Private Equity Flashcards
What is a private equity sponsor (or financial sponsor)?
A private equity fund.
What is an LBO and what’s the motivation behind it?
Company is bought with debt as less equity is needed and therefore returns can be higher; improves company operationally etc. and sells it for a profit.
In a PE deal would you rather have 50 optimization in WC in year 4 and year 5 or 10 EBITDA improvement in year 5 (exit year)?
Rather have +10 in EBITDA usually; WC improvement increases FCF by 100 but EBITDA increase is multiplied by exit multiple (e.g. +10 * 10x EBITDA = +100) and increases FCF in year 5
What makes an ideal LBO Candidate?
- Mature Industry
- Not very cyclical company
- Clean balance sheet with low amount of outstanding debt
- Strong management team
- Low WC requirements and steady cash-flows
- Low future Capex
- Feasible exit options
- Growth opportunities
- Strong market position
- Possibility of selling non-core or underperforming assets
How would you build an LBO?
- EBITDA etc. from Business Plan
- Assumptions for Sources & Uses
- Modelling of financing tranches
- Modelling of IS up to NI
- Modelling LFCF
- Assumptions for Exit Multiple
- Calculation of Return
What is the biggest problem in an LBO in building a debt schedule for an RCF (revolving credit facility) and how can it be solved?
Problem in calculating RCF is in times of losses, RCF is used but then interest also has to be paid and also changes cash flow again which leads to circular connections. It would be best to model the LBO on a quarterly basis instead of annually to get minimal time lag.
How do you get to Entry and Exit Multiples?
Entry multiple from football field or by putting in goal IRR and calculating back to required Entry multiple. Exit multiple is usually assumed equal to Entry multiple because higher exit multiple is very aggressive assumption.
Do you need to calculate NOPAT in an LBO?
No, never. It is a theoretical metric that is used in DCF but not in LBO.
Do you need all 3 financial statements to model an LBO?
No
Can you use LBO to determine today’s company value?
Yes, you need EV at Exit and Net Debt (as well as potential other relevant positions) to get Equity Value. This can then be discounted over planning horizon with LBO typical IRR of 20-30% to get PV of Equity. Assumes that company can’t be valued more than LBO makes of it.
If debt is cheaper than Equity, what could be reasons to still finance through Equity?
- Debt becomes increasingly expensive the more you take on
- Equity makes capital structure more stable
- Relatively more equity costs are compensated by lower risk that reduces COE and COD.
- Maximum flexibility
How are UFCF and LFCF calculated in an LBO?
EBITDA - Capex - WC - Cash tax payments \+ Any other non-cash items included in P&L - Any other cash items not included in P&L = FCF to Firm (UFCF) - Interest payments - Debt amortization = FCF to Equity (LFCF)
What returns do PEs expect?
20-30% (10-15% for Infra etc.)
What’s the difference between PE and VC?
PE invests in mature businesses, VC in startups
How would you finance an LBO?
As much debt as possible. Bank loan (“senior loan”) with additional second lien or mezzanine capital. Secondly, a HY Bond and third a combination of bonds and loan. Fourth you could combine senior loan, second lien and mezzanine capital into one unitranche loan.
What is a dividend recap in an LBO?
Take on additional debt to boost returns and invest further. Other reason would be to get money out of company without selling equity if there is still a high upside on the investment or you just don’t want to sell it.
What happens in the financial statements during a dividend recap?
- No changes in IS (possibly transaction costs)
- Liabilities and Cash increase shortly on BS and then decrease again after payout
- CFS reflects this BS effect. CF from financing shows inflow from debt and outflow from dividend
After that, especially IS is touched. Interest increases, taxes and NI decrease. RE therefore grows at a slower rate. CF from Operations decreases as higher interest has to be paid.
What are pros and cons of an LBO?
Pros:
- LBOs are detailed
- Central part of PE Deal
- Good cross-check for DCF and multiples
- Inputs usually available
- Recognizes change in capital structure
- No need for peer group
Cons:
- Needs lots of input parameters
- Volatile if cyclical business model
- Change in capital structure (debt repayment etc.) can be very time intensive
- Sensitive outputs
- Results not always intuitive
- Because of entanglement very time intensive
How much debt is usually used in an LBO?
ND/EBITDDA usually between 5-7x depending on cyclicality and business model.
What happens in the three statements during a dividend recap?
- Income Statement: Nothing
- Balance Sheet: Debt goes up, equity goes down and cancel each other out
Why would a PE do a dividend recap?
To boost returns
How does dividend recap affect 3 statements?
- No changes to IS
- BS: debt goes up, equity goes down (cancel each other out)
- CFS: CF from Financing: additional debt raised would cancel out Cash paid out to investors
How do you pick purchase and exit multiples?
Using comparables. Sometimes you set purchase and exit multiples based on specific IRR target but this is just for valuation purposes if you’re using an LBO to value a company.
PE firm acquires $100m EBITDA company for 10x using 60% debt. EBITDA grows to $150m by Y5 but exit multiple drops to 9x. Company repays $250m debt and generates no extra cash. What’s the IRR?
Entry: $400m equity to buy company
Exit: $1’350 EV (9 * $150). Remaining debt of $350 (600 – 250) will be repaid: $1’000 equity value
Multiple: 2.5x ($1’000 / $400) or 20% IRR (15% IRR = 2x; 25% IRR = 3x)
What are the main value drivers in an LBO?
Sorted by largest to smallest driver (usually)
- Multiple Expansion: Exit multiple > entry multiple
- Leverage
- Financials: Revenue, EBITDA, margin improvements
You buy a $100 EBITDA business for 10x EBITDA and sell sell it for 10x EBITDA in 5 years. You use 5x Debt/EBITDA and repay 50% over the 5 years. How much does EBITDA need to grow to realize a 20% IRR?
Purch. Price of $1000 ($500 debt; $500 equity); 20% over 5 years corresponds to ~2.5x, so equity needs to grow to $1’250 ($500 * 2.5). Add $250 of remaining debt (after repaying $250) to get to exit EV of $1’500. Assuming 10x multiple EBITDA needs to grow to $150.
Could a PE firm earn a 20% IRR if it buys a company for an EV of $1bn and sells it for an EV of $1bn after 5 years?
Yes, cash flows over those 5 years make this possible.
How is the FCF in an LBO different from FCF in a DCF?
- LBO determines company’s ability to repay debt, not implied value of entire company
- FCF in LBO starts with Net Income, not NOPAT as in DCF
- FCF is end point in DCF, in LBO you have to go beyond it like minimum cash requirement, potential other obligations etc. to find out what’s possible to repay
If a company has $10m in sales and $5m in EBITDA what is the most appealing option: 20% more units sold, 20% higher prices or 20% fewer expenses?
20% higher prices because it flows through to EBITDA; 20% more units incurs high variable costs; cutting expenses by 20% only increases EBITDA by $1m
How do you use LBO to value a company and why is it considered a floor valuation?
You set a target return (e.g. IRR of 25%) and back-solve it to get your financials. Floor valuation because PE almost always pays less than strategist
How is the BS adjusted in an LBO?
- Liabilities & Equities side adjusted: New debt is added, and Shareholders’ Equity is wiped out and replaced by contribution of PE
- Asset side: Cash adj. for any cash used to finance transaction and Goodwill & Other Intangibles is used as a plug to balance both sides
Strategist usually prefers cash payment, why does PE firm use debt in LBO?
- PE doesn’t want to hold company long-term; it’s using leverage to boost return rather than to think about cash as an expense
- In LBO, debt is owned by the company, so the portfolio company bears risk; the strategist bears the full risk
