LBOs Flashcards
(38 cards)
Look at this picture of deleveraging!
10.8% return on a company that hasn’t grown a bit.
If co DOES grow, it can not only pay down more debt, but also, sell at higher EBITDA (exit multiple will likely be the same) / sell a bigger company.
What makes a good LBO candidate?
1) has strong, predictable, and stable cash flow (so it can service debt) … this is the most important one, after price
2) is mature, steady, practically boring
3) strong defensible market position (gives it ability to weather economic downturns)
4) has limited CapEx and product development requirements
5) is undervalued or has synergy opportunities (might be synergy opps if PE sponsor already has a portco in same industry that it can combine with the target)
6) is owned by a motivated seller (privately held co where owners want to cash out their investments, or, a large co eager to sell off non-core subsidiaries … how can you gauge commitment / motivation of seller? look at how many shares they’re rolling over)
7) has a viable exit strategy [i) IPO - not full exit, ii) M&A - full exit, premium, or secondary buyout, iii) special dividends / recap]
Others, from BIWS:
- is in a fast-growing and highly fragmented industry (so the co can make add-on acquisitions)
- have opportunities to cut costs and increase margins
- have a strong management team
- have a strong base of assets to use as collateral for debt
- have a realistic path to an exit, with returns driven by EBITDA growth and Debt paydown rather than multiple expansion
LBO Diagram
How do you fund an LBO?
1) Sponsor Equity
~30-35% of funding
- goal: 20+% returns (annualized) in 4-6 years
2) Bank Debt
- senior bank term loans & revolving credit facilities
- amortize (repay) over the term
- term of 5-7 years
- 40-50% of funding
3) High Yield
- subordinated debt
- higher interest rates
- high yield or “junk” bonds
- single bullet payments (not paid off until very end of term)
- term of like 10+ years
Common Financing Parameters
What is a dividend recapitalization? Why might it be used?
In a dividend recap, a portfolio company incurs new debt. The proceeds of the debt are used to pay the sponsor a special dividend, with the goal of enhancing returns.
The company must have a strong balance sheet / cash flows.
A dividend recap might be used when the portfolio company is not yet ready for IPO / sale.
LBO House Analogy
PE firm searches for companies that might be undervalued and that could yield high returns if managed properly.
Then, just like a real estate investor might buy a house using a combination of a down payment and a mortgage, the PE firm uses Cash (Equity) and Debt to buy a company.
The private equity firm will run the company for several years and make “improvements,” similar to the renovations that a real estate investor might make.
In the end, the PE firm will sell the company, ideally for a higher price, and use the proceeds to repay the Debt it borrowed. If all goes well, it will earn back a multiple of the Cash it invested and get a high internal rate of return (IRR).
Important distinction btw LBOs and actually buying a house: an LBO is like buying a house to RENT OUT and eventually SELL rather than buying a house.
Why don’t PE firms use Stock to fund acquisitions?
- they dont own the acquired companies directly
- they plan to sell the acquired companies eventually, and its easier to earn a high IRR when you invest less upfront
E.g. if you bought an Asset for $100, earned $10 on it each year, and eventually sold it for $100, your IRR would be 10%.
versus, if you bought the Asset for $50, still earned $10 on it each year, and eventually sold it for $50, your IRR would be 20%.
As a result, PE firms prefer to use as much Debt and as little of their own money as possible to fund deals.
Why does using Debt to fund deals help PE firms?
1) reduces upfront cost of acquiring a co, which makes it easier for PE firm to earn a high return
2) lets PE firm use co’s cash flows to repay the Debt and make interest payments
The PE firm must still repay the Debt when it sells the co, but the benefits of Debt far outweigh this drawback, because MONEY TODAY is worth more than money tomorrow: the IRR increases by a greater amount if you can reduce the purchase price by $100 today than if you can increase the exit price by $100 in 5 years.
What would be a terrible LBO candidate?
A pre-revenue startup, perhaps in biotech, because it’s extremely risky and could not afford to carry interest bearing Debt.
What are the key drivers of return in an LBO?
Price, EBITDA growth and/or debt paydown
Where EBITDA growth and/or debt paydown is minimal, returns become dependent on multiple expansion, which is risky/not gauranteed
How do you set up a simple LBO model?
1) Make basic transaction assumptions (re Purchase Enterprise Value, % Debt and Equity used)
- in real LBO, purchase EV might be above actual purchase price, if management / existing investors rollover / maintain ownership in deal
2) Project cash flow and debt repayment (need info on co’s Revenue, EBITDA, Taxes, and other key items such as Working Capital and CapEx; and, know the interest rate on the Debt used and its replacement terms)
- Cash Flow here is NEITHER Unlevered nor Levered FCF; it’s just “Free Cash Flow” : Cash Flow from Operations - CapEx (you start with Net Income rather than NOPAT because you want to reflect the Net Interest Expense – it reduces how much Debt the company can repay, and we want to know how much Debt principal co can repay each year)
- you don’t need full 3-statement projections, just IS and portions of CFS
3) Make exit assumptions and calculate the returns (i.e. calculate EV by multiplying EBITDA by EV / EBITDA multiple, and calculate MoM and IRR)
4) Draw conclusions

Is there a rule of thumb for quickly calculating IRR?
Yes. You can approximate IRR if you know the Money-on-Money multiple and the holding period.
For “double your money” scenarios, you take 100%, divide by the # of years, and then estimate the IRR as about 75-80% of that value.
“Triple Your Money” scenarios are similar, but the compounding effect is greater there. Take 200%, divide by the # of years, and then multiply by ~65% to approximate the IRR.
The most important approximations are as follows:
- Double Your Money in 1 Year = 100% IRR
- Double Your Money in 2 Years = ~40% IRR
- Double Your Money in 3 Years = ~25% IRR
- Double Your Money in 4 Years = ~20% IRR
- Double Your Money in 5 Years = ~15% IRR
- Triple Your Money in 3 Years = ~45% IRR
- Triple Your Money in 5 Years = ~25% IRR
What are the three exit strategies in LBOs?
1) M&A - Sell the co to another co or PE firm within the next 3-7 years. Clean break where firm earns all deal proceeds at once (highest IRR in part b/c no waiting, and removes legal risk … But, co may be too big, or no interested acquirers)
2) IPO - Take the co public and sell off the stake gradually over time; sometimes co’s that can’t be acquired due to size can go public which is main advantage; disadvantage is that sale of PE firm’s stake takes much longer, so there’s more risk (e.g. if share price drops)
3) Dividend recap - the PE firm never “sells” the co, but instead asks the co to issue Dividends continually (sometimes, by taking on additional Debt). Eventually, if these Dividends get big enough, quickly enough, the firm might realize acceptable returns. Tough to earn acceptable IRR via this method but it’s sometimes the only option if the M&A or IPO markets are underdeveloped or the company has legal or PR issues
What is an LBO, and why does it work?
In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells the company at the end of the period to realize a return on its investment.
During the period of ownership, the PE firm uses the company’s cash flows to pay for the interest expense on the Debt and to repay the Debt principal.
It works because leverage amplifies return: if the deal performs well, the PE firm will realize higher returns than if it had bought the company with 100% equity.
But leverage also presents risks because it means the returns will be even worse if the deal does not perform well.
Why do PE firms use leverage when buying companies.
To amplify their returns. Using leverage – borrowing money from others – to fund a deal makes positive returns even more positive and negative returns even more negative.
All PE firms aim for positive returns above a certain IRR, and using leverage makes it easier to achieve those returns.
A secondary benefit of using leverage is that the PE firm will have more capital to pursue other investments.
Walk me through a basic LBO model.
- Make transaction assumptions based on the purchase price, Debt interest rate, etc.
- Build the Sources & Uses table, where “Sources” lists how the transaction will be financed and “Uses” lists the capital uses—i.e., where the “Sources” or money will be spent.
- Adjust the Balance Sheet for the new Debt and Equity, and other transaction-related adjustments.
- Project out the three financial statements (usually 5 years); determine how much Debt is paid down each year.
- Calculate exit value scenarios based on EBITDA multiples.
Can you explain the legal structure behind an LBO and how it benefits the PE firm?
PE firm forms a holdco, which it owns, and then this holdco acquires the real company
The banks and other lenders provide Debt to this holdco so that the Debt is at the “holdco level”
Managers and executives at the acquired co that retain ownership after the deal closes also have shares in this holdco
This structure is important because it means that the PE firm is not on the hook for the Debt it uses in the deal: It’s up to the Target Co to repay it
What assumptions impact an LBO the most?
The Purchase and Exit assumptions, usually based on EBITDA multiples, make the biggest impact on an LBO
A lower Purchase Multiple results in higher returns, and a higher Exit Multiple results in higher returns
After that, the % Debt Used makes the biggest impact. If the deal performs well, more leverage will make it perform even better, and vise versa if it does not perform well
Revenue growth, EBITDA margins, interest rates and principal repayments on Debt all make an impact as well, but less so than the other assumptions
LBO versus DCF
They are both based on cash flows, but in a DCF you’re saying, “What could this company be worth, based on the Present Value of its cash flows?”
Whereas in an LBO, you’re saying, “What could we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?”
Both methodologies are similar, but with the LBO valuation, you’re constraining the values based on the returns you’re targeting.
Other differences
- In an LBO, when projecting Cash Flows and Debt Repayment, you start with Net Income rather than NOPAT because you want to reflect the Net Interest Expense (it reduces how much Debt the co can repay)
How could a PE firm boost its returns in an LBO?
The main returns drivers are Multiple Expansion, EBITDA Growth, and Debt Paydown and Cash Generation, so a PE firm could improve its returns by improving any of those.
In practice, this means:
- Multiple Expansion - Reduce Purchase Multiple and/or increase Exit Multiple
- EBITDA Growth - Increase the company’s revenue growth rate or boost its margins by cutting expenses
- Debt Paydown and Cash Generation - Increase the Leverage (Debt) used in the deal, or improve the company’s cash flow by cutting CapEx and Working Capital Requirements
Since the PE firm has the most control over the last factor, the easiest way to boost returns is to use more Debt
How do you calculate the IRR in an LBO model, and what does it mean?
The IRR in an LBO is “the effective annual compounded interest rate”: For example, if you invest $100 in the beginning and get back $200 after 5 years, what interest rate would turn that $100 into $200 by the end?
IRR = (Exit Proceeds / Investor Equity) ^ (1 / # years) - 1
What’s the true purchase price in a leveraged buyout?
Just as in a merger model, you always start with the Equity Purchase Price – the cost of acquiring all the company’s common shares.
Then, depending on the treatment of Cash, Debt, Transaction Fees, and Equity Rollovers, the “true price” may be different, which is why you create a Sources & Uses schedule.
For example, if existing Debt is “assumed” (kept in place or replaced with new Debt that’s the same), it won’t affect the purchase price. But if the PE firm repays the existing Debt with its Investor Equity or a combination of Debt and Investor Equity, that increases the effective price.
Using Excess Cash to fund the deal reduces the true price, as do Equity Rollovers.
The true price is often close to the Purchase Enterprise Value, but it won’t be the same because of these issues.
Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause controversy?
Excess Cash might act as a funding source in an LBO if a company uses its Cash to repurchase its shares, reducing the number of shares that a PE firm has to purchase.
It’s not that the PE firm “gets” the company’s Excess Cash before the deal takes place – it’s that the company uses its Cash to reduce the purchase price for the PE firm.
Pre-deal shareholders often object to such moves, saying that the company should have issued a Special Dividend to them or used the cash in a more productive way.
Using Excess Cash to fund a deal also increases the ownership stakes of existing investors that choose to roll over their shares – since Excess Cash reduces the Investor Equity the PE firm needs to contribute.
