400 Question Flashcards - LBO Model
What is a leveraged buyout and why does it work?
- In an LBO‚ a PE firm acquires a company using a combination of debt and equity (cash)‚ operates it for several years‚ possibly makes operational improvements‚ and then sells the company at the end of the period to realize a return on investment.
- During the period of ownership‚ the PE firm uses the company’s cash flows to pay interest expense from the debt and to pay off debt principal.
- An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
- By using debt‚ the PE firm reduces the up-front cash payment for the company‚ which boosts returns.
- Using the company’s cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows.
- The PE firm sells the company in the future‚ which allows it to regain the majority of the funds spent to acquire it in the first place.
Why do PE firms use leverage when buying a company?
- They use leverage to increase their returns.
- Any debt raised for an LBO is not “your money”‚ so if you’re paying $5B for a company‚ it’s easier to earn a high return on $2B of your own money and $3B borrowed from other people than it is on $5B of your own money.
- A secondary benefit is that the firm also has more capital available to purchase other companies b/c they’ve used debt rather than their own funds.
Walk me through a basic LBO model.
In an LBO Model:
• Step 1: is making assumptions about the Purchase Price‚ Debt/Equity ratio‚ Interest Rate on Debt‚ and other variables; you might also assume something about the company’s operations‚ such as Revenue Growth or Margins‚ depending on how much information you have.
• Step 2: is to create a Sources & Uses section‚ which shows how the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required.
• Step 3: is to adjust the company’s Balance Sheet for the new Debt and Equity figures‚ allocate the purchase price‚ and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
• 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.
• 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.
What variables impact a leveraged buyout the most?
- Purchase and exit multiples (and therefore purchase and exit prices) have the greatest impact‚ followed by the amount of leverage (debt) used.
- A lower purchase price equals a higher return‚ whereas a higher exit price results in a higher return; generally‚ more leverage also results in higher returns (as long as the company can still meet its debt obligations).
- Revenue growth‚ EBITDA margins‚ interest rate and principal repayment on Debt all make an impact as well‚ but they are less significant than those first 3 variables.
How do you pick purchase multiples and exit multiples in an LBO model?
- The same way you do it anywhere else: you look at what comparable companies are trading at‚ and at what multiples similar LBO transactions have been completed at. As always‚ you 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 - but this is just for valuation purposes if you’re using an LBO model to value the company.
What is an “ideal” candidate for an LBO?
Ideal candidates should:
• Have stable and predictable cash flows so they can repay debt (the most important)
• Be undervalued relative to peers in the industry (lower purchase price)
• Be a low-risk business (debt repayments)
• Not have much need for ongoing investments such as CapEx
• Have an opportunity to cut costs and increase margins
• Have a strong management team
• Have a solid base of assets to use as collateral for debt
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?
- 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” b/c PE firms almost always pay less for a company than strategic acquirers (no synergies to be realized).
How is an LBO valuation different from a DCF valuation? Don’t they both value the company based on its cash flows?
- The difference is that in DCF you’re saying‚ “What could this company be worth‚ based on the present value of its near-future and far-future cash flows?
- But in an LBO‚ you’re saying‚ “What CAN we pay for this company if we want to achieve an IRR of say‚ 25%‚ in 5 years?”
- So both methodologies are similar‚ but w/ the LBO valuation‚ you’re constraining the values based on the returns you’re targeting.
Give me an example of a “real-life” LBO?
The most common example is taking out a mortgage when you buy a house. We think it’s better to think of it as “buying a house that you rent out to other people‚” b/c that situation is more similar to buying a company that generates cash flow. 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
• Rental Income from Rentals - Cash Flow to Pay Interest and Repay Debt in an LBO
A strategic acquirer usually prefers to pay for another company with 100% cash - if that’s the case‚ why would a PE firm want to use debt in an LBO?
It’s a different scenario because:
- The PE firm does not hold the company for the long-term - it sells it after a few years‚ so it is less concerned with the higher “expense” of debt over cash and is more concerned about using leverage to boost its returns by reducing the capital it contributes upfront.
- In an LBO‚ the company is responsible for repaying the debt‚ so the company assumes much of the risk. Whereas in a strategic acquisition‚ the buyer “owns” the debt‚ so it is more risky for them.
Why would a PE firm buy a company in a “risky” industry‚ such as technology?
Although technology is “riskier” than other markets‚ remember that there are mature‚ cash flow-stable companies in almost every industry. There are PE firms that specialize in very specific goals‚ such as:
• Industry Consolidation: Buying competitors in a market and combining them to increase efficiency and win more customers.
• Turnarounds: Taking struggling companies and improving their operations
• Divestitures: Selling off divisions of a company or turning a division into a strong stand-alone entity.
- So even if a company isn’t doing well or even if it seems risky‚ the PE firm might buy it if it falls into one of the categories that the firm focuses on.
- This whole issue of “risk” is more applicable in industries where companies truly have unstable cash flows - anything based on commodities‚ such as oil‚ gas‚ and mining‚ for example.
How could a PE firm boost its return in an LBO?
- Reduce the Purchase Price.
- Increase the Exit Multiple and Exit Price.
- Increase the Leverage (debt) used.
- Increase the company’s growth rate (organically or via acquisitions)
- Increase margins by reducing expenses (cutting employees‚ consolidating buildings‚ etc.)
• These are all “theoretical” and refer to the model rather than reality - in practice it’s hard to actually implement these changes.
How could you determine how much debt can be raised in an LBO and how many tranches there would be?
- Usually you look at recent‚ similar LBOs and assess the debt terms and tranches that were used in each transaction.
- You could also look at companies in a similar size range and industry‚ see how much debt outstanding they have‚ and base your own numbers on those.
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?
- 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.
- There are some general rules: for example‚ you would never lever a company at 50x EBITDA‚ and even during bubbles‚ leverage rarely exceeds 10x EBITDA.
- For interest coverage ratios (e.g. EBITDA/Interest)‚ you want a number where the company can pay for its interest w/o much trouble‚ but also not so high that the company could clearly afford to take on more debt.
- For example a 20x coverage ratio would be far too high b/c the company could easily pay 2-3x more in interest. But a 2x coverage ratio would be too low‚ b/c a small decrease in EBITDA might result in a disaster at that level.
What is the difference between Bank Debt and High-Yield Debt?
This is a simplification‚ but broadly speaking there are 2 “types” of Debt: “Bank Debt” and “High-Yield Debt.” Usually in a sizable LBO‚ the PE firm uses both types of debt. There are many differences‚ but here are a few of the most important ones:
• High-Yield Debt tends to have higher interest rates than Bank Debt (hence the name “high-yield”) since it’s riskier for investors.
• High-Yield Debt interest rates are usually fixed‚ whereas Bank Debt interest rates are floating (they change based on LIBOR or the prevailing interest rates in the economy).
• High-Yield Debt has incurrence covenants‚ while Bank Debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset‚ buying a factory‚ etc.) while maintenance covenants require you to maintain minimum financial performance (for example‚ the Total Debt / EBITDA ratio must be below 5x at all times).
• Bank Debt is usually amortized - the principal must be paid off over time - whereas High-Yield Debt‚ the entire principal is due at the end (bullet maturity) and early principal repayments are not allowed.
If High-Yield Debt is “riskier‚” why are early principal repayments not allowed? Shouldn’t investors want to reduce their risk?
This isn’t the right way to think about it - remember that investors need to be compensated for the risk they take. And now think about what happens if early repayment is allowed:
• Initially‚ the investors might earn $100M in interest on $1B worth of debt‚ at a 10% interest rate.
• Without early repayment‚ the investors keep getting that $100M in interest each year paid directly to them.
• With early repayment‚ this interest payment drops each year and the investors receive increasingly less each year - and that drops their effective return.
All else being equal‚ debt investors want companies to keep debt on their Balance Sheets as long as possible.
