Picasso - LBO Flashcards
What is private equity?
Private equity is an asset class, where by a PE fund, run by a general partner, raises outside capital from investors (“LPs”) to make controlling investments in companies. The sponsor will put in roughly 20-30% of equity, with the remainder funded by debt, excess cash, and other, with the goal of making operating improvements and increasing equity value over a holding period of ~5 years.
What is a LBO fund? What are its characteristics?
Buyout fund: lockup period of 10 years. Controlling investments. Industry or specialty focus. Target companies by EV and EBITDA
Stages of a PE fund
(1) Create fund
(2) Find target
(3) Structure deal
(4) Obtain financing
(5) Unlock value
(6) Exit the investment
Why lever up a firm?
The short, sponsor puts up less equity and magnifies returns.
- Reduces the sponsor’s equity check, which increases returns and frees up capital for other projects
- Creditors do not participate in equity upside
- Interest is tax deductible
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?
When you raise debt, you are still paying the shareholders off in cash (unless they roll their equity).
- Uses debt for reasons already described
What is a hedge fund?
No single, agreed-upon definition.
- Invest in public markets with public information; offer investors quarterly liquidity; absolute returns; 2 and 20
What are the main differences between private equity and hedge funds?
Both are marketed to accredited investors and charge a 2-20 compensation structure. Not correlated with the market.
- Time horizon: LP lock-up period of 10 years vs. quarterly liquidity (depends on the fund)
- Control**
- Private vs public investments (generally)
- Strategy: Holding period of investments / source of value creation (HF usually needs a catalyst to rec value)
- Fee structure: HFs are paid quarterly or every year, while PE funds get paid when they exit their investments - no performance fees are taken for 5 years or more
What is IRR? What is the formula for calculating the IRR of a LBO?
Internal rate of return is an investors annualized return of its investment in the fund.
- Cost of capital to make NPV = 0
- If you lay out the cash flow schedule, with a cash outflow at T=0, and dividends received throughout the holding period and exit at T=N, you can solve for the discount rate, which is equal to IRR
- If no intermittent cash flows = CAGR formula
What is the hurdle rate?**
Minimum IRR to make an investment
Run me through the changes between the existing balance sheet and the pro forma balance sheet in an LBO model.
Every item in the sources and uses and purchase price allocation.
Assets
- Excess cash used? Cash to balance sheet?
- Write up of assets; intangible assets created
- Wipe out old goodwill; add new goodwill
Liabilities
- Write up
- DTL
- Debt refi’d, assumed?
- New debt (OID? Financing fees? Contra accounts!)
Equity
- Wipe out old SHE
- New Cash + rollover = equity
- Transaction fees subtracted out of RE
Walk me through an LBO analysis.**
I’d be happy to:
- Lay out your valuation and operating assumptions around minimum cash needed to run the business, M&A expenses, etc
- Purchase price allocation
- Financing assumptions - how much debt can this company support while maintaining flexibility? What’s the cost?
- Sources and uses
- Financial forecast
- Project income statement
- Project balance sheet accounts except debt balances
- Build down to LFCF - Debt schedule
- Calculate annual debt repayment and interest expense
- Feed interest expense, debt repayments, and EoP debt to financials - Returns analysis
- Sensitivities
- Dividend recap
- Exit multiple, etc
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?**
- Operating performance
- Sales: increase prices? Increase volume?
- Expand margins? Cut costs? - Leverage!
- FCF generation to pay down debt
- Purchase price
- Multiple expansion (add on)
- Dividends
What are ways to increase the exit multiple?
Assuming you cannot reduce the purchase price:
- Add-on investments (increase scale, growth prospects, diversification, size)
- Sale to a strategic
- Sale when financing and M&A markets are hot
- Trajectory –> growth prospects
- Pivot to new industry that has more favorable valuation
- Reduce customer / supplier concentration
- IP, asset specificity
What are the three ways to create equity value?**
- EBITDA growth
- Multiple expansion
- Debt paydown
What are the potential investment exit strategies for an LBO fund?**
- Sale to a strategic buyer
- Sale to a financial buyer
- IPO
- Not a full exit, but dividend recapitalization
Advantages of LBO financing?**
- Debt: lowers equity check. Sponsor relationships with funds and banks.
- mgmt equity roll
What are some characteristics of a company that is a good LBO candidate?**
Industry
- Not overly cyclical
- Industry growth
- Low barriers to entry with a strong competitive position
Company
- Stable and defensible free cash flow for debt paydown and debt capacity
- Unencumbered Assets
- Pricing power with customers; bargaining power with suppliers
- Low capex and wc requirements
- Business plan
- Experienced management
- Clean balance sheet
- *Undervalued!
Operational improvements
- Divestable assets?
Risks can be mitigated
Viable exit
What is a good due diligence framework?
- Situation overview; understand why the seller is selling
- Industry
- Market size, trends, growth, market share over time
- Porter’s 5 forces
- Stage of business cycle
- Fragmented or concentrated - Company
- Pricing power, increase volume? Platform investment?
- Opportunity to cut costs
- Products diff on cost, brand or quality?
- Off balance sheet liabilities
- Management - Financials make sense
- Exit
Due diligence: what industry specific questions would you ask?
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?
Customer
(1) What is the unmet need?
(2) Which segment is being targeted?
(3) Price sensitivity
(4) Motivated by quality or service
Growth of Market
(1) Rate of growth and reason behind it
(2) Sustainability
(3) Cyclicality
External Factors
(1) Regulatory (creating high barriers to entry)
(2) Technology (quick changes making inventory obsolete)
(3) Litigation / public perception (adverse lawsuits, celebrity endorsement)
Due Diligence: What firm specific questions would you ask?
- Get a picture of financials: sales, unit economics, costs (variable and fixed), growth from organic or inorganic means?
- Product mix
- Pricing strategy
- Levers to increase sales (price or volume?)
- Levers to reduce costs (fixed / variable?)
- Labor: cross train, work overtime, reduce workweek, pay cuts, layoff workers, automate
- Production: IT, efficiency, lease rationalization, raw materials
- Financial: hedging? Cost of debt (unlikely)?
- Experience of mgmt through cycles. Track record.
- Capital requirements to support existing operations? What about growth capex? Ability to reduce cash conversion cycle?
- Off balance sheet liabilities
- Non core assets
- Exit
Other
- Will key customers react to the acquisition
What is a good framework for an investment memorandum?***
1) Investment Thesis / Recommendation
2) Merits and Considerations
- 5 Major Points
- Mitigating Factors
3) Industry Analysis
4) Company Analysis
5) Model Drivers
6) Financial Summary
- Structure
- FCF and financial summary
- Multiples
- Credit stats
- Returns and sensitivity
7) Next steps and areas for further diligence
What is an offering memorandum?
An offering memorandum is a legal document that states the objectives, risks, and terms of an investment involved with a private placement.
Includes: company’s financial statements, management biographies, a detailed description of the business operations
If I handed you an offering memorandum, what are some of the things you’d think about?**
- Industry and the firm’s competitve positioning. Niche player? Consolidating and is the firm winning market share through M&A? Organically?
- Company: financial performance. Unit economics. Pricing power. Volume. Operating leverage. Ability for operating improvements. Managment
- Valuation
- Good investment
- Structure
- Risks
- Exit. What if the investment flops?
Walk me through S&U?**
Sources
- Excess cash
- New debt
- Equity roll
- Debt assumed, if any
- Sponsor cash and other co-invest
Uses
- Offer price
- Debt
- Fees
- OID
What is a revolving credit facility and what are its characteristics?
RCF can be best described as a corporate credit card, secured by either certain current assets or cash flow of the company.
- Commitment amount
- Availability
- Interest rate
- Commitment fee
- Prepay / draw at any time, assuming you’re in compliance and have availability
Helps seasonal businesses that must build up inventory ahead of a holiday season
What is bank debt and what are its characteristics?
40-50% of cap stk
- RCF
- Term loans (usually A)
- Secured
- Floating rates, usually at a margin above LIBOR
- Prepayable
- Amortization
- ECF Sweep
- Fewer holders. Easier to negotiate
- Restrictive covenants
What forms does bank debt usually take?
Credit facility: RBL, ABL, RCF, TL-A and B (1L and sometimes 2L), DIP financing
What are incurrence and maintenance covenants?
- Incurrence: Covenants generally restrict a company’s flexibility to make further acquisitions, raise additional debt, and make payments (e.g. dividends) to equity holders.
- Maintenance: financial maintenance covenants, which are quarterly performance tests, and is generally secured by the assets of the borrower.
What is high-yield debt (sub notes or junk bonds) and what are its characteristics?
20-30% of cap stk
Offered to institutional investors, such as hedge funds, pension funds, CDO funds, sovereigns, endowments, etc.
- As the name suggests, the higher yield reflects the credit risk of the issuer –> not investment grade
- Likely unsecured
- Fixed rate paid semi-annually
- OID to incentivize investors
- No call period, no amortization, prepayment premiums
- Make-whole provisions
What are the advantages of subordinated debt?
To the investor?
- Yield
- Warrants?
- Can be treated differently after issued (tender shares)
- Liquidity
What is cash-pay vs PIK?
Interest paid in cash or additional principal
- Can be PIK toggle
What is the minimum high-yield debt amount?
Public and 144A high yield offerings are generally $150mm or larger; for offerings below this size, assume mezzanine debt. In some case, it may be appropriate to include warrants such that the expected IRR is 17-19% to the bondholder
What is mezzanine debt and what are its characteristics?
Mezzanine normally the tranche junior to all other debt, but senior to equity and preferred insturments
Provided by credit and hedge funds to help get the deal over the line. Fairly high cost of capital. Miniminal covenants. Warrants / convertible to equity. PIK. Unsecured.
What are seller notes and what are their characteristics?
Buyer does pay the entire purchase price up front in cash, amortized over time. Lower cost of capital than other forms of debt. As part of the negotiation, be held liable to pay some or all of purchase price by seller notes.
Seller has faith that the buyer will pay off the seller’s note.
Why do PE multiples and EBITDA multiples yield you different valuation results? Why use EBITDA multiples instead of PE multiples?**
EBITDA multiple represents value to all stakeholders while PE represents value to only equity holders.
EBITDA for LBOs
- Value firms running at net losses but may be cash flow positive
- Represents operating cash flow
- You must buyout the whole firm
- Compare firms with different leverage & DA schedules
What are the ways in which a company can spend available cash/FCF?**
Reinvest in the business - R&D, Capex Keep on balance sheet as cushion M&A - expand into new market Distribute to equity - Dividend, share buyback Buyback debt
Given that there is no multiple expansion and flat EBITDA, how can you still generate a return?**
- Dividends
- Reduce taxes; interest expense
- Paydown debt
- Take on more debt at close
- Reduce capex / nwc investment
What is the different between bank loan and high-yield debt covenants?**
Bank includes maintennace covenants that are tested quarterly
High yield includes incurrence covenants that are tested at certain events (capex, M&A, debt incurrence)
What determined your split between bonds and bank in the deal? **
Will first look to issue bank debt as it allows for prepayments and lower interest rates, however.
- Banks will only lend up to a certain amount of assets or EBITDA
- Covenants
- Collateral required
(What determined your split between bonds and bank in the deal? )
If there is a higher growth capex proportion of total capex, would you still want to use same split?
- Bank debt will require that you use a certain % of ECF to pay down principal
- Bond covenants, while you’ll need to be in compliance with certain incurrence covenants (PI), will give you flexibility
Which valuation will be higher or lower, all else the same? DCF or LBO?*
DCF will be higher. LBOs have a higher cost of equity capital
Assume the following scenario: EBITDA of $10 million and FCF of $15 million. Entry and exit multiple are 5x. Leverage is 3x. At time of exit, 50 percent of debt is paid down. You generate a 3x return. 20 percent of options are given to management. At what price must you sell the business?**
Basis = 50-30=20 Equity at close = 20*3=60 Before options 60/0.8=60*5/4=75 Debt at close = 15 TEV = 75+15=90
Multiple = 90/10=9.0x
If you have a company with a P/E of 10x and cost of debt of 5 percent, which is cheaper for an acquisition?**
Cost of debt is cheaper
Cost of equity = 10%
Cost of debt (after tax) = 5%
Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?**
Extra dollar of EBITDA.
- $1 increase in EBITDA increases equity by multiple * $1, while $1 debt reduction increases equity by $1
