shorter term (5-7years), higher amortization
(3) Term Loan B – longer term 95-8years), nominal amortization, bullet payment
-Allows borrowers to defer repayment of a large portion of the loan, but is more costly to
borrowers than Term Loan A.
What is high-yield debt (sub notes or junk bonds) and what are its characteristics?
High-yield debt is so named because of its characteristic high interest rate (or large discount to
par) that compensates investors for their risk in holding such debt. This layer of debt is often
necessary to increase leverage levels beyond that which banks and other senior investors are
willing to provide, and will likely be refinanced when the borrower can raise new debt more
cheaply.
(1) Typically 20-30% of cap structure
(2) Generally unsecured
(3) Fixed coupon may be either cash-pay, payment-in-kind (“PIK”), or a combination of both
(4) May be classified as senior, senior subordinated, or junior subordinated
(5) Longer maturity than bank debt (7-10 years), with no amortization and a bullet payment
(6) Incurrence covenants
What are the advantages of subordinated debt?
(1) A company retains greater financial and operating flexibility with high-yield debt through
incurrence, as opposed to maintenance, covenants and
(2) Greater flexibility due to a bullet (all-at-once) repayment of the debt at maturity.
(3) Early payment options typically exist (usually after about 4 and 5 years for 7- and 10-year
high-yield securities, respectively), but require repayment at a premium to face value.
What is mezzanine debt and what are its characteristics?
The mezzanine ranks last in the hierarchy of a company’s outstanding debt, and is often financed
by private equity investors and hedge funds. Mezzanine debt often takes the form of high-yield
debt coupled with warrants (options to purchase stock at a predetermined price), known as an
“equity kicker”, to boost investor returns to acceptable levels commensurate with risk.
(1) Can be preferred stock or debt
(2) Convertible into equity
(3) IRRs in the high teens to low twenties on 3-5 year holding period
The debt component has characteristics similar to those of other junior debt instruments, such as
bullet payments, PIK, and early repayment options, but is structurally subordinate in priority of
payment and claim on collateral to other forms of debt. Like subordinated notes, mezzanine debt
may be required to attain leverage levels not possible with senior debt and equity alone.
*Note: For example, regular subordinated debt might have an interest rate of 10%, while a
hedge fund investor expects a return (IRR) in the range of 18-25%. To bridge this gap and
attract investment by the hedge fund investor, the borrower could attach warrants to the
subordinated debt issue. The warrants increase the investor’s returns beyond what it can achieve
with interest payments alone through appreciation in the equity value of the borrower.
What are the typical credit stats of an LBO?
Total Debt / EBITDA = 4.5x – 5.5x
Senior Bank Debt / EBITDA = 3.0x
EBITDA / Interest Coverage = > 2.0x
(EBITDA – Capex) / Interest Coverage = > 1.6x
