LBOs

Question 1

Look at this picture of deleveraging!

Answer 1

10.8% return on a company that hasn’t grown a bit.

If co DOES grow, it can not only pay down more debt, but also, sell at higher EBITDA (exit multiple will likely be the same) / sell a bigger company.

Question 2

What makes a good LBO candidate?

Answer 2

1) has strong, predictable, and stable cash flow (so it can service debt) … this is the most important one, after price
2) is mature, steady, practically boring
3) strong defensible market position (gives it ability to weather economic downturns)
4) has limited CapEx and product development requirements
5) is undervalued or has synergy opportunities (might be synergy opps if PE sponsor already has a portco in same industry that it can combine with the target)
6) is owned by a motivated seller (privately held co where owners want to cash out their investments, or, a large co eager to sell off non-core subsidiaries … how can you gauge commitment / motivation of seller? look at how many shares they’re rolling over)
7) has a viable exit strategy [i) IPO - not full exit, ii) M&A - full exit, premium, or secondary buyout, iii) special dividends / recap]

Others, from BIWS:

• is in a fast-growing and highly fragmented industry (so the co can make add-on acquisitions)
• have opportunities to cut costs and increase margins
• have a strong management team
• have a strong base of assets to use as collateral for debt
• have a realistic path to an exit, with returns driven by EBITDA growth and Debt paydown rather than multiple expansion

Question 3

LBO Diagram

Answer 3

Question 4

How do you fund an LBO?

Answer 4

1) Sponsor Equity
~30-35% of funding
- goal: 20+% returns (annualized) in 4-6 years

2) Bank Debt
- senior bank term loans & revolving credit facilities
- amortize (repay) over the term
- term of 5-7 years
- 40-50% of funding

3) High Yield
- subordinated debt
- higher interest rates
- high yield or “junk” bonds
- single bullet payments (not paid off until very end of term)
- term of like 10+ years

Question 5

Common Financing Parameters

Answer 5

Question 6

What is a dividend recapitalization? Why might it be used?

Answer 6

In a dividend recap, a portfolio company incurs new debt. The proceeds of the debt are used to pay the sponsor a special dividend, with the goal of enhancing returns.

The company must have a strong balance sheet / cash flows.

A dividend recap might be used when the portfolio company is not yet ready for IPO / sale.

Question 7

LBO House Analogy

Answer 7

PE firm searches for companies that might be undervalued and that could yield high returns if managed properly.

Then, just like a real estate investor might buy a house using a combination of a down payment and a mortgage, the PE firm uses Cash (Equity) and Debt to buy a company.

The private equity firm will run the company for several years and make “improvements,” similar to the renovations that a real estate investor might make.

In the end, the PE firm will sell the company, ideally for a higher price, and use the proceeds to repay the Debt it borrowed. If all goes well, it will earn back a multiple of the Cash it invested and get a high internal rate of return (IRR).

Important distinction btw LBOs and actually buying a house: an LBO is like buying a house to RENT OUT and eventually SELL rather than buying a house.

Question 8

Why don’t PE firms use Stock to fund acquisitions?

Answer 8

• they dont own the acquired companies directly
• they plan to sell the acquired companies eventually, and its easier to earn a high IRR when you invest less upfront

E.g. if you bought an Asset for $100, earned $10 on it each year, and eventually sold it for $100, your IRR would be 10%.

versus, if you bought the Asset for $50, still earned $10 on it each year, and eventually sold it for $50, your IRR would be 20%.

As a result, PE firms prefer to use as much Debt and as little of their own money as possible to fund deals.

Question 9

Why does using Debt to fund deals help PE firms?

Answer 9

1) reduces upfront cost of acquiring a co, which makes it easier for PE firm to earn a high return
2) lets PE firm use co’s cash flows to repay the Debt and make interest payments

The PE firm must still repay the Debt when it sells the co, but the benefits of Debt far outweigh this drawback, because MONEY TODAY is worth more than money tomorrow: the IRR increases by a greater amount if you can reduce the purchase price by $100 today than if you can increase the exit price by $100 in 5 years.

Question 10

What would be a terrible LBO candidate?

Answer 10

A pre-revenue startup, perhaps in biotech, because it’s extremely risky and could not afford to carry interest bearing Debt.

Question 11

What are the key drivers of return in an LBO?

Answer 11

Price, EBITDA growth and/or debt paydown

Where EBITDA growth and/or debt paydown is minimal, returns become dependent on multiple expansion, which is risky/not gauranteed

Question 12

How do you set up a simple LBO model?

Answer 12

1) Make basic transaction assumptions (re Purchase Enterprise Value, % Debt and Equity used)
- in real LBO, purchase EV might be above actual purchase price, if management / existing investors rollover / maintain ownership in deal
2) Project cash flow and debt repayment (need info on co’s Revenue, EBITDA, Taxes, and other key items such as Working Capital and CapEx; and, know the interest rate on the Debt used and its replacement terms)
- Cash Flow here is NEITHER Unlevered nor Levered FCF; it’s just “Free Cash Flow” : Cash Flow from Operations - CapEx (you start with Net Income rather than NOPAT because you want to reflect the Net Interest Expense – it reduces how much Debt the company can repay, and we want to know how much Debt principal co can repay each year)
- you don’t need full 3-statement projections, just IS and portions of CFS
3) Make exit assumptions and calculate the returns (i.e. calculate EV by multiplying EBITDA by EV / EBITDA multiple, and calculate MoM and IRR)
4) Draw conclusions


Question 13

Is there a rule of thumb for quickly calculating IRR?

Answer 13

Yes. You can approximate IRR if you know the Money-on-Money multiple and the holding period.

For “double your money” scenarios, you take 100%, divide by the # of years, and then estimate the IRR as about 75-80% of that value.

“Triple Your Money” scenarios are similar, but the compounding effect is greater there. Take 200%, divide by the # of years, and then multiply by ~65% to approximate the IRR.

The most important approximations are as follows:

• Double Your Money in 1 Year = 100% IRR
• Double Your Money in 2 Years = ~40% IRR
• Double Your Money in 3 Years = ~25% IRR
• Double Your Money in 4 Years = ~20% IRR
• Double Your Money in 5 Years = ~15% IRR
• Triple Your Money in 3 Years = ~45% IRR
• Triple Your Money in 5 Years = ~25% IRR

Question 14

What are the three exit strategies in LBOs?

Answer 14

1) M&A - Sell the co to another co or PE firm within the next 3-7 years. Clean break where firm earns all deal proceeds at once (highest IRR in part b/c no waiting, and removes legal risk … But, co may be too big, or no interested acquirers)
2) IPO - Take the co public and sell off the stake gradually over time; sometimes co’s that can’t be acquired due to size can go public which is main advantage; disadvantage is that sale of PE firm’s stake takes much longer, so there’s more risk (e.g. if share price drops)
3) Dividend recap - the PE firm never “sells” the co, but instead asks the co to issue Dividends continually (sometimes, by taking on additional Debt). Eventually, if these Dividends get big enough, quickly enough, the firm might realize acceptable returns. Tough to earn acceptable IRR via this method but it’s sometimes the only option if the M&A or IPO markets are underdeveloped or the company has legal or PR issues

Question 15

What is an LBO, and why does it work?

Answer 15

In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells the company at the end of the period to realize a return on its investment.

During the period of ownership, the PE firm uses the company’s cash flows to pay for the interest expense on the Debt and to repay the Debt principal.

It works because leverage amplifies return: if the deal performs well, the PE firm will realize higher returns than if it had bought the company with 100% equity.

But leverage also presents risks because it means the returns will be even worse if the deal does not perform well.

Question 16

Why do PE firms use leverage when buying companies.

Answer 16

To amplify their returns. Using leverage – borrowing money from others – to fund a deal makes positive returns even more positive and negative returns even more negative.

All PE firms aim for positive returns above a certain IRR, and using leverage makes it easier to achieve those returns.

A secondary benefit of using leverage is that the PE firm will have more capital to pursue other investments.

Question 17

Walk me through a basic LBO model.

Answer 17

1. Make transaction assumptions based on the purchase price, Debt interest rate, etc.
2. Build the Sources & Uses table, where “Sources” lists how the transaction will be financed and “Uses” lists the capital uses—i.e., where the “Sources” or money will be spent.
3. Adjust the Balance Sheet for the new Debt and Equity, and other transaction-related adjustments.
4. Project out the three financial statements (usually 5 years); determine how much Debt is paid down each year.
5. Calculate exit value scenarios based on EBITDA multiples.

Question 18

Can you explain the legal structure behind an LBO and how it benefits the PE firm?

Answer 18

PE firm forms a holdco, which it owns, and then this holdco acquires the real company

The banks and other lenders provide Debt to this holdco so that the Debt is at the “holdco level”

Managers and executives at the acquired co that retain ownership after the deal closes also have shares in this holdco

This structure is important because it means that the PE firm is not on the hook for the Debt it uses in the deal: It’s up to the Target Co to repay it

Question 19

What assumptions impact an LBO the most?

Answer 19

The Purchase and Exit assumptions, usually based on EBITDA multiples, make the biggest impact on an LBO

A lower Purchase Multiple results in higher returns, and a higher Exit Multiple results in higher returns

After that, the % Debt Used makes the biggest impact. If the deal performs well, more leverage will make it perform even better, and vise versa if it does not perform well

Revenue growth, EBITDA margins, interest rates and principal repayments on Debt all make an impact as well, but less so than the other assumptions

Question 20

LBO versus DCF

Answer 20

They are both based on cash flows, but in a DCF you’re saying, “What could this company be worth, based on the Present Value of its cash flows?”

Whereas in an LBO, you’re saying, “What could we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?”

Both methodologies are similar, but with the LBO valuation, you’re constraining the values based on the returns you’re targeting.

Other differences
- In an LBO, when projecting Cash Flows and Debt Repayment, you start with Net Income rather than NOPAT because you want to reflect the Net Interest Expense (it reduces how much Debt the co can repay)

Question 21

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

Answer 21

The main returns drivers are Multiple Expansion, EBITDA Growth, and Debt Paydown and Cash Generation, so a PE firm could improve its returns by improving any of those.

In practice, this means:

• Multiple Expansion - Reduce Purchase Multiple and/or increase Exit Multiple
• EBITDA Growth - Increase the company’s revenue growth rate or boost its margins by cutting expenses
• Debt Paydown and Cash Generation - Increase the Leverage (Debt) used in the deal, or improve the company’s cash flow by cutting CapEx and Working Capital Requirements

Since the PE firm has the most control over the last factor, the easiest way to boost returns is to use more Debt

Question 22

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

Answer 22

The IRR in an LBO is “the effective annual compounded interest rate”: For example, if you invest $100 in the beginning and get back $200 after 5 years, what interest rate would turn that $100 into $200 by the end?

IRR = (Exit Proceeds / Investor Equity) ^ (1 / # years) - 1

Question 23

What’s the true purchase price in a leveraged buyout?

Answer 23

Just as in a merger model, you always start with the Equity Purchase Price – the cost of acquiring all the company’s common shares.

Then, depending on the treatment of Cash, Debt, Transaction Fees, and Equity Rollovers, the “true price” may be different, which is why you create a Sources & Uses schedule.

For example, if existing Debt is “assumed” (kept in place or replaced with new Debt that’s the same), it won’t affect the purchase price. But if the PE firm repays the existing Debt with its Investor Equity or a combination of Debt and Investor Equity, that increases the effective price.

Using Excess Cash to fund the deal reduces the true price, as do Equity Rollovers.

The true price is often close to the Purchase Enterprise Value, but it won’t be the same because of these issues.

Question 24

Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause controversy?

Answer 24

Excess Cash might act as a funding source in an LBO if a company uses its Cash to repurchase its shares, reducing the number of shares that a PE firm has to purchase.

It’s not that the PE firm “gets” the company’s Excess Cash before the deal takes place – it’s that the company uses its Cash to reduce the purchase price for the PE firm.

Pre-deal shareholders often object to such moves, saying that the company should have issued a Special Dividend to them or used the cash in a more productive way.

Using Excess Cash to fund a deal also increases the ownership stakes of existing investors that choose to roll over their shares – since Excess Cash reduces the Investor Equity the PE firm needs to contribute.

Question 25

How does an Equity Rollover affect the Sources & Uses schedule in an LBO?

Answer 25

The Equity Rollover counts as a Source of Funds because it reduces the amount of Debt and Investor Equity that are required to do the deal

For example, if a company’s existing investors are rolling over 10 million out of 50 million shares, the PE firm only needs to purchase 40 million shares

The Equity Rollover also results in reduced ownership for the PE firm after the deal takes place

Question 26

Can you explain how to adjust the Balance Sheet in an LBO model?

Answer 26

The adjustments are similar to those in an M&A deal, but in an LBO, you don’t “combine” the Seller’s Balance Sheet with the Buyer’s since the “Buyer” is an empty shell corporation.

You still write down the company’s Shareholders’ Equity and replace it with the Investor Equity the PE firm is contributing, you still create Goodwill and Other Intangible Assets, and you might adjust the Deferred Tax-related items as well.

You also add the new Debt and possibly adjust the existing Debt on the L&E side of the Balance Sheet; you adjust Cash on the Assets side for deal funding and transaction fees. You may also write up or down Asset values.

You deduct one-time Transaction Fees from Retained Earnings and Financing Fees from the book value of the new Debt issued.

Question 27

How do you project Free Cash Flow and Cash Flow Available for Debt Repayment in an LBO model?

Answer 27

Start with Net Income, add back D&A, factor in the Change in Working Capital, and subtract CapEx to determine a company’s FCF in a LBO

Cash Flow Available for Debt Repayment is similar to FCF, but also adds the company’s Beginning Cash Balance and subtracts its Minimum Cash Balance and other obligations such as repayments of assumed Debt

Question 28

Which Key Metrics and Ratios might you calculate in an LBO, and what do they tell you?

Answer 28

You calculate key metrics and ratios such as Debt / EBITDA, EBITDA / Interest, and FCF Conversion because they give you better insight into how a deal performs over time. They can also indicate how risky a deal is, what the key risks are, and if the PE firm can do anything to boost returns.

For example, if the company goes from 5x Debt / EBITDA to 3x in 1-2 years, perhaps the PE firm could use more Debt in the beginning, or it could do a Dividend Recap at that stage to boost its returns.

And if the company’s FCF Conversion increases from 10% to 30%, the deal is more attractive because it’s a sign that more of the returns come from Debt Paydown and Cash Generation.

Question 29

What iRR and MoM multiple do PE firms usually target?

Answer 29

Most private equity firms aim for an IRR of at least 20%, about twice what public equity markets in developed countries have returned historically.

The targeted multiple depends on the time frame of each investment, but a 20% IRR over 5 years equates to a 2.5x multiple, so many firms target at least that much.

If the firm holds companies for longer periods – say, 7 years on average – then it may need to target a higher multiple, such as 3.5x (a ~20% IRR over 7 years).

Most firms also target different numbers for Base, Upside, and Downside cases, and aim to avoid losing money no matter what happens.

Question 30

Would you rather achieve a high IRR or MoM multiple in a LBO?

Answer 30

It’s completely dependent on the time frame. Over a short period, such as 6 months, a high IRR, such as 50%, is meaningless because you’ve barely made money (~1.25x multiple).

But over a long period – say, 10 years – a high MoM multiple such as 3x is meaningless because it corresponds to a ~12% IRR.

The best answer to this question is: “PE firms care more about IRR because that’s how they’re measured, but over short time frames, it’s better to earn a high multiple, and over longer time frames, it’s better to earn a high IRR. Also, if the PE firm has already exceeded its hurdle rate, it will focus more on MoM multiples.”

Question 31

Leverage Ratio

Answer 31

Debt / EBITDA

Is it too high or low relative to other companies? Can this co take on more debt?

Question 32

Interest Coverage Ratio

Answer 32

EBITDA / Interest

How quickly can this company pay interest on its outstanding debt

Question 33

Common Sources & Uses of Funding

Answer 33

Sources

A. Debt (all types, e.g., revolver, senior, subordinated, mezzanine)
B. Investor Equity (cash from PE firm, or Equity Rollover)
C. Debt Assumed (only if it assumes it rather than paying it)

Uses

A. Equity Value of Company (what it costs to buy 100% of shares)
B. Advisory, Legal, Financing and other fees
C. Debt Assumed (has to either repay now or later but always included here either way)
D. Refinanced Debt

• if Debt is assumed, its kept in place or replaced with new Debt thats the same as existing Debt)
• if Debt is refinanced, PE firm repays it using the Debt and Equity funding the deal

Question 34

Why would you use leverage when buying a company?

Answer 34

• Leverage Increases returns
• Leaves capital available for firm to use to purchase other companies

Why does leverage increase returns?

• Because reducing the amount of cash you pay up-front for an asset has a disproportionate effect on your returns… since money today is worth more than money tomorrow.

Question 35

Does X increase or decrease returns (IRR)?

Answer 35

Will it boost cashflows? If so, it will increase IRR

Question 36

We saw that a strategic acquirer will usually prefer to pay for another company in cash – if that’s the case, why would a PE firm want to use debt in an LBO?

Answer 36

Different scenario because:

1. PE firm not trying to hold for long term— it usually sells it after a few years, so it is less concerned with the “expense” of cash vs. debt and more concerned about using leverage to boost its returns by reducing upfront capital
2. In an LBO, the debt is “owned” by the company, so company assumes much of the risk. Whereas in a strategic acquisition, the buyer “owns” the debt so it is more risky for them.

Question 37

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

Answer 37

Interest paid is tax deductible, which increases cash-flow, this incremental increase is called a tax-shield

(Cash flow is still lower than it would be without the debt)

Question 38

Free Cash Flow in LBO versus DCF

Answer 38

In LBO, determines company’s ability to repay debt

In DCF, determines implied value of co

In LBO, FCF starts with net income (so it includes net interest expense)

In DCF, FCF starts with NOPAT