LBO Model Questions - Basic Flashcards

1
Q

Walk me through a basic LBO model.

A

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 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

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2
Q

Why would you use leverage when buying a company?

A

To boost your return

any debt you use in an LBO is not “your money

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3
Q

What variables impact an LBO model the most?

A

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.

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4
Q

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

A

The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity tables.

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5
Q

What is an “ideal” candidate for an LBO?

A

“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.

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6
Q

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?

A

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.

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7
Q

Give an example of a “real-life” LBO.

A

Taking out a mortgage for a house.

  • 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
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8
Q

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

A

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.

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9
Q

Why are Goodwill & Other Intangibles created in an LBO?

A

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.

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10
Q

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?

A
  1. The PE firm does not intend to hold the company for the long-term – it usually sells it after a few years, so it is less concerned with the “expense” of cash vs. debt and more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront.
  2. 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.
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11
Q

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

A

Yes, there are shortcuts and you don’t necessarily need to project all 3 statements.

For example, you do not need to create a full Balance Sheet – bankers sometimes skip this if they are in a rush. 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.

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12
Q

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

A

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.

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13
Q

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?

A

You would look at “debt comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently.

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14
Q

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

A
  • High-yield debt tends to have higher interest rates than bank debt (hence the name “high-yield”).
  • High-yield debt interest rates are usually fixed, whereas bank debt interest rates are “floating” – they change based on LIBOR or the Fed interest rate.
  • 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 a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times).
  • Bank debt is usually amortized – the principal must be paid off over time – whereas with high-yield debt, the entire principal is due at the end (bullet maturity).
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15
Q

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

A

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.

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16
Q

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

A

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 the high-yield option if they don’t have plans for major expansion or selling off the company’s assets.

17
Q

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

A
  • Industry consolidation – buying competitors in a similar market and combining them to increase efficiency and win more customers.
  • 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. If it falls into one of these 3 categories,
18
Q

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

A
  1. Lower the Purchase Price in the model.
  2. Raise the Exit Multiple / Exit Price.
  3. Increase the Leverage (debt) used.
  4. Increase the company’s growth rate (organically or via acquisitions).
  5. Increase margins by reducing expenses (cutting employees, consolidating
    buildings, etc.).
19
Q

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

A

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 as a result of having debt from the LBO.

20
Q

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

A

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

Note: It would be like if you made your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds.
As you might guess, dividend recaps have developed a bad reputation, though they’re still commonly used

21
Q

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

A

Primarily to boost returns, all else being equal, more leverage means a higher return to the firm.

22
Q

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

A

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 so that everything remained in balance.

On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change.