Flashcards in LBO Deck (31)
Explain several ways to improve LBO IRR.
LBO IRR is driven off of four components: entry multiple, exit multiple, the EBITDA growth rate between entry and exit and also the time period. So you can decrease your entry multiple by paying a lower price on the company, increase your exit by selling your company for a higher price, increase the EBITDA between it – perhaps there’s some operational improvements, and also shorten the time period. And all those four factors will help you get a higher IRR.
Why don’t we do a paper LBO? So assume that you’re looking at a $100 million revenue business in the paper and packaging industry. What are some of the, uh, information you would need, uh, to see if this is a good LBO candidate. What Qualifying Questions should you ask ?
Sample Outline: First and foremost, I’d say what is top line growing at? (Interviewer Response: Assume 5 percent.) 5 percent, okay. And then what are the EBITDA margins of the business? (Interviewer Response: Assume 10 percent.) And then also what are the free cash flow margins of the business? (Interviewer Response: good question. Assume they remain at 5 percent throughout the whole.) Is the free cash flow that we’re using a levered free cash flow or an unlevered free cash flow? (Interviewer Response: Assume levered free cash flow).
Explain several ways to improve the IRR on an LBO.
LBOs really have three value levers. One is EBITDA growth. Two is the financial structure, uh, meaning leverage. And then three is multiple expansion. So the first, you can grow EBITDA by growing the top line or through operational efficiencies. Leverage is useful because – because the cost of debt is less than the cost of equity, and you pay down with the free cash flow generated. And then multiple expansion is determined by the market and is as a result out of control of the sponsor and so can be harder to underwrite.
What is an LBO?
A leveraged buyout is one company's acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
Walk me through the mechanics of an LBO model.
3) Adjust Balance Sheet - Debt and Equity - Goodwill
4) Project 3 statements
5) Project FCF
6) Debt and Interest Schedule
7) Exit Calc (MOic and IRR)
8) Sensitivity Tables
What makes a good LBO investment candidate?
Mature industry and/or company: Stock price of the public target company is trading at a lower multiple to free cash flow as compared to a new and high growth industry or company.
– Clean balance sheet with no or low amount of outstanding debt: Need the ability to be able to use debt as part of the acquisition consideration or “leverage” as the name suggests. A company with no debt and high free cash flow may be a great candidate given the fact that you can buy the company with senior debt and use the free cash flows of the company to pay the principal and interest due.
– Strong management team and potential cost-cutting measures: Management is able to run and create a more efficient company with same cash generating characteristics. PE firms might decide to get rid of the old management team and hire a new team that has a successful track record of building great businesses in the respective industry.
– Low working capital requirement and steady cash flows: Looking for stable and recurring cash flows that can be used to pay down debt over the years before exit, thus increasing the equity/total assets ratio of the company.
– Low future capital expenditure requirements: Same reason as low working capital requirements.
– Feasible exit options: One question you might ask is if there have been any historical LBO or IPO precedents in the relative industry as your LBO target candidate. Will you be able to sell this business at the same or higher entry multiple that you originally paid for the company?
– Strong competitive advantages and market position: Overall, company is in a great position to keep generating steady cash flows and keep position in its markets.
– Possibility of selling some underperforming or non-core assets: Company can sell assets to raise cash to pay off outstanding debt. Note that these assets should not represent a significant contributor to company’s current cash flow. The spin-off of these non-core assets may increase your market multiples because your business going-forward may be compared to a new set of public peers.
What are the 4 main drivers of the change in IRR for an LBO scenario?
1) Lower purchase 2) Exit Multiple 3) Amount of Leverage 4) EBITDA expansion.
What are the three ways to create equity value?
1) EBITDA/earnings growth, 2) FCF generation/debt paydown, and 3) multiple expansion.
What are the potential investment exit strategies for an LBO fund?
Sale (to strategic or another financial buyer), IPO or recapitalization (re-leveraging by replacing equity with more debt in order to extract cash from the company).
Advantages of LBO financing?
a) As the debt ratio increases, equity portion shrinks to a level where one can acquire a company by only putting up 20 to 40 percent of the total purchase price. b) Interest payments on debt are tax deductible. c) By having management investing, the firm guarantees the management team's incentives will be aligned with their own.
What are some characteristics of a company that is a good LBO candidate?
Ideally, LBO'ed companies have steady cash flows, strong management, opportunities for earnings growth or cost reductions, high asset base (for collateral to raise more debt), low business risk and low need for ongoing investment (e.g. capex and working capital). The most important characteristic is steady cash flows, because sponsors need to be able to pay off the relatively high interest expense each year.
What are some of the due diligence questions that you would ask?
You might start off with industry questions to determine if it is an industry that the sponsor would want to be in, and then determine how well positioned the company is within that industry. Ask about market rivalry, whether the industry is growing, what the company's and its competitors respective market shares are, what the primary strategy for product competition (brand, quality, price?) is. Ask whether there are barriers to entry or economies of scale, supplier and buyer power, threat of substitutes, etc.
Then move onto questions about the company's own operating performance. Zero in on growth, what is projected, how much is attributed to growth of the industry versus market share gains. What is the resilience of this company to downturns? What demographics is the revenue focused in, and how will these demographics change? What is the cost structure, how efficient are the supply and distribution chains? What's the proportion of fixed to variable costs? How well do you utilize assets? Ask about capital expenditures, growth versus maintenance. Also ask about how working capital is managed. How well do you collect on account receivables or manage accounts payable?
Next, move to financials: How much cash is available right now? What are the projected financials?
Then you want to ask about opportunities: Are there non-core or unprofitable assets or business lines? Is there opportunity for improvement or rationalization?
You also care significantly about the quality of management. How long have they been in their positions, what are their backgrounds? Is the sponsor able to replace them, if needed?
What are the legal and regulatory risks? Are there any HR issues, like union or labor problems?
What's your exit strategy here? Is the industry consolidating so that a sale might be made easier?
If I handed you an offering memorandum, what are some of the things you'd think about?
You would think about how you would value the company; whether it was a good LBO candidate. You'd try to understand the business as much as possible, especially in operational points like capex, working capital needs, margins, customers, etc. You'd examine at the industry, look for growth opportunities and question whether the sponsor and/or management could capitalize on those opportunities. You would wonder what would be appropriate capital structure, and whether it is achievable in the current markets. Most importantly, you'd think about all the potential risks.
Walk me through S&U?
Sources contain the variable tranches of capital structure. Some examples from senior to junior are bank debt, junior subordinated notes, convertible preferred, hybrids and sponsor equity. Cash belonging to the target can also be used as a source. Finally, proceeds from options exercised at the target are a source. You need to determine how these sources are used; the main component is the purchase of the company, either of the assets or shares. Then is purchase of the target's options, refinancing debt and transaction costs (banker and lawyer fees).
Why do PE multiples and EBITDA multiples yield you different valuation results? Why use EBITDA multiples instead of PE multiples?
EBITDA multiples represent the value to all stakeholders, while the PE multiples only represent the value to equity holders. Three reasons to use EBITDA for an LBO are: 1) it can be used for firms reporting losses, 2) it allows you to compare firms regardless of leverage, and 3) because it represents operational cash flow.
What are the ways in which a company can spend available cash/FCF?
Pay down debt, issue dividends, buy back stock, invest in the business (capital expenditures), and engage in acquisitions.
Given that there is no multiple expansion and flat EBITDA, how can you still generate a return?
Reduce interest expense, improve tax rate, depreciation tax shield, the simple act of leverage, pay down debt, pay a dividend, reduce capex, reduce working capital requirements and reduce change in other.
What is the different between bank loan and high-yield debt covenants?
Bank loans are more strict. For looser covenants, high-yield debt is rewarded with higher interest rates. Covenants can restrict economic activities, finance activities or accounting measurements. Economic activities restricted would include the sale of assets, capex, changes in corporate structure. Finance activities restricted could include issuance of additional debt and payment of cash dividends. Covenants often track accounting measurements, such as interest coverage, current ratios, minimum EBITDA.
What determined your split between bonds and bank in the deal? If there is a higher growth capex proportion of total capex, would you still want to use same split?
Typically, you'd like as much bank debt as possible because it's cheaper than regular bonds. However, this mostly depends on how much a bank is willing to loan. Next, the sponsor and debt holders have to negotiate the agreements/covenants that they can live with. The more senior the debt, like the bank debt, the more restrictive it tends to be. Bank debt also usually requires collateral to be pledged. Finally, the timeline of debt payback needs to evaluated; bank debt usually has a shorter maturity, so the bank needs to ensure that the company will be able to face its liabilities when due or else face bankruptcy. Growth capex is more favorable than maintenance capex. It's flexible; maintenance capex needs to be paid every year just to keep the company running, whereas growth capex can be stalled in times of downturn. Also, growth capex implies investments, which yield higher cash flows in the future, that can be used to support more debt.
Let's say you run an LBO analysis and the resulting return is below the required return threshold of your PE firm. What drivers to the model will increase the return?
Some of the things that will boost return are: 1) increase leverage (debt), 2) reduce purchase price, which decreases the amount that the firm has to pay, 3) increase exit/sale price or multiple, which increases the return on the investment, 4) increase the growth rate, which raises operating income/cash flow/EBITDA in the projections, and 5) decrease costs, to also raise operating income/cash flow/EBITDA in the projections.
Which valuation will be higher or lower, all else the same? DCF or LBO?
LBO is lower, as it's discounted at a higher cost of equity.
Why do private equity firms use leverage when buying a company?
Using more debt to finance the purchase of a company allows the PE firm to use less of their money (equity) to pay for the deal. If the investment is successful, the higher the leverage, the higher the return when exiting the investment (e.g. selling the company five years later).
Assume the following scenario: EBITDA of $10 million and FCF of $15 million. Entry and exit multiple are 5x. Leverage is 3x. At time of exit, 50 percent of debt is paid down. You generate a 3x return. 20 percent of options are given to management. At what price must you sell the business?
To make a 3x return based on the financial parameters, you must sell the business at $90 million. You know the EV is EBITDA times entry multiple: $10 million * 5x = $50 million. Debt is equal to EBITDA times leverage: $10 million * 3x = $30 million. EV minus debt equals equity: $50 million - $30 million = $20 million. Debt needs to be paid down by half or $30 million * 50% = $15 million. To make a 3x return, sponsor equity needs to grow to $20 million * 3x = $60 million. Since management receives 20 percent of the equity in options, the total equity needs to grow to $60 million/(1 — 20%) = $75 million. Since your ending debt is $15 million and ending equity is $75 million, the EV at exit is $90 million.
If you have a company with a P/E of 10x and cost of debt of 5 percent, which is cheaper for an acquisition?
Debt. The cost of equity is approximately the inverse of P/E so 1 / 10x = 10
percent. The cost of debt at 5 percent is lower, and, therefore, cheaper
Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?
You would rather have the extra dollar of EBITDA because of the multiplier effect. At exit, the EV is dependent on the EBITDA times the exit multiple. An extra dollar of debt paydown increases your equity value by only one dollar; an extra dollar of EBITDA is multiplied by the exit multiple, which results in a greater value creation.
A company runs two operating subsidiaries. One sells coffee and one sells doughnuts. You own 100 percent of the coffee subsidiary. You own 80 percent of the doughnut subsidiary. The coffee subsidiary generates $100 million of EBITDA. The doughnut subsidiary generates $200 million of EBITDA. Doughnut companies are worth 5.0x EBITDA. The parent share price is $10 and there are 100 million shares. The company has cash of debt of $500 million and cash of $200 million. What's the enterprise value to EBITDA multiple for this company?
The enterprise value is market capitalization plus net debt plus minority interest. Market cap is easily to calculate, shares * share price, so $10*100 million = $1,000 million. Net debt is debt less cash so $500 million - $200 million = $300 million. The question has given you the approximate market value of the minority interest in the doughnut company which is 5.0x EBITDA, so $200 * 5.0x * (1 - 80%) = $200 million. As a side note, when calculating enterprise value for comps, you might take the minority value from the balance sheet. This fine to do in such cases. However, a finance professional always chooses market value over book value, so this question gives you enough information to calculate the market value of the minority interest. Back to the answer: you total this all up for EV, which comes to $1,500 million = $1,000 million + $300 million + $200 million. The total EBITDA is $300 million = $100 million + $200 million. Therefore, the EV/EBITDA multiple is $1,500/$300 = 5.0x.
A company has $100 million of EBITDA. It grows to $120 million in five years. Each year you paid down $25 million of debt. Let's say you bought the company for 5.0x and sold it for 5.5x. How much equity value did you create? How much is attributed to each strategy of creating equity value?
The purchase price is $500 million = $100 million * 5.0x. It exits at $660 million = $120 million * 5.5x. This is a profit of $160 million, plus you paid down debt of $125 million = $25 * 5, so your total equity value increased by $285 million = $160 million + $125 million. Obviously the $125 million of the total equity value is due to debt paydown. $100 million comes from the EBITDA growth, ($120 million - $100 million) * 5. Finally, the rest of its equity value increase is attributed to multiple expansion, (5.5x — 5.0x) * $120 million = $60 million. Totaling these up, $125 million + $100 million + $60 million is the $285 million of equity value increase that matches what we calculated earlier.
Given $100 million initial equity investment, five years, IRR of 25 percent, what's exit EBITDA if sold at 15x multiple?
Knowing an IRR of 25 percent over five years is approximately 3.0x equity return (there is no mathematical way of knowing this, so if you don't know this, try asking the interviewer). The ending equity value is, therefore, $300 million = $3.0x * $100 million, so the exit EBITDA must be $300/15x = $20 million.
In an LBO, if cost of debt is 10 percent, what is the minimum return required to break even?
Since interest is tax deductible, the break-even return is the after-tax cost of debt. Assuming tax rate of 40 percent, the break-even return is 6 percent.