LBO Qs

Question 1

What is a LBO fund? What are its characteristics?

Answer 1

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

Question 2

What does a PE firm do?

Answer 2

There are 6 steps to the PE process 
Create fund
Find target
Structure deal
Obtain financing
Unlock value
Exit the investment

Question 3

Why lever up a firm?

Answer 3

(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

Question 4

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?

Answer 4

(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

Question 5

What are the main differences between private equity and hedge funds?

Answer 5

-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

Question 6

What is the hurdle rate?

Answer 6

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

Question 7

What is IRR? What is the formula for calculating the IRR of a LBO?

Answer 7

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.

Question 8

Run me through the changes between the existing balance sheet and the pro forma balance
sheet in an LBO model.

Answer 8

(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

Question 9

Walk me through an LBO analysis.

Answer 9

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

Question 10

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?**

Answer 10

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

Question 11

What are ways to increase the exit multiple?

Answer 11

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.

Question 12

What are some characteristics of a company that is a good LBO candidate?

Answer 12

(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

Question 13

What is a good due diligence framework?

Answer 13

(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

Question 14

What are Porter’s Five Forces?

Answer 14

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?

Question 15

Due Diligence: What firm specific questions would you ask?

Answer 15

(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?

Question 16

What is a good framework for an investment memorandum?

Answer 16

(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

Question 17

If I handed you an offering memorandum, what are some of the things you’d think
about?

Answer 17

(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.

Question 18

What is a revolving credit facility and what are its characteristics?

Answer 18

-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

Question 19

What is bank debt and what are its characteristics?

Answer 19

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

Question 20

What forms does bank debt usually take?

Answer 20

(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.

Question 21

What is high-yield debt (sub notes or junk bonds) and what are its characteristics?

Answer 21

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

Question 22

What are the advantages of subordinated debt?

Answer 22

(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.

Question 23

What is mezzanine debt and what are its characteristics?

Answer 23

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.

Question 24

What are the typical credit stats of an LBO?

Answer 24

Total Debt / EBITDA = 4.5x – 5.5x
Senior Bank Debt / EBITDA = 3.0x
EBITDA / Interest Coverage = > 2.0x
(EBITDA – Capex) / Interest Coverage = > 1.6x

Question 25

Given that there is no multiple expansion and flat EBITDA, how can you still generate a
return?**

Answer 25

(1) Leverage
- Improve tax rate
- Pay down debt
- Reduce interest
(2) Dividends
(3) Reduce capex
(4) Reduce working capital requirements
(5) Depreciation tax shield

Question 26

If there is a higher growth capex proportion of total capex, would you still want to use same
split?**

Answer 26

Growth capex is more favorable than maintenance capex. It’s flexible; maintenance capex needs
to be paid every year just to keep the company running, whereas growth capex can be stalled in
times of downturn. Also, growth capex implies investments, which yield higher cash flows in the
future, that can be used to support more debt.

Question 27

What are the advantages of an LBO?

Answer 27

(1) There is an opportunity to execute long-term strategy outside of the short-term focus of the
public markets (examples: acquisitions, cost reductions, capital investments).
(2) Use of levered capital structure to increase equity returns. Debt is tax deductible and private
equity firms can put up less equity to purchase a firm.
(3) Private equity firms bring a sense of urgency to the entire business, disciplining the company
to quickly seize opportunities.
(4) Incentive compensation schemes align management incentives with the sponsor’s.
(5) The company gets a stable shareholder base of long-term investors.
(6) The company now has the capability to leverage private equity firm’s networks to reach new
customers or improve supplier relationships.
(7) There is also decreased regulatory governance (Sarbanes-Oxley).

Question 28

Why is capex so important to a private equity investor? What is the difference between
maintenance capex and growth capex?

Answer 28

Capex is important because it can significantly influence the value of a business. We are
primarily interested in maintenance capex, which refers to the capex required to keep a business
running at current cash flow levels. Growth capex refers to capex required to grow the business
beyond typical cash flows (e.g. acquisitions). Financial statements do not have a line item titled
maintenance capex, and no formula exists to calculate maintenance capex from the financial
statements. Therefore, maintenance capex calculations are mostly estimates. The reason we only
want maintenance capex is because we’re valuing the business based on its current state and
current cash flows.

Question 29

What is the primary weakness of FCF?

Answer 29

It is calculated on a historical basis

Question 30

What do you look for in potential investments in this economic climate?

Answer 30

(1) Potential market size: depending on the size of the fund and the size of the potential investee,
the market for that investee needs to be a certain size to mitigate a range of risks. A larger
market means you need less of a share to achieve target returns. It also means that competitors
have less of an influence when they get aggressive. For a lower-mid-market fund, I look for
markets with a current size of at least $0.5-$1b and with growth rates that are at least positive
(not as common in our current economic climate).
(2) Customer/Supplier Fragmentation: the last thing you want in this market (when it’s already
tough to grow) is to invest in a business with high customer concentration. If a major customer is
lost, you could lose a significant part of your business. All of those great strategic plans you had
to grow the business will now only bring the business back to its former glory. The same goes
with the supply side, although there’s often less of an impact (unless you are licensing someone
else’s brand).
(3) Counter-cyclical offering: most of the highly defensive industries make for bad investments.
They either don’t have the growth prospects or are too risky. I’m thinking agricultural
commodities, certain financial services, natural resources, etc. But, you can benefit from
counter-cyclicality in other industries too by finding sub-industries that businesses visit in
tougher economic conditions due to cost savings.
(4) Invested management team: we’re seeing many business owners looking to sell out
completely while telling us that their businesses would make great investments even in a
downturn. One would think that a mass exodus would indicate something quite different to a
great opportunity. So, beware of business owners jumping ship, especially if they’re not on their
deathbeds and are sufficiently able to continue their businesses. They know more about their
business than you do, so take notice of their behavior. Also, don’t let earn-outs that seem to lock
management in fool you; they’ve often done their numbers and have accounted for the risk of
losing the earn-out.
(5) Low gearing: a seemingly low risk business with high gearing can become high risk and
virtually non-existent if revenue softens or a refinancing event strikes. A lowly geared business
gives you room, should you need it, if things turn sour. We are seeing businesses file for
insolvency every day due to gearing, so it should serve as a powerful warning to private equity
investors looking to buy in this market. Again, common sense and looking at deals objectively
will save face.

Question 31

What are the value-based components of a PE deal?

Answer 31

(1) Clawback (or ratchet): a clawback involves a condition whereby the private equity firm’s
stake in the business increases (and the management’s stake decreases) if the business doesn’t
meet certain earnings targets. The purpose of the clawback is to protect the investor against
downturns in earnings. Inherently, this is a protection mechanism for the private equity firm.
(2) Incentive scheme (or ESOP): an incentive scheme, or employee stock ownership plan,
balances the effect of a clawback. It provides incentives to management to reach certain
earnings targets (or a particular exit price). It often only partly offsets the effect of a clawback,
meaning that the net effect is in favor of the private equity firm. Inherently, this is an incentive
mechanism for the management team.
(3) Earn-out: this is a condition whereby a portion of the purchase price is deferred and
conditional upon predetermined targets. While deals involving expansion capital use clawbacks,
complete buyouts of a business use earn-outs (therefore, earn-outs are usually mutually
exclusive to clawbacks). The purpose of the earnout (just like the clawback) is to protect the
private equity firm from downside volatility in earnings and from any unintended consequences
to misinformation. Inherently, this is a protection mechanism for the private equity firm.
(4) Management Fees: these fees are paid upfront and/or periodically to the private equity firm
in return for help to grow the business. Management fees are another way the private equity
firms can realize a return on their investment prior to exiting. Inherently, this is a protection
mechanism for the private equity firm.
(5) Coupon or interest payments: although the term “private equity” suggests the invested capital
exists as equity, some firms prefer to invest in hybrid securities such as convertible notes (which
include an equity component). The benefit to the firm is they receive the upside of equity with the
protection of regular interest or coupon payments. This can seem perverse to potential investees,
but it can also facilitate higher valuations. Inherently, this is a protection mechanism for the
private equity firm.
(6) Preference subordination: private equity firms prefer to invest in preferred stock so in the
case of failure, they rank ahead of ordinary shareholders. A coupon payment is often included,
but even without a coupon the subordination mitigates some risk for the investor. Inherently, this
is a protection mechanism for the private equity firm.

Question 32

What covenants are used to evaluate the debt structure of a firm by a PE firm?

Answer 32

(1) Debt/EBITDA: how many years of earnings will pay back the debt principal (this measure is
also called the gearing ratio). A typical multiple for this covenant is between 2-4x, although for
larger deals a multiple of 5x isn’t unusual.
(2) EBITDA/Interest: how many times the current earnings could pay back the interest on the
debt (also called interest cover ratio). The idea being that earnings could fall X% before the
business couldn’t pay the interest on its debt. A typical multiple for this covenant is at least 2x,
the higher the better.
(3) FCF/Repayment: this is similar to the interest cover ratio, except it uses free cash flow (FCF)
in the numerator to bypass the obvious downfalls of using an accounting earnings number. It
also adds the compulsory principal repayments to the denominator (so the denominator =
interest + principal repayments). The reason for this is that the expected repayment often
contains a principal component.

Question 33

What are the advantages and disadvantages of EBITDA over FCF?

Answer 33

The advantage of EBITDA over FCF is that it is independent of depreciation, cost of capital
(such as interest on debt) and taxes. The disadvantage of EBITDA is that it doesn’t account for
capex, which is a vital driver to ongoing earnings.
The other difference compared to FCF, is that EBITDA still includes accrued debtors and
creditors. However, for the purpose of business valuation, this is a better representation of the
future (as long as there’s no fraudulent manipulation) because accrual accounting is forward
looking.

Question 34

Does enterprise value include working capital?

Answer 34

Yes. Your calculation of a firm’s enterprise value must account for working capital because it
affects cash flow. And, anything that affects cash flow, affects returns, and anything that affects
returns, affects the value of an investment.

Question 35

What happens to EV when you issue more equity?

Answer 35

(1) If the equity is issued for no reason, just to increase cash for a rainy day, then there is no
effect on enterprise value (EV). Theoretically, equity increases, but so does cash, which offsets
debt to give net debt. Intuitively, if you sell the business the day after raising the money, the cash
is just used to pay back the people that just funded the new issue. Practically, it could be a little
different. If you raised money at a premium, the new shareholders will get less back as the new
cash is shared between everyone (either by paying down debt or via a capital return). The
opposite happens if you issue at a discount.
(2) If the equity is issued to invest in the business, then the effect on EV depends on the
profitability of the investment. Remember, we’re working with market value. If the “market”
values the investment at cost, then it cancels out. If they value the investment at zero, the EV
stays the same, the equity value stays the same, but you have more share, so the per share price
drops. If they value it above cost, then the opposite happens.

Question 36

Explain a few drivers of purchase multiples of a business.

Answer 36

1) Growth
(2) ROIC
(3) Business size: a larger business has a larger market share (usually), more stability (mostly)
and is more attractive to buyers (generally). Therefore, a larger business demands a premium.
(4) Stability: revenue and earnings stability drives confidence in forecasts, which demand a
premium. Unstable businesses are riskier and require a higher required return, hence a lower
multiple.
(5) Diversification: a business with a diversified product range, customer base and supplier list
is less risky. These all affect earnings stability (see above) and hence, influence the multiple.
(6) Capex: this is often forgotten when just looking at EBITDA, which is why some people use
multiples of EBIT (using depreciation as a proxy for capex). Capex represents a large portion of
costs that don’t hit the P&L (until depreciated), so it’s important to consider capex in your
valuation. Reduce EBITDA multiples for high capex businesses.
(7) Intellectual property: in private equity, we tend not to pay extra for IP because it is often
needed to produce the cash flow. However, we may pay a higher multiple because proprietary IP
represents greater differentiation, more stability, higher barriers to imitation and less risk.
(8) Synergies: a buyer that has the potential to realize synergistic benefits from an acquisition
can generally pay a higher multiple because the acquisition represents a greater value to them.
This is one of those drivers that mean the ideal multiple for me can be different to the one for
you.
(9) Debt capacity: more debt adds more risk (insolvency, default, etc) to the business, but it also
amplifies returns and reduces the overall cost of capital. The ability to add more debt commands
a premium.
(10) Deal terms: a purchase multiple can be manipulated by the terms of the deal. If the deal is
100% cash up-front, the multiple will be lower than if some of the purchase price is contingent
on future earnings. Be very cognizant of the time value of money and that contingent payments
have less value if paid later. So, if $100m is paid today plus $100m is paid in 5 years, the
purchase price isn’t $200m. It could be more like $130m, depending on your discount rate. A
much higher multiple can be shown on paper through deal manipulation

Question 37

What is a bolt-on acquisition? What are the advantages of a bolt-on?

Answer 37

A bolt-on acquisition is an investment via an existing portfolio company into a business that
presents strategic value (usually in the same industry).
(1) Usually smaller businesses, which attract lower multiples with better terms
(2) Provide the chance to create instant value (by acquiring lower multiple businesses using a
higher multiple vehicle)
(3) Often require less work because they are smaller and attract less competition
(4) Offer strategic value (revenue and cost synergies), meaning you can pay a little more and be
more successful in an auction process
(5) Provide for easier due diligence since you have access to industry experts in your primary
investment vehicle (access to this experience is invaluable)
(6) Bolt-on owners are more likely to do a deal with a larger industry player, since there is
prestige in being part of a leading firm (compared to being gobbled up by financial vultures).
(7) Provide access to a whole new market of potential investees as certain mandated restrictions
(regarding size) don’t apply

Question 38

What are the advantages/disadvantages to a recap?

Answer 38

Leveraged recapitalizations are used by privately held companies as a means of refinancing,
generally to provide cash to the shareholders while not requiring a total sale of the company.
Debt (in the form of bonds) has some advantages over equity as a way of raising money, since it
can have tax benefits and can enforce a cash discipline. The reduction in equity also makes the
firm less vulnerable to a hostile takeover.
There are downsides, however. This form of recapitalization can lead a company to focus on
short-term projects that generate cash (to pay off the debt and interest payments), which in turn
leads the company to lose its strategic focus.[1] Also, if a firm cannot make its debt payments,
meet its loan covenants or rollover its debt it enters financial distress which often leads to
bankruptcy. Therefore, the additional debt burden of a leveraged recapitalization makes a firm
more vulnerable to unexpected business problems including recessions and financial crises.

Question 39

What the different uses of a LBO analysis?

Answer 39

(1) Calculating private equity fund’s IRR
(2) By assuming the private equity fund’s IRR, we can back into a purchase price for the
company, which is useful for valuation purposes (might provide a price floor)
(3) Analyze trend of credit statistics (important from a lender’s perspective

Question 40

How would a dividend recapitalization impact the three financial statements?

Answer 40

Income Statement: no change
Statement of Cash Flows: increase financing cash flows from debt issuance, decrease financing
cash flows from dividend payout
Balance Sheet: increase debt, decrease shareholders’ equity

Question 41

Why do bondholders need covenants?

Answer 41

Covenants protect bondholders against a reduction in the value of their investment through:
(1) Credit deterioration
(2) Loss of equity cushion
(3) Loss of control over assets
(4) Loss of seniority position
Covenants increase the chance of capital gains for bondholders because they force the company
to deleverage (or limit the ability to relever) and reinvest.

Question 42

Does an LBO or DCF give a higher valuation?

Answer 42

LBO generally gives a lower valuation because:

(1) LBOs do not necessarily improve cash flows dramatically over the investment time horizon
(2) LBO does not provide a specific valuation; set desired IRR and back out the purchase price