Technical Questions

Question 1

Ways to improve the IRR on an LBO investment:

Answer 1

–	Reduce the purchase price
–	Increase leverage (add more debt)
–	Generate higher cash flows over course of investment (variety of levers to pull)
–	Increase EBITDA
–	Multiple expansion

Question 2

Three potential exit strategies for an LBO:

Answer 2

– IPO
– Sale to strategic or financial buyer
– Recapitalization (distribute cash to equity holders and take on more debt)

Question 3

— Benefits of LBO transaction structure / financing:

Answer 3

– Management incentives become directly aligned with the PE firm when management invests too
– Capable of acquiring a large company with limited equity from sponsor
– Debt magnifies equity holder returns
– Interest payments on debt raised are tax deductible

Question 4

— Characteristics of a good LBO candidate:

Answer 4

– High and stable cash flows
– Typically looking for non-cyclical industry and a company with a differentiated product in a market leading position with barriers to entry
– Contracted, recurring or visible revenue stream supported by favorable industry or demographic trends
– Cost structure that allows passing of costs to end customers and margins that can withstand a downturn
– Minimal working capital and capex investment requirements
– Together, there should be some kind of thesis or idea for improving this company
– On the qualitative side, you want strong management, company you can acquire at attractive price, put leverage on and then be able to sell at exit

Question 5

— Due diligence questions regarding an LBO investment:

Answer 5

– Typical three levels to understand: industry, operational elements of business and other qualitative aspects about the opportunity
– Industry:
§ What industry is the company in?
§ What position does the company have? Market share and degree of competition?
§ How defensible is this company’s position? Barriers to entry, differentiated product and who has power in the vertical supply chain between buyers and suppliers?
§ What are the general trends and risks in the industry? Is this business cyclical and susceptible to downturns?
– Operational:
§ How does the company make money and grow revenue? Contracted or recurring? Growing through industry or market share gains? Target demographic? Do industry trends support this?
§ What type of cost structure? Fixed vs. variable? How easily can company pass along costs and how safe are margins during a downturn?
§ How efficiently does the company manage working capital and capex?
§ Where is the opportunity to grow this business or what is the investment thesis for improvement?
– Qualitative:
§ How strong is the management team and what type of expertise do we have in industry?
§ What is the company trading at or how expensive will it be to acquire? Can we put leverage on it?
§ What is the exit strategy?

Question 6

— Benefits of using EBITDA multiples over P/E multiples:

Answer 6

– Allows you to compare firms regardless of leverage / capital structure
– Allows you to value firms reporting losses

Question 7

— Different ways a company can spend available cash / FCF:

Answer 7

–	Pay down debt
–	Issue dividends
–	Buy back stock
–	Invest in the business (CAPEX)
–	Acquire other companies

Question 8

— With no multiple expansion and flat EBITDA, ways to generate a return:

Answer 8

– Must generate cash flow – reduce capex costs, improve NWC management and pay down debt to lower future interest obligations

Question 9

— Difference between bank loan and high-yield debt covenants:

Answer 9

–	Bank loans:
§	Cons: more strict, tighter covenants
§	Pros: lower interest rates
–	High-yield debt
§	Pros: less strict, looser covenants
§	Cons: higher interest rates

Question 10

— Impact of covenants:

Answer 10

– Can restrict economic activities, finance activities, or accounting measurements
– Covenants can possibly benefit a business through limiting poor management decisions
§ More common in regular companies, less common in LBO situations where company is more closely monitored

Question 11

— View of split between bonds and bank debt in a deal:

Answer 11

– Normally, taking as much bank debt as possible is best because it is cheaper than regular bonds
§ However, the split depends on how much a bank is willing to loan and you don’t want to borrow too much to point where covenants become too restrictive
§ Bank debt usually has a shorter maturity, so company must be able to support that liability when it comes due

Question 12

— All else equal, LBO vs. DCF in terms of valuation:

Answer 12

– LBO will produce a lower value as it is discounted at a lower rate

Question 13

— Relative benefit of $1 of debt paydown vs $1 of EBITDA

Answer 13

– The extra $1 of EBITDA is better
§ $1 of additional debt paydown will only increase your equity value by $1
§ $1 of additional EBITDA will increase your equity value by more than $1 through two methods: 1) multiplier effect where value at exit is equal to a multiple off EBITDA; 2) additional debt paydown through added EBITDA

Question 14

— IRR – Calculating estimate for upper bound:

Answer 14

– Taking the average of your return is an easy way to get the upper limit of the IRR
§ Ex: $100 grows to $200 over 2 years  return of $100 divided by 3 years equals a 33% upper bound for the IRR; the actual IRR is 26%
– The longer the duration of the investment, the greater the impact of compounding, and the farther the above estimate will be off

Question 15

— IRR - Rule of 72:

Answer 15

– 72 / (years for equity investment to double) = estimate of IRR
– Rule of 72 is less accurate for shorter periods and more accurate for longer periods
§ Ex: 72 / (1 year for equity investment to double) = 72% IRR estimate; 100% actual IRR
§ Ex: 72 / (5 years for equity investment to double) = 14% IRR estimate; 15% actual IRR

Question 16

— Ways companies can manipulate earnings:

Answer 16

– Switching form LIFO to FIFO
§ In a rising cost environment, LIFO will show higher costs and lower earnings but less taxes; the assets on balance sheet will also be lower
– Taking write-downs
§ Write-downs will decrease earnings and save taxes
– Changing depreciation methods
– Changing revenue recognition policy
– Capitalizing interest
§ Capitalizing interest removes it from the IS and will show higher earnings

Question 17

— Sarbanes-Oxley:

Answer 17

– Sabanes-Oxley was a bill passed in 2002 in response to several accounting scandals
§ The law established enhanced standards for publicly held companies but also made reporting much more expensive, which was an issue for very small public firms

Question 18

— Reasons for one company to acquire another:

Answer 18

– Target company is viewed as undervalued
– Synergies can be obtained
– Could provide growth if organic growth has stalled
– Creating a larger total company makes the firm more resilient to downturns
– Way to dispose of excess cash / satisfy management desire to do something

Question 19

— Two companies with same earnings but different total assets:

Answer 19

– The company that has the lower total assets is better from the sense that it is more efficient and has a higher return on assets; however, capital structure can also play a role:
§ If the company with higher total assets is almost all debt financed, then it might have a higher ROE or ROI, though it would be more risky

Question 20

— Working Capital in mature companies:

Answer 20

– Net working capital needs should decrease as a business matures because it becomes more efficient and the needs are more predictable

Question 21

— Bank Debt maturity vs. Subordinated Debt maturity:

Answer 21

– Bank debt will usually have a shorter maturity for two reasons:
§ Bank debt is supposed to be safer, and a shorter maturity will leave the bank less exposed to risk
§ Bank deposits tend to have shorter maturities, so shorter bank debt maturities keep cash flows of the business better aligned
– Bank debt usually has the names: Term Loan A, Term Loan B, etc.

Question 22

— LIBOR:

Answer 22

– LIBOR: London Interbank Offered Rate
– LIBOR tracks the daily interest rates at which banks borrow unsecured funds from each other in the London wholesale money market
– LIBOR is comparable to the Fed Funds rate

Question 23

— PIPE:

Answer 23

– PIPE: Private Investment in Public Equity
– A PIPE is an alternative way for companies to raise capital; PIPEs are made by qualified investors (HF, PE, mutual funds, etc.) who purchase a company’s stock at a discount to current market value
– The advantage of a PIPE is that it is a cheaper and more efficient option when compared to a formal traditional secondary offering with a roadshow

Question 24

— Greatest Impact on a company:

Answer 24

– Increasing sales volume, increasing price, or decreasing expenses?
§ Increasing price is the most beneficial to a company because it captures all of the benefit
§ Increasing volume also brings along other new costs
§ Decreasing expenses will depend on the magnitude of the decrease

Question 25

— Growth in revenues versus growth in EBITDA:

Answer 25

– Growing revenues by a given percent will lead to an even higher growth in EBITDA, unless there are no fixed costs
– However, for a simple calculation question in an interview, you might usually assume there are no fixed costs such that EBITDA will grow at the same rate as revenue

Question 26

— Impact of change in leverage on cost of equity:

Answer 26

– A decrease in leverage will lower the beta of a company as the firm has a lower risk of defaulting; and consequently, the cost of equity for the firm will decrease as investors no longer expect as much of a premium for their investment

Question 27

— IRR vs. NPV vs. Payback:

Answer 27

– IRR is the discount rate that makes the NPV zero
– NPV measures whether a project creates positive or negative value based on its costs
– Payback measures how long it takes for a company to recoup its investment without considering time value of money

Question 28

— Company repurchasing its own stock:

Answer 28

– Positive signal: shows the company views its stock as undervalued and is getting a good deal

Question 29

— Raising debt vs. equity for a potential investment:

Answer 29

– The proper source of funding will depend on the situation and a variety of factors; in general, the cheaper the source of funding, the better

Question 30

— Difference between cash flows in DCF vs. LBO:

Answer 30

– DCF uses unlevered free cash flows while LBO uses cash flow available for debt service
– The main difference is that the LBO factors in capital structure (namely, after-tax interest expense) while the DCF does not

Question 31

— Lenders in an LBO transaction:

Answer 31

– Lenders must provide financing for an LBO, and although an investment could have a great IRR, the important factors for lenders are leverage multiples and credit analysis
– The major types of credit ratios used are leverage ratios (amount of debt on the company) and coverage ratios (ability of company’s cash flows to service the debt)
– Credit ratios improve significantly over the projection period

Question 32

— IRR and holding period for an investment:

Answer 32

– Although an investment could have a very high IRR in year one that decreases over subsequent years, it still might make sense for the PE firm to hold onto the investment for a longer time period
– Holding the investment will produce far more cash since you are earning a good return each year, not just in the first year; there is also a significant time cost to finding a good investment, so it is better to get as much cash as possible out of the investment

Question 33

— Why returns on private equity investments are more difficult in today’s market:

Answer 33

– PE firms now must put in more equity due to inability to put as much debt on a business, thereby reducing returns
– Initial excess returns in private equity have led to an increase in the number of PE firms, adding even more pressure to PE returns
– Many companies have undertaken internal strategic reviews and have already taken a lot of the efficiency improving actions that financial sponsors would attempt

Question 34

— Screening criteria for potential LBO targets:

Answer 34

– Companies in need of growth capital – growth capital can come from an IPO or an investment from another company, either way there is a capital inflow for the target
– Out of favor companies – market not rewarding company appropriately and management under pressure from shareholders
– Family-owned companies with no succession plan
– Divestitures mandated by regulators – the divestiture might be a very good company, and the parent might be more inclined to sell to a sponsor instead of a competitor
– Companies in need of operating expertise – if the sponsor has good in-house operating executives
– Companies in need of financial expertise

Question 35

— Club deal:

Answer 35

– Club deal is when financial sponsors team together for an acquisition; a club deal allows sponsors to make a larger acquisition and diversify each firms risk for the size of the transaction

Question 36

— How financial sponsors are compensated:

Answer 36

– Management fees – typically paid semiannually out of the fund
– Advisory fees or transaction fees – paid on a deal-by-deal basis
– Carry – typically paid at the end of the life of a fund

Question 37

— For LBO Sensitivity:

Answer 37

– Most standard to show: a) IRR at different entry / exit multiples b) IRR at different exit / leverage multiples

Question 38

— Investment Memo Topics:

Answer 38

– Investment Thesis / Recommendation:
§ Very important – state whether you would invest in this idea and under what type of strategy
– Company overview:
§ Keep very short
– Industry overview:
§ Discuss outlook of industry and Porter’s Five Forces (Competition, Substitutes, Buyer Power, Supplier Power, and Barriers to Entry)
– Investment positives / investment concerns:
§ Spend significant time on the concerns / risks
– Financial Summary:
§ Fill in with numbers on free cash flow, credit metrics, and EV multiples
– Investment Returns / Sensitivity
– Key Issues for further diligence:

Question 39

— If you could have only one, which financial statement would you ask for?

Answer 39

– Cash Flow Statement

Question 40

— If you could have only two, which financial statements would you ask for?

Answer 40

– Income Statement and Balance Sheet (assuming you have beginning and ending balances) – imply C.F.S.

Question 41

— Can you have negative shareholders equity?

Answer 41

– Possible in an LBO if there is a dividend recap where a large dividend brings the balance down or if losing money

Question 42

— What are implications of negative working capital?

Answer 42

– Could be bad – company’s short-term assets are not enough to cover short-term liabilities
– Could be good – increasing current liabilities is a boost to cash (i.e. deferred, or unearned, revenue)

Question 43

— What are DTAs and DTLs? When do they occur?

Answer 43

– DTLs – GAAP taxes exceed Cash taxes; GAAP pre-tax profit is higher than Tax pre-tax profit
§ Created in transaction / reduced over time as GAAP taxes are too low due to non-deductible amortization
§ Created if tax depreciation exceeds book depreciation
– DTAs – Cash taxes exceed GAAP taxes; Cash pre-tax profit is higher than GAAP pre-tax profit
§ Created when you have negative income

Question 44

— What flows into Additional Paid in Capital (APIC)?

Answer 44

– Beginning Balance + Stock-Based Compensation + Option Exercises

Question 45

— What is the difference between operating and capital leases?

Answer 45

– Operating leases are used for short-term purposes and do not involve ownership; as such, they do not show up on the balance sheet but produce operating expenses in rent expense on income statement
– Capital leases are used for longer-term purposes and do involve ownership; as such, they show up on balance sheet, like debt, and on income statement through depreciation and interest expense

Question 46

— Can you have negative equity value or negative enterprise value?

Answer 46

– Negative equity value is not possible
– Negative enterprise value is possible if there is a lot of cash and low market cap (i.e. company on brink of bankruptcy)

Question 47

— Should WACC and CoE be higher for a $500mm or $5.0bn company?

Answer 47

– All else equal, the smaller the company, the higher the WACC or CoE as there is greater risk and thus greater expected return; that said, capital structure can play a role for WACC

Question 48

— How do dividends impact CoE?

Answer 48

– Dividends are factored into Beta when calculating a company’s returns in excess of market as a whole, so CoE already accounts for dividends; no additional adjustment needed

Question 49

— What is capital structure order in an LBO?

Answer 49

– Revolver  Term Loan  Senior Notes  Subordinate Notes  Mezz Debt
§ Revolver and Term Loan are floating rates; Senior Notes on are typically fixed rates
§ Revolver and Term Loan have more maintenance covenants; the others have incurrence covenants that limit a firm’s actions
§ Revolver, Term Loan and usually Senior Notes are secured; other debt is not secured
§ Revolver and Term Loan can be prepaid and Term Loan may have amortization; others cannot be prepaid and are just a bullet payment
§ Mezz can have PIK

Question 50

— What is difference between incurrence and maintenance covenants?

Answer 50

– Incurrence covenants: limits on assets sales, new debt issuances, acquisitions and capex
– Maintenance covenants: leverage and interest coverage ratios

Question 51

You have a company with $100 million EBITDA (Unadjusted) and comps trade at 10x. Next year, the Company will have to pay an additional $80 million in Working Capital and $20 million in Cash Litigation Expense. How much do you pay for the business on a TEV basis?

Interest expense is $20 million and cost of debt is 10%. How much is equity value?

Answer 51

=$120 million Adj. EBITDA (adjusted for $20 million Litigation Expense in the P&L this year) @ 10x = $1,200 million less $80 million for Working Capital and $20 million Cash Litigation = $1,100 million

”= $20 million Interest / 10% = $200 million Debt.
= $1,100 million - $200 million = $900 million Equity”

Question 52

You pay $500 in Year 0 for an asset and receive $1,100 in Year 5. What is your return?

You make a bolt-on investment in Year 4 by paying $400 for a $50 EBITDA business. When you sell your company at Year 5, how do returns change? Assume no change in exit multiple for the bolt-on

Answer 52

2.2x and 17% IRR

Returns go down. Returns on bolt on = $450 / $400 = 1.125x or 12.5% return compared to 17% IRR on the original

Question 53

Two companies have the same aggregate value. One is 4x levered. The other is 7x levered. Which has the higher P/E?

Answer 53

• Need to compare the cost of equity to the after tax cost of debt (inverse is asset p/e vs. cash p/e). If the P/E of cash is higher than the P/E of the asset, then adding incremental leverage is accretive to earnings and P/E will be lower.
• Key is that aggregate value is held constant because, in theory, adding debt would lower your cost of capital and increase the valuation of the asset.

Question 54

Consider two insurance companies. One underwrites property insurance. The other underwrites disaster/catastrophe insurance. Why is it not proper to use these as comps for one another?

Answer 54

• Risk
• Problem is that risks inherent to each business are not comparable. You can diversify away much of the property insurance risk by pooling. Catastrophes, by nature, impact large segments of the population at once.

Question 55

There are two companies in the world. The first is a Coke bottler whose only customer is Six Flags, the other company, which is located across the street. Which would you rather own in the event of an economic downturn?

Answer 55

• Operating leverage
• Rather own the Coke bottler since you have the ability to scale back production. Lower revenues can be offset on the cost side of the equation. Six Flags is more of a fixed cost business since you still have to operate the rides, clean the park, etc. at the same cost regardless of attendance.

Question 56

There are two companies. One produces and distributes Hollywood films. The other manufactures generic Tylenol. Which trades at a higher multiple?

Answer 56

• Risk
• Assuming equal growth, you would expect the generic Tylenol producer to trade at a higher multiple due to lower risk. Discretionary spending on entertainment will take a hit in the event of an economic downturn and the film production company’s performance will suffer. On the other hand, people will always need Tylenol, regardless of how the economy is performing.
• Filmmaking is also a higher risk business because you never know which projects will succeed or fail and it is common to see wild swings in performance. The demand for generic Tylenol is much more constant.

Question 57

You have the option to either purchase a specialty magazine publisher (i.e. Bass Fisherman) or an auto parts manufacturer. Each has contracted revenues in perpetuity and you know that each will have the same growth, EBITDA margins, etc. Which would you rather own?

Answer 57

• Capex / cash flow
• Would rather own the magazine publisher since it is a business that requires much less capital. The auto parts company has to re-tool its factories every time technology changes and new cars hit the market. This requires large amounts of capex, which results in lower cash flow. The magazine publisher only has to replace equipment when it reaches the end of its useful life.

Question 58

There are two companies. One has 15% EBITDA margins. The other has 40% EBIDA margins. The higher margin business is a better company sometimes, all the time, or never?

Answer 58

• Cash flow / capital intensity
• The answer is sometimes. You need more information on the items below EBITDA that impact cash flow. Specifically, capex requirements, whether working capital is a source or use of cash, and to what extent.
• Also worthwhile to consider the amount of capital required to generate the same EBITDA (i.e. ROIC analysis), although this should be correlated to capex.

Question 59

What are the pros/cons of EBITDA multiples?

Answer 59

• Benefits: quick and dirty proxy for operating cash flow

- Cons: does not incorporate the cost of debt (interest expense) or capex

Question 60

Name three metrics you would consider when evaluating a debt investment. Why are they important?

Answer 60

• (EBITDA - Capex) / Interest Expense. Tells you how many times your cash flow covers interest expense and gives a sense of how much wiggle room remains. Company will default if it can’t make its interest payments, which is bad for debt investors because you don’t earn your return and can lose principal.
• Total Debt / EBITDA. Given a valuation multiple, this tells you how much of an equity cushion shields you against a drop in firm value.
• FCF / Total Debt. Tells you what portion of outstanding principal can be retired in a given year, based on available free cash flow.

Question 61

Consider a company that manufactures steel. What happens to net income if the price of steel drops by 5%? Down by more than 5%, less than 5%, or exactly 5%?

Answer 61

• Fixed vs. variable costs
• Drops by more than 5%. A 5% decline in the price of steel means revenues fall by 5%. If you can offset this by lowering production (i.e. reduce COGS by 5%), then gross profit drops by exactly 5%. But there are fixed costs such as SG&A and financing costs that remain intact even in the event of a downturn. Thus, net income falls by more than 5%.

Question 62

What are the factors that impact a P/E or EBITDA multiple?

Answer 62

• Growth, risk, cyclicality

Question 63

What makes a good LBO candidate?

Answer 63

• Predictable cash flows
• Ability to improve operations by eliminating excess overhead, R&D, etc. (margin improvement)
• Flexibility to reduce capex and working capital needs
• Ability to take on leverage
• Strong management team that realizes the demands imposed by a highly levered capital structure

Question 64

Why can certain businesses take on more leverage than others?

Answer 64

• Industry: growth profile, cyclicality, capital intensity, barriers to entry/substitution
• Company: FCF generation, competitive positioning, historical & projected performance, asset base
• Other: equity cushion provided by sponsors, credit rating, market conditions

Question 65

How would you think about the cyclicality of a commodity chemicals manufacturer?

Answer 65

• Annual EBITDA fluctuates with the cycle but the market normalizes for this by valuing on a run rate EBITDA. Thus, multiples will appear to fluctuate over time when based on reported financials for the period.
• When thinking about valuation, it is better to use the perpetuity method rather than applying an exit multiple in a DCF. This minimizes the number of variables you have to normalize.