Leveraged Buyouts and LBO Models

Question 1

Why might one company acquire another company?

Answer 1

1. The company believes it will be better off afterwards
2. Asking price < NPV of free flows
3. Buyer will realize an IRR > it’s WACC

Question 2

What is the key difference between a PE firm purchasing a company and a normal firm purchasing a company?

Answer 2

The private equity firm NEVER plans to hold the company forever.

Question 3

Describe a PE firms approach

Answer 3

1. It searches for companies that might be undervalued and could yield high returns if managed properly
2. PE Firm buys company using a combination of Cash (Equity) and Debt
3. PE Firm will run the company and make improvements to the firm.
4. PE Firm will sell the company, ideally for a higher price, and use the proceeds to repay the debt.

Question 4

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

Answer 4

1. They don’t ever “own” the companies directly
2. They plan to sell the company eventually

Question 5

Calculate the IRR: You bought an Asset for $100, earned $10 on it each year, and eventually sold it for $100

Answer 5

IRR = 10%

Question 6

Calculate the IRR: You bought an Asset for $50, earned $10 on it each year, and eventually sold it for $50

Answer 6

IRR = 20%

Question 7

How does using debt to fund deals help a PE firm?

Answer 7

1. It reduces the upfront cost of acquiring a company, making a high return easier
2. It lets the PE firm use the company’s cash flows to repay the debt and interest payments

Question 8

Leverage is said to ________ a return.

Answer 8

Amplify.

If a deal performs well, it will do even better when you pay less upfront. But if a deal does poorly, you’ll lose even more.

Question 9

How are the following related in an LBO:

• Banks
• PE Firm
• Holding Company
• Target Company

Answer 9

Question 10

Who is responsible for paying the debt used in an LBO deal?

Answer 10

The private equity firm is NOT “on the hook” for the Debt it uses in the deal! It’s up to the Target Company to repay it.

Question 11

Which qualities are needed for a company to be a candidate of a LBO?

Answer 11

1. Underpiced, Fair Priced
2. Stable Cash Flows
3. Significant fixed-costs (PP&E) used for collateral
4. Low fixed-costs
5. STABILITY

Question 12

Does a firm need revenue growth to be attractive for an LBO?

Answer 12

No!

Revenue and cash flow growth help, but are not essential next to stability.

Question 13

Does a company’s current capital structure affect its appeal as an LBO candidate?

Answer 13

For the most part, a company’s current capital structure does NOT affect its appeal as a leveraged buyout candidate.

Question 14

Which of the following is a more appealing target for an LBO?

• An industry where the #1 company has 5% market share, with companies #2 – 99 all having market shares between 1% and 5%
• An industry where the top 3 companies own 80% of the market.

Answer 14

An industry where the #1 company has 5% market share, with companies #2 – 99 all having market shares between 1% and 5%, is more appealing than one where the top 3 companies own 80% of the market.

That’s because many PE firms pursue add-on acquisitions to make the companies they acquire bigger and more valuable, and such acquisitions are easier to execute in a fragmented market.

Question 15

What are ideal exit strategies for a PE firm?

Answer 15

1. Prefer deals where M&A exits are feasible
2. Sale to another PE firm
3. IRR 20-25%

Question 16

The buyer in an LBO deal is always a ______ corporation.

Answer 16

Shell

Question 17

What is the traditional definition of free cash flow (FCF)?

Answer 17

FCF = [Cash Flow from Operations] - [CapEx]