WSP - L*O Flashcards
Walk me through an LBO
A leveraged buyout is similar to purchasing a house. The purchase price is funded partially by an equity investor – which is the private equity firm also called the financial sponsor. The remainder is funded through loans and bonds that the financial sponsor secures ahead of the transaction.
Once the sponsors gain control of the company, they get to work on streamlining the business – which usually means restructuring, layoffs and asset sales with the goal of making the company more efficient at generating cash flow so that the large debt burden can be slowly paid down.
The investment horizon for sponsors is 5-7 years, at which point they hope to be able to ‘exit’ by either 1) Selling the company to another private equity firm or strategic acquirer 2) Taking the company public, or 3) Recapitalizing the business by taking on additional debt and issuing themselves a dividend with the debt proceeds. Accomplishing this can provide financial sponsors with a high internal rate of return. Financial sponsors usually target returns of 15-25% when considering making an investment.
The keys to making this work include:
Acquiring the company at a low multiple (“getting in cheap”)
Successfully restructuring and increasing cash flows
Selling at a high multiple
Walk me through an LBO model
An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity as well as new borrowing as the two primary sources of capital. The specific impacts analyzed by the model include an equity valuation of the pre-LBO “oldco”, the IRR to the various new debt and equity capital providers, impacts on the company’s financial statements and ratios.
To build an LBO, start with identifying the uses of funds – how much oldco equity will be paid, any oldco debt that needs to get refinanced, as well as any fees. Based on this, make assumptions about the sources of funds: How much and the type of debt capital needs to be raised, with the residual being funded by sponsor equity.
Ideally, the operations are forecasted over 5-7 years (the expected holding period), and a complete 3 statement model is built so that the LBO debt assumptions correctly impact the income statement and cash flow statement.
In getting the correct cash flow forecasts, it is important to build a debt schedule that accurately modifies debt based on the flow of excess cash or deficits.
Next, exit assumptions need to be made – most notably around what the exit EV/EBITDA multiple will be. Based on this assumption and the existing state of the balance sheet at the presumed exit date, IRR and cash on cash returns can be estimated for the sponsors (and any debt providers as well).
Lastly, scenarios and sensitivity analysis can be added to provide users with different ways to look at the model’s output – one common sensitivity is to back into the implied oldco equity value based on explicit sponsor hurdle rates and/or operating assumptions.
What ratios or metrics would you want to look at to figure out if a company is over-levered?
I would first look at its overall capital structure and compute its Debt/Equity ratio. Since rates of leverage that are considered acceptable can vary across industries, I would compare across companies of similar size and operating in the same industry.
Next, I would look at interest coverage ratio (EBIT/Interest expense) and leverage ratio (Debt / EBITDA) and compare to my universe of comparable companies. If, for example, the company I’m looking at has some combination of a high Debt/Equity ratio, a low interest coverage ratio, and a high leverage ratio, that’s an indication that the business might be over-levered.
What is the maximum leverage in an LBO typically based on?
Debt to equity mix in private equity deals has hovered around 60% debt / 40% equity as M&A activity stabilized since the 2008 financial crisis. However, leverage varies across industries.
The more predictable the cash flows, the larger the tolerance for higher debt to equity mix. Debt/EBITDA – a measure of leverage relative to profitability has hovered in the 5.0-7.0x range and is pressured upward as overall valuations increase.
When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. It has come down because of the risks inherent to high debt burdens.
How do financial sponsors “exit” their investments?
There are four common ways that sponsors exit their investments:
Sale to a strategic acquirer.
Sale to another financial buyer (“secondary buyout”).
Take the company public through an IPO.
A recapitalization, whereby the sponsors add more debt to the business (presuably after they’ve paid down some of the debt or have significantly grown the value of the business) and use the proceeds to fund a dividend to themselves.
How might operating a highly levered company be different from operating a company with little or no debt?
Highly leveraged companies have a lower margin of error due to high fixed debt related payments (interest and principal). This forces management to become extremely disciplined with costs, to become more conservative when it comes to capital spending and embarking on new initiatives and acquisitions. It increases the importance of effective planning and instituting better financial controls.
Why is LBO analysis used as a floor valuation when analyzing company value using several valuation methodologies?
The “hurdle rates” – that is, the rate of return that financial sponsors need to believe they can exceed in order to undertake an LBO tend to be in the 15-25% range. This is due to the risks associated with high leverage and relatively short investment horizons.
These hurdle rates are usually higher than the cost of equity capital on the same business without those LBO-specific risks. As a result, the present value (or valuation) implied given those higher hurdle rates will be lower than the valuation of the company when analyzed through the traditional DCF and comps approaches.
Since senior debt is cheaper, why don’t financial sponsors fund the entire debt portion of the capital structure with senior debt?
Senior lenders will only lend up to a certain point – usually 2.0-3.0x EBITDA, beyond which only costlier debt is available. This is because the more debt a company incurs, the higher its risk of default. The lowest rate senior debt enjoys the lowest risk due to its seniority in the capital structure and imposes the strictest limits on the business via covenants, requires secured interests. Subordinated, junior debt is less restrictive, but requires highest interest rates.
Where do financial sponsors typically get their money?
Financial sponsors (or private equity firms) raise capital to fund their investments from Insurance companies, pension funds, endowments, high net worth individuals, and financial institutions.
When analyzing the viability of undertaking an LBO, how do private equity firms estimate the value of the business in the exit year?
The most common approach is to assume that the company will be exited at the same EV/EBITDA multiple that it was acquired at.
For example, if sponsors are contemplating an LBO where the purchase price reflects a 10.0x EV/EBITDA multiple, the exit year assumption (usually 5-7 years from the LBO date) will likely be that they will be able to sell at the same 10.0x multiple. Because of the importance of this assumption in determining the attractiveness of the deal to a financial sponsor (i.e. the deal’s IRR), this exit multiple assumption is often sensitized and IRRs are presented for a range of possible exit multiples.
What is the impact of the 2017 tax reform?
Probably the most significant thing that happened is that corporate tax rates were reduced from $35 to 21%. There were also reductions to S Corporations and LLCs, but the impact is a little murkier and not as significant as the corporate tax reduction. There were 3 other significant impacts:
- Companies now face limits on how much interest expense can be deducted for tax purposes. While the formula is a little more complicated, companies can roughly deduct interest up to 30% of the company’s EBITDA. This offsets the lower tax rate benefits for highly levered companies like PE portfolio companies.
- Companies are now able to accelerate depreciate for tax purposes even more than they could before, which lowers upfront tax bills. This lowers taxes even further for capital intensive businesses.
- Companies can no longer carryback NOLs, but they can carryforward indefinitely instead of just 20 years. Also, companies can use NOLs to offset only 80% of current period income (prior to tax reform, NOLs could be used to offset 100% of current period income).
What is management equity rollover?
In an LBO, cash is raised via debt financing and sponsor equity. Sometimes, management and owners of the pre-LBO company might choose to participate in the LBO by rolling over the value of their oldco equity into the newco rather than cashing out. In this way, oldco management gets to participate in the upside of LBO alongside the financial sponsors.
What is a management buyout (“MBO”)?
A management buyout is a leveraged buyout where the major (or at least a significant) portion of the newco equity comes from oldco management. Management will usually provide cash equity and rollover any existing equity. In addition, equity financing can also include financial sponsors or other investors. The debt financing portion of the MBO is similar to that of an LBO.
What is PIK interest or a PIK toggle?
PIK stands for Paid-in-Kind. PIK interest expense is interest charged by a lender that doesn’t need to be paid right away in cash, but rather increases the debt owed and accrued the debt balance. For the borrower (the company), this conserves cash but compounds the obligation each year.
In addition to loans set up as a PIK, some preferred stock investments allow the company to pay PIK dividends and let the dividends grow the preferred stock obligation. A PIK toggle allows the company to choose (or “toggle”) between paying cash or PIK in any given period.
What is the difference between a recapitalization and an LBO?
An LBO is accounted for as an acquisition, which means assets are written up and goodwill is recognized. A recapitalization is mechanically the same thing but accounted for not as an acquisition but as a simple recapitalization – asset bases carryover unchanged, with no goodwill recognized. Because no goodwill is recognized, negative equity is often created in a recapitalization because the offer price is often significantly higher than the book value of equity.
