(2008) LBO Model - Basic

Question 1

Walk me through a basic LBO model.

Answer 1

“In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables.

Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required.

Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, and also add in Goodwill & Other Intangibles on the Assets side to make everything balance.

In Step 4, you project out the company’s Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments.

Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.”

Question 2

Why would you use leverage when buying a company?

Answer 2

To increase your returns. Any debt you use in an LBO is not “your money” - so if you’re paying $5 billion for a company, it’s easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere. A secondary benefit is that the firm also has more capital available to purchase other companies.

Question 3

What variables impact an LBO model the most?

Answer 3

Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margins.

Question 4

How do you pick purchase multiples and exit multiples in an LBO model?

Answer 4

You look at what comparable companies are trading at, and what multiples similar LBO transactions have had. You also show a range of purchase and exit multiples using sensitivity tables. Sometimes you set purchase and exit multiples based on a specific IRR target that you’re trying to achieve.

Question 5

What is an “ideal” candidate for an LBO?

Answer 5

“Ideal” candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt. The most important part is stable cash flow.

Question 6

How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?

Answer 6

You use it to value a company by setting a targeted IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR. This is sometimes called a “floor valuation” because PE firms almost always pay less for a company than strategic acquirers would.

Question 7

Give an example of a “real-life” LBO.

Answer 7

The most common example is taking out a mortgage when you buy a house. Here’s how the analogy works:

Down Payment: Investor Equity in an LBO

Mortgage: Debt in an LBO

Mortgage Interest Payments: Debt Interest in an LBO

Mortgage Repayments: Debt Principal Repayments in an LBO

Selling the House: Selling the Company / Taking It Public in an LBO

Question 8

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

Answer 8

First, the Liabilities & Equities side is adjusted - the new debt is added on, and the Shareholders’ Equity is “wiped out” and replaced by however much equity the private equity firm is contributing. On the Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Other Intangibles are used as a “plug” to make the Balance Sheet balance.

Question 9

Why are Goodwill & Other Intangibles created in an LBO?

Answer 9

These both represent the premium paid to the “fair market value” of the company. In an LBO, they act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.

Question 10

We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that’s the case, why would a PE firm want to use debt in an LBO?

Answer 10

It’s a different scenario because:

The PE firm does not intend to hold the company for the long-term, so it is more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront.

In an LBO, the debt is “owned” by the company, so they assume much of the risk. Whereas in a strategic acquisition, the buyer “owns” the debt so it is more risky for them.

Question 11

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

Answer 11

Yes, there are shortcuts. You do not need to create a full Balance Sheet. You do need some form of Income Statement, something to track how the Debt balances change and some type of Cash Flow Statement to show how much cash is available to repay debt. But a full-blown Balance Sheet is not strictly required.

Question 12

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Answer 12

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

Question 13

Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?

Answer 13

This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions. To figure out the numbers, you would look at “debt comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently.

Question 14

What is the difference between bank debt and high-yield debt?

Answer 14

High-yield debt tends to have higher, fixed interest rates than bank debt, which has floating rates.

High-yield debt has incurrence covenants (prevent you from doing something) while bank debt has maintenance covenants (require you to maintain a minimum financial performance).

Bank debt is usually amortized (principal must be paid off over time) whereas with high-yield debt, the entire principal is due at the end (bullet maturity).

Question 15

Why might you use bank debt rather than high-yield debt in an LBO?

Answer 15

If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt. They might also use bank debt if they are planning on major expansion or Capital Expenditures and don’t want to be restricted by incurrence covenants.

Question 16

Why would a PE firm prefer high-yield debt instead?

Answer 16

If the PE firm intends to refinance the company at some point or they don’t believe their returns are too sensitive to interest payments, they might use high-yield debt. They might also use it if they don’t have plans for major expansion or selling off the company’s assets.

Question 17

Why would a private equity firm buy a company in a “risky” industry, such as technology?

Answer 17

There are mature, cash flow-stable companies in almost every industry. There are also PE firms that specialize in specific goals, such as:

Industry consolidation: buying competitors and combining them.

Turnarounds: taking struggling companies and making them function properly again.

Divestitures: selling off divisions of a company or taking a division and turning it into a strong stand-alone entity.

Question 18

How could a private equity firm boost its return in an LBO?

Answer 18

Lower the Purchase Price in the model.

Raise the Exit Multiple / Exit Price.

Increase the Leverage (debt) used.

Increase the company’s growth rate.

Increase margins by reducing expenses.

Question 19

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

Answer 19

This means that the interest a firm pays on debt is tax-deductible - so they save money on taxes and therefore increase their cash flow. Note, however, that their cash flow is still lower than it would be without the debt.

Question 20

What is a dividend recapitalization (“dividend recap”)?

Answer 20

In a dividend recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it.

Question 21

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

Answer 21

Primarily to boost returns. More leverage means a higher return to the firm. With a dividend recap, the PE firm is “recovering” some of its equity investment in the company, and the lower the equity investment, the better, since it’s easier to earn a higher return on a smaller amount of capital.

Question 22

How would a dividend recap impact the 3 financial statements in an LBO?

Answer 22

No changes to the Income Statement. On the Balance Sheet, Debt would go up and Shareholders’ Equity would go down and they would cancel each other out. On the Cash Flow Statement, under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change.