Projecting and Adjusting the Financial Statements

Question 1

Can you explain how the Balance Sheet is adjusted in an LBO model?

Answer 1

First, liabilities and equity side adjusted, new debt is added and SE is wiped out, replaced by investor equity PE firm is contributing

On assets side, cash is adjusted for any cash used to finance the transaction and for transaction fees, then plug using Goodwill and OI

Question 2

Why are Goodwill & Other Intangibles created in an LBO?

Answer 2

Both represent the premium paid to SE of the company, plugs BS

Question 3

How do you project the financial statements and determine how much debt the company can pay off each year?

Answer 3

Assume a revenue growth rate, make key expenses a % of revenue, then tie BS and CFS items to revenue and expenses on the IS
- to project CF available to repay debt each year, take CFO and minus CapEx
- assume other items are non-recurring
- this calculation only determines how much in debt principal the company could potentially repay

Question 4

Is it really accurate to use Levered Free Cash Flow to determine how much debt can be repaid?

Can’t you reduce CapEx spending after a leveraged buyout?

Answer 4

CFO - CapEx isn’t necessarily exactly LFCF, as LFCF you need to minus mandatory debt repayments as well

Assuming you can reduce CapEx post-LBO is dangerous as it drives revenue growth.

Question 5

What if the company has existing debt? How does that affect the projections?

Answer 5

If the company has existing debt and the PE firm refinances it, it’s a non-factor as it goes away.

If PE firm assumes the debt instead, need to factor in interest and principal repayment on that debt over future.

Normally do this by assuming existing debt principal is paid off first after you’ve calculated CFO minus CapEx. Then can use remaining CF to pay off debt principal for new debt raised in the LBO

Question 6

What’s the proper repayment order if there are multiple tranches of debt?

Answer 6

Normally assume that existing debt on the BS gets repaid first
- after, depends on the seniority of the debt and also whether or not the debt can even be repaid early, like with HY debt.
- so if you have a revolver and then multiple term loans, normally you’ll repay revolver first, then most senior term loan, then more junior term loans.

Question 7

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

Answer 7

Yes, there are shortcuts, and not necessary.
- do not need full BS
- need some form of IS, to see how debt changes
- need some type of CFS to show how much cash available to repay debt

Question 8

What is meant by the “tax shield” in an LBO?

Answer 8

Means interest a firm pays on debt is tax-deductible - so they save money on taxes and therefore increase their cash flow as a result of the debt from the LBO

Note, however, that the firm’s cash flow is still lower than it would have been without the debt – saving on taxes helps, but the added interest expense still reduces Net Income by more than the reduced taxes helps the firm.