LBO - Advanced

Question 1

Tell me about all the different kinds of debt you could use in an LBO and the differences between everything.

Answer 1

Here’s a handy chart to explain all of this. Note that this chart does not cover every single feature or every single type of debt in the universe – just the most important ones, and what you’re likely to be asked about in finance interviews:

• Revolver:
• Interest Rate: Lowest
• Floating / Fixed?: Floating
• Cash Pay?: Yes
• Tenor: 3-5 years
• Amortization: None
• Prepayment: Yes
• Investors: Conservative Banks
• Seniority: Senior Secured
• Secured: Yes
• Call protection: No
• Covenants: Maintenance
• Term Loan A
• Interest Rate: Low
• Floating / Fixed?: Floating
• Cash Pay?: Yes
• Tenor: 4-6 years
• Amortization: Straight Line
• Prepayment: Yes
• Investors: Conservative Banks
• Seniority: Senior Secured
• Secured: Yes
• Call protection: Sometimes
• Covenants: Maintenance
• Term Loan B
• Interest Rate: Higher
• Floating / Fixed?: Floating
• Cash Pay?: Yes
• Tenor: 4-8 years
• Amortization: Minimal
• Prepayment: Yes
• Investors: Conservative Banks
• Seniority: Senior Secured
• Secured: Yes
• Call protection: Sometimes
• Covenants: Maintenance
• Senior Notes
• Interest Rate: Higher
• Floating / Fixed?: Fixed
• Cash Pay?: Yes
• Tenor: 7-10 years
• Amortization: Bullet
• Prepayment: No
• Investors: Hedge Funds, Merchant Banks, Mezzanine Funds
• Seniority: Senior Unsecured
• Secured: Sometimes
• Call protection: Yes
• Covenants: Incurrence
• Subordinated Notes
• Interest Rate: Higher
• Floating / Fixed?: Fixed
• Cash Pay?: Yes
• Tenor: 8-10 years
• Amortization: Bullet
• Prepayment: No
• Investors: Hedge Funds, Merchant Banks, Mezzanine Funds
• Seniority: Senior Subordinated
• Secured: No
• Call protection: Yes
• Covenants: Incurrence
• Mezzanine
• Interest Rate: Highest
• Floating / Fixed?: Fixed
• Cash Pay?: Yes
• Tenor: 8-10 years
• Amortization: Bullet
• Prepayment: No
• Investors: Hedge Funds, Merchant Banks, Mezzanine Funds
• Seniority: Equity
• Secured: No
• Call protection: Yes
• Covenants: Incurrence

“Tenor” is just the fancy word for “How many years will this loan be outstanding?”

Each type of debt is arranged in order of rising interest rates – so a revolver has the lowest interest rate, Term Loan A is slightly higher, B is slightly higher, Senior Notes are higher than Term Loan B, and so on.

“Seniority” refers to the order of claims on a company’s assets in a bankruptcy – the Senior Secured holders are first in line, followed by Senior Unsecured, Senior Subordinated, and then Equity Investors.

“Floating” or “Fixed” Interest Rates: A “floating” interest rate is tied to LIBOR. For example, L + 100 means that the interest rate of the loan is whatever LIBOR is at currently, plus 100 basis points (1.0%). A fixed interest rate, on the other hand, would be 11%. It doesn’t “float” with LIBOR or any other rate.

Amortization: “straight line” means the company pays off the principal in equal installments each year, while “bullet” means that the entire principal is due at the end of the loan’s lifecycle. “Minimal” just means a low percentage of the principal each year, usually in the 1-5% range.

Call Protection: Is the company prohibited from “calling back” – paying off or redeeming – the security for a certain period? This is beneficial for investors because they are guaranteed a certain number of interest payments.

Question 2

How would an asset write-up or write-down affect an LBO model? / Walk me through how you adjust the Balance Sheet in an LBO model.

Answer 2

All of this is very similar to what you would see in a merger model – you calculate Goodwill, Other Intangibles, and the rest of the write-ups in the same way, and then the Balance Sheet adjustments (e.g. subtracting cash, adding in capitalized financing fees, writing up assets, wiping out goodwill, adjusting the deferred tax assets / liabilities, adding in new debt, etc.) are almost the same.

The key differences:

• In an LBO model you assume that the existing Shareholders’ Equity is wiped out and replaced by the equity the private equity firm contributes to buy the company; you may also add in Preferred Stock, Management Rollover, or Rollover from Option Holders to this number as well depending on what you’re assuming for transaction financing.
• In an LBO model you’ll usually be adding a lot more tranches of debt vs. what you would see in a merger model.
• In an LBO model you’re not combining two companies’ Balance Sheets.

Question 3

Normally we care about the IRR for the equity investors in an LBO – the PE firm that buys the company – but how do we calculate the IRR for the debt investors?

Answer 3

For the debt investors, you need to calculate the interest and principal payments they receive from the company each year.

Then you simply use the IRR function in Excel and start with the negative amount of the original debt for “Year 0,” assume that the interest and principal payments each year are your “cash flows” and then assume that the remaining debt balance in the final year is your “exit value.”

Most of the time, returns for debt investors will be lower than returns for the equity investors – but if the deal goes poorly or the PE firm can’t sell the company for a good price, the reverse could easily be true.

Question 4

Why might a private equity firm allot some of a company’s new equity in an LBO to a management option pool, and how would this affect the model?

Answer 4

This is done for the same reason you have an Earnout in an M&A deal: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment.

The difference is that there’s no technical limit on how much management might receive from such an option pool: if they hit it out of the park, maybe they’ll all become millionaires.

In your LBO model, you would need to calculate a per-share purchase price when the PE firm exits the investment, and then calculate how much of the proceeds go to the management team based on the Treasury Stock Method.

An option pool by itself would reduce the PE firm’s return, but this is offset by the fact that the company should perform better with this incentive in place.

Question 5

Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?

Answer 5

Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest payments – instead, the interest just accrues to the loan principal, which keeps going up over time. A PIK “toggle” allows the company to choose whether to pay the interest in cash or have it accrue to the principal (these have disappeared since the credit crunch).

PIK is more risky than other forms of debt and carries with it a higher interest rate than traditional bank debt or high yield debt.

Adding it to the debt schedules is similar to adding high-yield debt with a bullet maturity – except instead of assuming cash interest payments, you assume that the interest accrues to the principal instead.

You should then include this interest on the Income Statement, but you need to add back any PIK interest on the Cash Flow Statement because it’s a non-cash expense.

Question 6

What are some examples of incurrence covenants? Maintenance covenants?

Answer 6

Incurrence Covenants:

• Company cannot take on more than $2 billion of total debt.
• Proceeds from any asset sales must be earmarked to repay debt.
• Company cannot make acquisitions of over $200 million in size.
• Company cannot spend more than $100 million on CapEx each year.

Maintenance Covenants:

• Total Debt / EBITDA cannot exceed 3.0x
• Senior Debt / EBITDA cannot exceed 2.0x
• (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0x
• EBITDA / Interest Expense cannot fall below 5.0x
• EBITDA / Cash Interest Expense cannot fall below 3.0x
• (EBITDA – CapEx) / Interest Expense cannot fall below 2.0x

Question 7

Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use Section 338(h)(10) election?

Answer 7

In most cases, no – because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC shell company that “acquires” the company on paper.

Question 8

Walk me through how you calculate optional repayments on debt in an LBO model.

Answer 8

First, note that you only look at optional repayments for Revolvers and Term Loans – high-yield debt doesn’t have a prepayment option, so effectively it’s always $0.

First, you check how much cash flow you have available based on your Beginning Cash Balance, Minimum Cash Balance, Cash Flow Available for Debt Repayment from the Cash Flow Statement, and how much you use to make Mandatory Debt Repayments.

Then, if you’ve used your Revolver at all you pay off the maximum amount that you can with the cash flow you have available.

Next, for Term Loan A you assume that you pay off the maximum you can, taking into account that you’ve lost any cash flow you used to pay down the Revolver. You also need to take into account that you might have paid off some of Term Loan A’s principal as part of the Mandatory Repayments.

Finally, you do the same thing for Term Loan B, subtracting from the “cash flow available for debt repayment” what you’ve already used up on the Revolver and Term Loan A. And just like Term Loan A, you need to take into account any Mandatory Repayments you’ve made so that you don’t pay off more than the entire Term Loan B balance.

The formulas here get very messy and depend on how your model is set up, but this is the basic idea for optional debt repayments.

Question 9

Explain how a Revolver is used in an LBO model.

Answer 9

You use a Revolver when the cash required for your Mandatory Debt Repayments exceeds the cash flow you have available to repay them.

The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment – Cash Flow Available to Repay Debt).

The Revolver starts off “undrawn,” meaning that you don’t actually borrow money and don’t accrue a balance unless you need it – similar to how credit cards work.

You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments.

Within the debt repayments themselves, you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans.

Question 10

How would you adjust the Income Statement in an LBO model?

Answer 10

The most common adjustments:

• Cost Savings – Often you assume the PE firm cuts costs by laying off employees, which could affect COGS, Operating Expenses, or both.
• New Depreciation Expense – This comes from any PP&E write-ups in the transaction.
• New Amortization Expense – This includes both the amortization from written- up intangibles and from capitalized financing fees.
• Interest Expense on LBO Debt – You need to include both cash and PIK interest here.
• Sponsor Management Fees – Sometimes PE firms charge a “management fee” to a company to account for the time and effort they spend managing it.
• Common Stock Dividend – Although private companies don’t pay dividends to shareholders, they could pay out a dividend recap to the PE investors.
• Preferred Stock Dividend – If Preferred Stock is used as a form of financing in the transaction, you need to account for Preferred Stock Dividends on the Income Statement.

Cost Savings and new Depreciation / Amortization hit the Operating Income line; Interest Expense and Sponsor Management Fees hit Pre-Tax Income; and you need to subtract the dividend items from your Net Income number.

Question 11

In an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell us about the company we’re modeling?

Answer 11

Yes, and it happens more commonly than you’d think. Remember, high-yield debt investors often get interest rates of 10-15% or more – which effectively guarantees an IRR in that range for them.

So no matter what happens to the company or the market, that debt gets repaid and the debt investors get the interest payments.

But let’s say that the median EBITDA multiples contract, or that the company fails to grow or actually shrinks – in these cases the PE firm could easily get an IRR below what the debt investors get.

Question 12

Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

Answer 12

This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes.

Sometimes in LBO models, increasing the leverage increases the IRR up to a certain point – but then after that the IRR starts falling as the interest payments or principal repayments become “too big.”

For this scenario to happen you would need a “perfect storm” of:

1. Relative lack of cash flow / EBITDA growth.
2. High interest payments and principal repayments relative to cash flow.
3. Relatively high purchase premium or purchase multiple to make it more difficult to get a high IRR in the first place.

Question 13

How does Preferred Stock fit into these different financing methods? Isn’t it a type of Debt as well?

Answer 13

Preferred Stock is similar to Debt and it would match the “Mezzanine” column in the table above most closely. Just like with Mezzanine, Preferred Stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt. It’s not included in the table above due to space constraints.

Question 14

How do you treat Noncontrolling Interests (AKA Minority Interests) and Investments in Equity Interests (AKA Associate Companies) in an LBO model?

Answer 14

Normally you leave these alone and assume that nothing happens – so they show up in both the Sources and Uses columns when you make assumptions in the beginning.

You could assume that the private equity firm acquires one or both of these, in which case they would only show up in the Uses column – similar to refinancing Debt.

Question 15

What about “Excess Cash”? Why do you sometimes see that in a Sources & Uses table?

Answer 15

This represents the scenario where the company itself uses its excess cash (i.e. if it only requires $10 million in cash but has $50 million on its Balance Sheet, $40 million is the excess cash) to fund the transaction. This always shows up in the Sources column.

It’s just like how you subtract Cash when calculating Enterprise Value: an acquirer would “receive” that Cash upon buying the company.

You do not always see this item – it’s more common when the company has a huge amount of excess cash and has no real reason for having it.

Question 16

Can you give a complete list of items that you might see in the Sources & Uses section and explain the less common ones?

Answer 16

Sources Column:

• Debt and Preferred Stock (All types)
• Investor Equity (PE firm’s cash)
• Debt Assumed
• Noncontrolling Interests Assumed
• Management Rollover

Uses Column:

• Equity Value of Company
• Advisory and Legal Fees
• Capitalized Financing Fees
• Debt Assumed
• Noncontrolling Interests Assumed
• Debt Refinanced
• Noncontrolling Interests Purchased

Debt and Debt-like items such as existing Preferred Stock and Noncontrolling Interests can always be either assumed (remain on the Balance Sheet) or refinanced / purchased (paid off and disappear).

The “Management Rollover” refers to the option to let the management team re- invest their shares and options into the deal.

For example, if the team currently owns 5% of the company, the PE firm might say, “We’ll acquire 95% of the shares, and then let you keep the 5% you own to incentivize you to perform well over these next few years and reap the rewards.”

Question 17

Walk me through how you adjust the Balance Sheet in an LBO model.

Answer 17

This is very similar to what you see in a merger model – you calculate Goodwill, Other Intangible Assets, and the rest of the Write-Ups in the same way, and then the Balance Sheet adjustments (e.g. subtracting Cash, adding in Capitalized Financing Fees, writing up Assets, wiping out Goodwill, adjusting the Deferred Tax Assets / Liabilities, adding in new Debt, etc.) are almost the same.

The key differences:

• In an LBO model you assume that the existing Shareholders’ Equity is wiped out and replaced by the value of the cash the private equity firm contributes to buy the company; you may also add in Preferred Stock, Management Rollover, or Rollover from Option Holders to this number as well depending on your assumptions.
• In an LBO model you’ll usually add more tranches of debt compared to what you would see in a merger model.
• In an LBO model you’re not combining two companies’ Balance Sheets.

Question 18

hy are Capitalized Financing Fees an Asset?

Answer 18

There are a couple ways to think about this:

• It’s just like the Prepaid Expenses item on the Assets side: paid for in cash up-front, and then recognized as an expense over many years. Since the company has already paid for it in cash, it’s not going to cost them anything more in future periods.
• An Asset represents potential future income or potential future savings; Capitalized Financing Fees have already been paid in cash, so when the expense is recognized on the Income Statement over several years it reduces the company’s taxes (similar to Prepaid Expenses).

Question 19

Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example, what happens when you have Existing Debt, a Revolver, Term Loans, and Senior Notes?

Answer 19

Let’s break this down by category and do a quick overview before jumping into more detailed explanations.
First off, note that you must make all mandatory debt repayments on each tranche of debt before anything else. So there is no real “order” there – you simply have to repay what is required. The “order” applies only when you have extra cash flow beyond what is needed to meet these mandatory debt repayments:

• Revolver: You borrow additional funds here and add them to the balance if you don’t have enough cash flow to meet the mandatory debt repayments each year; you use any extra cash flow each year to repay this Revolver
  first, before any other debt.
• Existing Debt: This comes first, before the new debt raised in the LBO,
  when setting aside extra cash flow to make optional repayments.
• Term Loans: Payments on these come after paying off the Revolver and
  any existing debt.
• Senior Notes: These come last in the hierarchy, and typically optional
  repayment is limited or not allowed at all.

To track this in an LBO model, you need to separate out the Revolver from the mandatory repayments from the optional repayments, and keep track of the cash flow that’s available after each stage of the process.

Question 20

Let’s walk through a real-life example of debt modeling now… let’s say that we have $100 million of debt with 5% cash interest, 5% PIK interest, and amortization of 10% per year. How do you reflect this on the financial statements?

Answer 20

To simplify this scenario, we’ll assume that interest is based on the beginning debt balance rather than the average balance over the course of the year.

• Income Statement: There’s $5 million of cash interest and $5 million of PIK interest, for a total of $10 million in interest expense, which reduces Pre-Tax Income by $10 million and Net Income by $6 million assuming a 40% tax rate.
• Cash Flow Statement: Net Income is $6 million lower, but you add back the $5 million in PIK interest because it was a non-cash charge. Cash Flow from Operations is down by $1 million. Since there’s 10% amortization per year, you repay $10 million of debt each year (and presumably the entire remaining amount at the end of the period) in the Cash Flow from Financing section – so cash at the bottom is down by $11 million.
• Balance Sheet: Cash is down by $11 million on the Assets side, so that entire side is down by $11 million. On the other side, Debt is up by $5 million due to the PIK interest but down by $10 million due to the principal repayment, for a net reduction of $5 million. Shareholders’ Equity is down by $6 million due to the reduced Net Income, so both sides are down by $11 million and balance.

Each year after this, you base the cash and PIK interest on the new debt principal number and adjust the rest of the numbers accordingly.

Question 21

Why do we show PIK interest in the Cash Flow from Operations section? Isn’t it a financing activity?

Answer 21

First, note that interest expense never shows up in the Cash Flow from Financing section because it is tax-deductible and it always appears on the Income Statement. So showing anything in that section for interest expense would be double-counting.

You show PIK interest in the CFO section because it is a non-cash expense – we’re adding it back because it’s just like Depreciation or Amortization. It reduces taxes but is not actually paid out in cash.

Question 22

What if there’s a stub period in a leveraged buyout? Normally you assume full years, but what happens if the PE firm acquires a company halfway through the year instead?

Answer 22

In this case, you have to project the financial statements for this “stub period,” which is easier than it sounds because it is usually a matter of multiplying the full-year statements by 1/4, 1/2, 3/4, and so on. If you have quarterly projections you could use those and avoid the need for extra math.

Example: If the PE firm buys the company on March 31, you would multiply the line items on the full-year Income Statement and Cash Flow Statement by 3/4 to determine the numbers from April 1 to December 31, which is three-quarters of the year. You would also have to project the Balance Sheet to the March 31 close date and use those numbers when adjusting the Balance Sheet and allocating the purchase price.

The IRR calculation will also be different in this case (see the next section).

This concept is not difficult, but it creates extra work without a huge benefit so most LBO models are built based on full calendar years instead.

Question 23

How would you model a “waterfall return” structure where different equity investors in an LBO receive different percentages of the returns, depending on the overall IRR?

For example, let’s say that Investor Group A receives 10% of the returns up to a 15% IRR (Investor Group B receives 90%), but then receives 15% of the returns (with Investor Group B receiving 85%) beyond a 15% IRR. How does that work?

Answer 23

The exact Excel formulas for doing this get tricky, but here is the basic idea with simple numbers to make it easier to understand:
* First, you do a check to see what the IRR is with the amount of net sale proceeds you’ve assumed. For example, let’s say you get back $500 million at the end and calculate that $500 million equates to an 18% IRR.

• Next, you determine what amount of those proceeds equals a 15% IRR. So let’s say you run the numbers and find that $450 million would equal a 15% IRR.
• You allocate 10% of this $450 million to Investor Group A and 90% to Investor Group B.
• Then, you allocate 15% of the remaining $50 million ($500 million minus $450 million) to Investor Group A and 85% to Investor Group B.

This scenario is common in real estate development, where multiple groups of equity investors are commonplace, but you do see it in some LBOs as well.

Question 24

How do different types of Debt and interest options affect the IRR? For example, does it benefit the PE firm to use a higher percentage of Term Loans or a higher percentage of Senior or Subordinated Notes? What about cash vs. PIK interest?

Answer 24

It is almost always better to use Debt with lower interest rates and Debt that can be repaid early. Otherwise, the company’s cash flows are being “wasted” because it’s generating cash but the PE firm is not using this cash in any way.

So all else being equal, having Term Loans rather than Senior or Subordinated Notes or Mezzanine will boost IRR; cash interest will boost IRR over PIK interest because the debt principal doesn’t “balloon” over time; and lower interest rates will also boost IRR.

However, this doesn’t tell the whole story: sometimes a PE firm will use High- Yield Debt or debt with PIK interest anyway if the company is having cash flow issues or if it’s too difficult to raise the funds via Term Loans.

Question 25

Let’s say that we have a stub period in an LBO, and that the PE firm initially acquires the company midway through the year (assume June 30th). How does that impact the returns calculation?

Answer 25

In this case you have to use the XIRR function in Excel rather than the IRR function, and you enter the dates of all the cash flows in addition to the amounts.

The impact on IRR depends on the length of the holding period. If this “stub period” results in a longer holding period (5.5 years or 5.75 years rather than 5 years), IRR will decrease because a longer time period means a lower effective interest rate.

If this “stub period” results in a shorter holding period (4.5 years or 4.75 years rather than 5 years), IRR will increase because a shorter time period = a higher effective interest rate.

Question 26

Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use a Section 338(h)(10) election?

Answer 26

In most cases, no – because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC shell company that “acquires” the company on paper.

Question 27

Why might a private equity firm allot some of a company’s new equity in an LBO to a management option pool, and how would this affect the model?

Answer 27

This is done for the same reason that buyers use Earnouts in M&A deals: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment.

The difference is that there’s no technical limit on how much management might receive from such an option pool: their proceeds will be a percentage of the company’s final sale value.

In your LBO model, you would need to calculate a per-share purchase price when the PE firm exits the investment, and then calculate how much of the proceeds go to the management team based on the Treasury Stock Method.

An option pool by itself would reduce the PE firm’s return, but this is offset by the fact that the company should perform better with this incentive in place.

Question 28

What if there’s an option for the management team to “roll over” its existing Equity rather than receive new shares or options?

Answer 28

An Equity Rollover would show up in the Sources column in the Sources & Uses table and it would reduce the amount of Equity and Debt the PE firm needs to use to acquire the company – because now the PE firm only needs to acquire 90%, or 95%, or some number less than 100%, rather than the entire company.

At the end, you would also subtract some of the proceeds and allocate them to the management team rather than the PE firm when calculating returns.

If nothing else changes, this reduces the PE firm’s IRR – but the idea is that it also incentivizes the management team to perform well and deliver greater results, which helps everyone.

Question 29

Let’s say that a PE firm buys a company that’s currently 20% owned by management, and the firm wants to maintain this 20% management ownership percentage afterward. Does the PE firm need to use a certain amount of Debt to maintain this ownership percentage, or does it not impact the model?

Answer 29

No. All this business with management ownership has nothing to do with the exact percentage of Debt and Equity used.

All that changes is that if the management team owns more, the PE firm can use less Debt and Equity (cash) overall to acquire the company.

Using 80% Debt vs. 60% Debt (or any other percentage) has no impact on the management ownership percentage, which is a separate issue entirely.