LBOs Flashcards
What is an LBO?
An LBO is the acquisition of a company, either privately held or publicly traded, where a significant amount of the purchase price is funded using debt. The remaining portion is funded with equity contributed by the financial sponsor and in some cases, equity rolled over by the company’s existing management team.
Once the transaction closes, the acquired company will have undergone a recapitalization and transformed into a highly leveraged financial structure.
The sponsor will typically hold onto the investment between 5 to 7 years. Throughout the holding period, the acquired company will use the cash flows that it generates from its operations to service the required interest payments and pay down some of the debt principal.
The financial sponsor will usually target an IRR of approximately ~20-25%+ when considering an investment.
Walk me through an LBO model.
- Entry valuation: The first step to building an LBO model is to calculate the implied entry valuation based on the entry multiple and LTM EBITDA of the target company.
- Sources and uses: Next, the “Sources and Uses” section of the model will lay out the proposed transaction structure. The “Uses” side will calculate the total amount of capital required to make the acquisition, whereas the “Sources” side will detail how the deal will be funded. Most importantly, the key question being answered is: What is the size of the equity check the financial sponsor must contribute?
- Financial projection: Once the Sources & Uses table has been completed, the free cash flows (FCFs) of the company will be projected based on the operational assumptions (e.g., revenue growth rate, margins, interest rates on debt, tax rate). The FCFs generated are central to an LBO as it determines the amount of cash available for debt amortisation and the interest expense due each year.
- Returns calculation: In the final step, the exit assumptions of the investment are made (i.e., exit multiple, date of exit), and the total proceeds received by the private equity firm are used to calculate the IRR and cash-on-cash return, with a variety of sensitivity tables attached below.
What is the basic intuition underlying the usage of debt in an LBO?
The typical transaction structure in an LBO is financed using a high percentage of borrowed funds, with a relatively small equity contribution from the private equity sponsor. As the principal of the debt is paid down throughout the holding period, the sponsor will be able to realise greater returns upon exiting the investment.
The logic behind why it is beneficial for sponsors to contribute minimal equity is due to debt having a lower cost of capital than equity. One of the reasons the cost of debt is lower is because debt is higher up on the capital structure – as well as the interest expense associated with the debt being tax-deductible, which creates an advantageous “tax shield.” Thus, the increased leverage enables the firm to reach its returns threshold easier.
Private equity firms, therefore, attempt to maximise the amount of leverage while keeping the debt level manageable to avoid bankruptcy risk. Simply put, the smaller the equity check the financial sponsor has to write towards the transaction, the higher the returns to the firm.
Another side benefit of using higher amounts of debt is that it leaves the firm with more unused capital (i.e., “dry powder”) that could be used to make other investments or to acquire add-ons for their portfolio companies.
What are the primary levers in an LBO that drive returns?
- Deleveraging: Through the process of deleveraging, the value of the equity owned by the private equity firm grows over time as more debt principal is paid down using the cash flows generated by the acquired company
- EBITDA growth: Growth in EBITDA can be achieved by making operational improvements to the business’s margin profile (e.g.. cost-cutting, raising prices), implementing new growth strategies to increase revenue, and making accretive add-on acquisitions
- Multiple expansion: Ideally, a financial sponsor hopes to acquire a company at a low entry multiple (“getting in cheap”) and then exit at a higher multiple. The exit multiple can increase from improved investor sentiment in the relevant industry, better economic conditions, and favourable transaction dynamics (e.g., competitive sale process led by strategic buyers). However, most LBO models conservatively assume the firm will exit at the same EV/EBITDA multiple it was purchased at. The reason is that the deal environment in the future is unpredictable and having to rely on multiple expansion to meet the return threshold is considered risky.
What assumptions is an LBO model most sensitive to?
- Purchase or exit multiple assumptions
- Total leverage the business can service (typically based on the debt/EBITDA ratio)
- Cost of debt
- Operating assumptions for the business (e.g., revenue growth and EBITDA margins)
Would an LBO or DCF give a higher valuation?
Technically it could go either way, but in most cases the LBO will give you a lower valuation.
With an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value.
With a DCF, by contrast, you’re taking into account both the company’s cash flows in
between and its terminal value, so values tend to be higher.
Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you’d set a desired IRR and determine how much you could pay for the company (the valuation) based on that.
What is an “ideal” candidate for an LBO?
“Ideal” candidates have stable and predictable cash flows, low‐risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
How do PE firms exit their investment?
The most common exits are:
* Sale to a strategic buyer: The sale to a strategic buyer tends to be the most convenient while fetching higher valuations as strategics are willing to pay a premium for the potential synergies
* Secondary buyout (aka sponsor-to-sponsor deal): Another option is the sale to another financial buyer – but this is a less than ideal exit as financial buyers cannot pay a premium for synergies.
* Initial Public Offering (IPO): The third method is for the portfolio company to undergo an IPO and sell its shares in the public market.
Why would a private equity firm buy a company in a “risky” industry, such as technology?
Although technology is more “risky” than other markets, remember that there are mature, cash flow‐stable companies in almost every industry. There are some PE firms that specialize in very specific goals, such as:
* Industry consolidation – buying competitors in a similar market and combining them to increase efficiency and win more customers.
* Turnarounds – taking struggling companies and making them function properly again
* Divestitures – selling off divisions of a company or taking a division and turning it into a strong stand‐alone entity.
So even if a company isn’t doing well or seems risky, the firm might buy it if it falls into
one of these categories.
How could a private equity firm boost its return in an LBO?
- Lower the Purchase Price in the model.
- Raise the Exit Multiple / Exit Price
- Increase the Leverage (debt) used
- Increase the company’s growth rate (organically or via acquisitions)
- Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.).
