Leveraged Buyouts and LBO Models

Question 1

Why do Private Equity firms (aka Financial Sponsors) make acquisitions?

Answer 1

Believe they will benefit afterward

Company is undervalued or the potential IRR > targeted returns

Question 2

What are the two main funding sources PE firms use in LBOs?

Answer 2

Cash and Debt

Don’t use stock because most PE firms are not publicly traded, holding periods tend to be shorter, holdco structure

Question 3

True or False: PE firms earn higher IRRs if they invest less money upfront, assuming they earn the same cash flows and sell the asset for the same amount.

Answer 3

True. This is why PE firms prefer to use as much debt as possible and as little of their own money as possible to fund deals

TMV: money today is worth more than money tomorrow

Question 4

How does debt funding help a PE firm?

Answer 4

Reduces upfront cost of acquiring a company, making it easier for the PE firm to earn a higher IRR

PE firm can use company’s cash flow to repay the debt/make interest payments

Question 5

True or False: Leverage boosts returns.

Answer 5

False. Leverage amplifies returns

Question 6

Explain the legal structure of LBOs.

Answer 6

PE firm does not directly own the acquired company, instead it forms holding company, which it owns, and the holdco acquires the real company

This is important because the PE firm is not “on the hook” for th edebt that it uses in the deal. The loans are made to the holdco and it is up to the target company to repay them.

Legal structure reduces risk for the PE firm and makes deals more attractive.

Question 7

Describe the ideal LBO candidate.

Answer 7

IBC: Mature/Steady, strong market position, limited CapEx, strong mgmt team, growth or cost-cutting opportunities, viable exit strategy
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The price must be right

Company size matters

Low fixed cost / minimal CapEx

High recurring revenue & (EBITDA) margins

Significant fixed assets (can be used as collateral)

Strong management team

High barriers to entry / Stable, growing industry / Fragmented market

Can support more tranches of debt

Post-deal credit rating

Exit strategies

Question 8

Why does a company’s existing capital structure not heavily affect its LBO candidacy?

Answer 8

In a LBO, the existing capital structure is wiped out and replaced with a new capital structure (with more Debt in most cases)

BUT there could be some impact if the company’s existing debt incurs early repayment fees

Question 9

What are the key drivers of return in an LBO?

Answer 9

EBITDA growth

Debt Paydown

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Multiple Expansion (but not ideal)

Question 10

What are the main differences between LBOs and M&A deals?

Answer 10

Holding Period (PE firms sells after 3-7 years; M&A are “indefinite”)

Holdco

Funding Sources (M&A use stock)

Financial Statement Projection (only project Seller’s financials vs. Buyer and Sellers in M&A)

Synergies (not as important in LBOs)

Relevant Analyses

Question 11

Walk me through an LBO model.

Answer 11

Set up transaction assumptions (i.e.: Purchase price,

Sources (where the funding is coming from) and Uses (where the funding is going) to show how financing transaction, etc. and how much investor equity is needed

Project the Sellers’ cash flow and debt repayment

Make the exit assumptions, usually assuming an EBITDA exit multiple, and calculate returns based on how much equity is returned to the firm

Question 12

Again, how do you determine the purchase price for a private company?

Answer 12

Based on an (EBITDA) multiple

Question 13

How do public and private LBOs differ?

Question 14

What are the three main exit strategies in LBOs?

Answer 14

M&A (preferably because stake sold at once and don’t have to wait years to recover investment also lessens risk)
- not always possible because the firm might be too big, no interested acquirers, no feasible offers, etc.

IPO

• advantage: any company above a certain size can go public, but PE firm can’t sell stake all at once
• typically result in lower IRRs because proceeds received over several years
• risky because share price could fall (decreasing MoM)

Dividend Recapitalizations
- useful for small companies, in the face of regulatory obstacles, etc. preventing IPO

Question 15

What is a dividend recap?

Answer 15

The company issues dividends to the PE firm using its annual FCF or by continually issuing new debt

Levered dividend recaps are funded with debt (vs. unlevered which are funded with cash flows)

In addition to being an exit strategy, dividend recaps can also be used to (modestly) boost returns (both the multiple and the IRR)

Question 16

What is the formula to calculate Returns from EBITDA Growth? Returns from Multiple Expansion? Returns from Debt Paydown/Cash Generatoin?

Answer 16

(Year t EBIDA - year 0 EBITDA) * EBITDA Purchase Multiple)

(EBITDA Exit Multiple - EBITDA Purchase Multiple) * Year t EBITDA

Total Returns - Returns from EBITDA Growth - Returns from Multiple Expansion (or Initial Debt - Final debt + Final Cash - Initial Cash - Transaction and Financing Fees)

Question 17

For an interview question, what information do you need to approximate IRR? What are some general approximation rules?

Answer 17

MoM and holding period

2x in 3 years = ~25% IRR
3x in 3 Years = ~45% IRR

2x in 5 years = ~15% IRR
3x in 5 Years = ~25% IRR

Rule of 72 (returns the years required to 2x your money at different IRRs) (for example, at an 8% IRR, money would double in 9 years because 72/8 = 9)

Rule of 115 for 3x multiples

IRR for 2x = 100% / # Years * 75%
IRR for 3x = 200% / # Years * 65%
IRR for 4x = 300% / # Years * 55%

Question 18

What is Paid-In-Kind interest (PIK)?

Answer 18

Interest that accrues to the loan principal and thus does not result in a cash expense

Question 19

What is an LBO?

Answer 19

Investment strategy for acquiring a company using debt as a major source of capital

Most commonly employed by PE firms aiming to buyout and hold a company for a period of 3-5 years aiming to achieve a target IRR

Question 20

How much debt do LBOs typically use?

Answer 20

Depends on strategy, but typically 50% or higher > max is probably 75 or 80% (or else over-levered)

Question 21

What are the main drivers of IRR?

Answer 21

Leverage (i.e.: increase initial debt, favorable loan terms, etc.)

Operational Improvements (i.e.: top-line growth, cut costs, margin growth)

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Multiple Expansion (i.e.: lower entry multiple, higher exit multiple, etc.)

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Timing of exit

Dividend Recap

Invest in the business/M&A/add-on acquisitions