LBOs

Question 1

Ideal LBO Candidates? (*Q)

Answer 1

Valuation: lower-mid-range EBITDAx (compared to industry comps)

STABILITY = major theme / most impt

1) Valuation/low price: co is relatively undervalued compared to its peers
2) STABLE & PREDICTABLES CASH FLOWS (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:
- INDUSTRY: 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
—
IS: low fixed costs, high recurring revenue, relatively high EBITDA margins; rev growth not necessarily essential

BS: significant fixed assets for use as debt collateral

CFS: stable CFS! minimal capex is deal (ex: mature co’s w/ lots of assets, but not spending much on new assets). minimal WC requirements helps.

Question 2

Co’s Capital Structure - does it affect viability as LBO candidate?

Answer 2

• No - in LBO, the existing cap structure would be “wiped out” anyways & replaced w/ new one.
• But, can still matter a bit: ex - if existing Debt has penalty fees associated. w/early repayment

Question 3

Qualitative factors that PE firms look at?

Answer 3

• Strong management team
• Industry/market - fragmented market is better
• Exit strategies & sources of return: prefer markets w/ feasible exits; target IRRs of 20-25%; avoid deals overly dependent on “multiple expansion”

Question 4

Exit strategies & sources of return factors that PE firms look at?

Answer 4

• prefer markets w/ feasible exits;
• target IRRs of 20-25%;
• Key drivers of return: mostly from EBITDA Growth and/or Debt Payment; avoid deals overly dependent on “multiple expansion”

Question 5

Financing related factors that PE firms look at?

Answer 5

• financing method & debt capacity
• credit stats & ratios
• credit rating

Question 6

Critical analysis in LBOs?

Answer 6

• Compare IRR to Discount Rate

Question 7

Simple LBO model

Answer 7

1) Set up transaction assumptions: includes purchase price + sources & uses
2) project out the co’s CFs and debt repayment
3) make the EXIT ASSUMPTIONS, calculate IRR & MoM multiples, assess returns drivers

Question 8

Purchase price assumption for private companies?

Answer 8

almost always based on multiple of EBITDA

Question 9

What is an LBO?

Answer 9

• PE firm buys a co w/ combo of debt & equity (cash), MOSTLY DEBT -> operates co for a few years -> sells co at the end to earn a return
• when PE firm is holding the co: use co’s CFs to make 1) debt interest expense payments and 2) debt principal repayments

Question 10

Why does an LBO work?

Answer 10

• in an LBO: PE firm trying to minimize up-front cash payment as much as possible, and maximize use of debt to fund the deal.
• this works b/c: time value of money.
  –> reducing upfront purchase price = boosts returns –> easier to get high IRR
  –> can use co’s CFs to repay debt & make interest payments over time ==> better than holding onto those CFs
  –> when PE firms sells co: uses proceeds to repay debt

Question 11

Walk me through a basic LBO model (*Q)

Answer 11

1) set up transaction assumptions (incl. purchase price):
- make assumptions for pp, debt & eq, int rate on debt, co’s operations (rev growth & margins)

2) create sources & uses schedule:
- show how deal will be financed (incl. how much investor eq PE firm will contribute) and what capital will be used for

3) project co’s CFs & debt repayment
- project co’s IS & partial CFS –> to FCF
–> project out how much debt principal co will repay each year, based on avail CFs & after interest payments

4) make exit assumptions & calculate the returns
- assume Exit multiple (ex: EBITDA)
- calculate IRR & MOM multiple: based on proceeds PE firm earns when selling at the end vs. investor eq at beg.

Question 12

Why do PE firms use leverage when buying co’s?

Answer 12

=> leverage AMPLIFIES returns.
- if you make money: make even more w/ leverage & PE firm has more capital avail for other investments/acqs
- if you don’t: make even less w/ leverage (b/c have to make int payments & repay principal still)

Question 13

Legal structure of an LBO? How does it benefit PE firm?

Answer 13

-PE firm does not directly hold the co. The co is held by a holding co, owned by pe firm.
- holding co acqs the real co
- banks & other lenders lend to holding co

• benefits PE firm b/c not “on the hook” for the co’s debt: it is up to co itself to repay it
• co itself raises debt to purchase a certain # of shares (+ PE firm uses inv eq to buy remaining shares)
  ==> co is borrowing money so PE firm can do the deal

Question 14

Minimum Cash Balance assumption in an LBO

Answer 14

rationale: all co’s need some minimum cash balance to run biz –> not ALL of cash can be assumed to fund deal or repay debt

• even in cash-free/debt-free deals: when deal closes, t’s cash goes to zero but immediately is brought up to (replaced w/ new balance) min cash balance for daily operations
• factored in: 1) if excess cash is assumed to fund deal and 2) when calculating CF avail for debt repayment

Question 15

Minimum Cash Balance - how to estimate if co does not disclose?

Answer 15

1) look at historically how low it has fallen; or
2) make it a % of total expenses of total cash expenses

Question 16

Management Rollover - effect on Sources & Uses on an LBO model?

Answer 16

• management rollover = management keeping certain % of the co

effect:
- contributes as a source of funds –> pe firms needs to buy less of the co ==> reduces amount pe firm has to pay (debt and/or inv eq)
- pe firm has reduced ownership after deal closes

Question 17

Variables that impact LBO most?

Answer 17

1) purchase & exit prices –> purchase & exit multiples
2) amount of leverage used

lower PP ==> higher returns
higher exit price ==> higher returns
more leverage ==> higher returns (as long as co can meet its debt obligations)

3) other: revenue growth, EBITDA margins, interest rates and principal repayment on Debt

Question 18

LBO - how to use to value a co? Why do we say it set a “floor valuation”? (*Q)

Answer 18

• set a targeted IRR (ex: 25%) –> work backwards: what maximum price can pe firm pay to reach this IRR?
• “floor valuation” b/c: pe firm almost always pays less than what a strategic acq would (lack of synergies + don’t want to hold long-term)

–> constrains valuation from the beginning, unlike other methods

Question 19

LBO Valuation vs. DCF Valuation (*Q)

Answer 19

• LBO = “what MAXIMUM CAN we pay for this co, if we want to achieve a target IRR over next X years?” –> constraining values based on target (IRR) you are trying to achieve
• DCF = “What COULD this co be worth, based on the PV of its future cash flows?”

Question 20

PE Firm vs. Strategic Acq

Answer 20

• unlike strategic, PE firm does not want to hold co long-term.
  –> cares about boosting returns –> so, cares about using leverage & reducing cash up-front to boost returns
• unlike strategic, the co here (rather than buyer) assumes the debt -> pe firm takes on less risk than strategic buyer

Question 21

Reason why PE firm would buy co in a “risky” industry? (ex: tech)

Answer 21

• even in “risky” industries, there are mature co’s w/ stable CFs
• even if risky or struggling co, PE firm may have specific goals: industry consolidation, turnarounds, divestitures

Question 22

How can PE firm boost its returns in an LBO? –> Factors that impact returns?

Answer 22

1. Purchase Price - reduce
2. Exit Multiple and Exit Price - increase
3. Leverage (debt) used - increase
4. Co’s growth rate (organically or via acquisitions) - increase
5. Improve operational efficiency: reducing expenses (cutting employees, consolidating buildings, etc.) -> increase margins
6. Exit faster

Question 23

How to determine how much debt can be raised in an LBO? Reasonable leverage & coverage ratios

Answer 23

1) LOOK AT DEBT COMPS: shows types, tranches, and terms of debt that similarly sized co’s in the industry have used recently
- use median Debt/EBITDA levels from recent, similar LBOs or highly levered public comps

2) Test these assumptions by projecting the co’s leverage (Debt/EBITDA) and coverage (EBITDA/Interest) ratios over time.

If they hold up reasonably well – e.g., the company’s coverage ratio always stays above 2x – then you might stick with the original numbers. If not, you have to try different assumptions.

• general rules:
  1) Debt/EBITDA: never lever a co at 50x; even in bubbles, leverage rarely exceeds 10x
  2) EBITDA/Interest: # between where co can pay for its interest w/out much trouble, but not so high that co could clearly afford to take on more debt

Question 24

Transaction Assumptions - how to est Interest Rate on Debt? (assume no debt comps)

Answer 24

• use default spreads (similar to cost of debt method in WACC calculation:
  1) look at yields of 10-yr govt bonds (of co’s govt)
  2) calculate co’s interest coverage ratio & leverage ratio ==> get a sense of its credit rating
  3) look up co’s default spread based on this credit rating (spreads of similar co’s) –> add that to 10 yr bond-yield

Question 25

Transaction & Financing Fees in an LBO model

Answer 25

• transaction & financing fees contribute to uses in sources&uses schedule => increases amount PE firm pays - PE firms pay for these upfront in Cash
  ==> increases purchase price
• but accounting treatment differs …..

Question 26

Diff exit strategies in an LBO? Advantages/disadvantages?

Answer 26

3 main exit strategies:
1) M&A: sell go to another co or PE firm
(+) generally produces highest IRR - b/c clean break: selling whole stake –> get proceeds at once
(-) co may be too big to sell; no interested acquirers (@ price wanted; acq may not want 100% of the co; stagnant or declining industry)

2) IPO Exit: takes co public & sells stake over time
(+): some co’s that can’t be acq can go public
(-): lower IRR than M&A generally & riskier - b/c can’t sell whole stake at once (or else sends negative signal to the market); co’s share price could decrease –> lowers both IRR & MoM
*sometimes not avail (emerging markets; regulatory issues, too smalletc)

3) Dividend recap: co issues dividends to PE firm using annual FCF or continually issuing new debt & use proceeds for dividends
(+): sometimes only option if M&A and IPO aren’t avail
(-): hard to realize 20% IRR

Question 27

IRR & MoM multiples - typical targets for PE firms?

Answer 27

• IRR: at least 20% (2x what public equity markets in developed countries have returned historically)
• MoM multiple: depends on the time frame, but typically in 2.5x range (=20% IRR over 5 years)

Question 28

IRR & MoM multiples - which would you rather get higher of?

Answer 28

• PE firms care more about IRR b/c it’s how LPs judge them
• but if short time frame: better to earn high multiple & long term frame: higher IRR is better

Question 29

What is a dividend recapitalization? Why might it be used?

Answer 29

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.

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

if M&A and IPO aren’t available:
- emerging & frontier markets (small cap markets & underdeveloped)
- co is too small to go public
- co has regulatory, legal or public relations obstacles (hard to find willing acqs or investors)

Question 30

IRR - how to calculate in LBO model?

Question 31

How can you estimate the IRR in an LBO? Are there any rules of thumb?

Answer 31

• If a PE firm doubles its money in 5 years, that’s a 15% IRR.
• If a PE firm triples its money in 5 years, that’s a 25% IRR.
• If a PE firm doubles its money in 3 years, that’s a 26% IRR.
• If a PE firm triples its money in 3 years, that’s a 44% IRR.

Question 32

How to select Purchase Multiples & Exit Multiples in an LBO model?

Answer 32

PURCHASE MULTIPLES:
- public co’s: 1) assume share-price premium then 2) check implied purchase multiple against valuation methods to make sure it’s reasonable

• private co’s: determine purchase multiple by looking at comparable companies, precedent trx, dcf analysis

EXIT MULTIPLES:
- similar to purchase multiple, but could go higher or lower depending on co’s growth rates & ROIC upon exit

• always use a RANGE of purchase/exit multiples to analyze the trx via sensitivity tables

Question 33

LBO vs. normal M&A deal?

Answer 33

Diffs: holding period, key metrics, financing, purchase price analysis

• LBO: assume co is sold after holding period (3-7); not planning to hold co indefinitely. back into purchase price view targeted IRR.
  –> focus on IRR & MoM as key metrics.
• M&A: synergies & EPS accretion/dilution impt
• PE firms in LBOs: use only debt & equity (“cash”); normal M&A deals: can use debt, cash, stock

Question 34

A strategic acquirer usually prefers to pay for acquisitions with 100% Cash – so why would a PE firm want to use Debt in an LBO?

Answer 34

1) The PE firm plans to sell the company in a few years – so, it’s less concerned with the added expense of Debt and more concerned with using leverage to amplify its returns by reducing the upfront capital required.

2) In an LBO, the company is responsible for repaying the Debt, so the acquired company assumes most of the risk. In a standard M&A deal, the Buyer or “Combined Entity” carries the Debt, so there’s far more risk for the acquirer.

Question 35

How could a private equity firm boost its returns in an LBO? (*Q)

Answer 35

Main returns drivers are: 1) Multiple Expansion, 2) EBITDA Growth, and 3) Debt Paydown and Cash Generation
==> PE firm could boost its returns by improving any or all of those.

In practice, this means:
* Multiple Expansion – Reduce the Purchase Multiple (e.g., by negotiating a lower price) and/or increase the Exit Multiple.

• EBITDA Growth – Increase the company’s revenue growth rate or boost its EBITDA margins by cutting expenses.
• Debt Paydown and Cash Generation – Use more Debt to fund 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, it’s usually easiest to boost returns by using more Debt (assuming the company can service the increased Debt).

Question 36

How do you calculate the internal rate of return (IRR) in an LBO model, and what does it mean?

Answer 36

The IRR in an LBO is “the effective compounded interest rate” or the “average annualized returns.”

For example, if you invest $100 in the beginning and get back $200 after 5 years, what compound interest rate would turn that $100 into $200 by the end?

You calculate the IRR by making the Investor Equity (Cash) that a PE firm contributes a negative, and then using positives for Dividends to the PE firm and the Net Proceeds to the PE firm upon exit.

Then, you apply the IRR function in Excel to all the numbers, ensuring that you’ve entered “0” for any periods where there’s no cash received or spent.

If there are no Dividends or other distributions or contributions in between purchase and exit: IRR = (Exit Proceeds / Investor Equity) ^ (1 / # Years) – 1

Question 37

FCF in a DCF vs. LBO

Answer 37

1) purpose of FCF in an LBO: determines co’s ability to repay debt, NOT the implied value of the entire co (like in DCF)

2) FCF in an LBO: deducts Int. Expense but does NOPAT deduct debt principal
starts w Net Income, not NOPAT –> so, deducts Interest Expense. But, it’s also NOT levered FCF since it does NOT deduct the debt principal repayments.

3) While FCF is the endpoint in a DCF, you have to go beyond it in an LBO b/c of the co’s beginning cash, min cash, and other obligations such as required debt principal repayments.

Question 38

What is a dividend recap? (*Q)

Answer 38

• co raises more debt –> uses it to pay sponsors via special dividends over time
  => boosts IRR

Question 39

What’s the true purchase price in a leveraged buyout?

Answer 39

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.

Question 40

What happens to a co’s cap structure in an LBO?

Answer 40

• it gets “wiped out” & replaced w/ new cap structure (in most cases, w more Debt) –> so, cap structure not impt for deciding LBO candidates.
• but can still matter a bit:
  ex: existing Debt has penalty dees associated w early repayment
  ex: long history of borrowing/repaying Debt –> makes lenders more comfy

Question 41

LBO “Tax Shield”

Answer 41

• Interest on Debt reduces a company’s taxes b/c the Interest is tax-deductible
• However, the company’s cash flow is still lower than it would have been WITHOUT the Debt – the tax savings helps, but the additional Interest Expense still reduces Net Income.
• Some people believe this “tax shield” makes a huge difference in an LBO, but it makes a marginal impact next to drivers such as the purchase and exit multiples.

Question 42

Common metrics/ratios in an LBO

Answer 42

Debt/EBITDA
EBITDA/Interest
FCF Conversion

==> Tells you how a deal performs over time & how risky it is & if PE firm can use add Debt to boost returns

For example, if the company goes from 5x Debt / EBITDA to 3x in 1-2 years, perhaps the PE firm could use more Debt initially, or it could do a Dividend Recap to boost its returns.
And if the company’s FCF Conversion increases from 10% to 30%, the deal is more attractive because it’s a sign that more of the returns come from Debt Paydown and Cash Generation.

Question 43

Effect on IRR - co repays ALL debt but nothing else changes?

Answer 43

IRR increases

Question 44

Different Types of Debt Co can use in an LBO

Answer 44

1) Secured Debt (“Bank Debt”/”Senior Debt”):
- consists of Term Loans and Revolvers
- backed by collateral
- tends to have lower, floating interest rates
- may have amortization (required principal repayments)
- may have maintenance covenants such as limits on the company’s Debt / EBITDA and EBITDA / Interest
- Early repayment of principal is allowed, maturity periods tend to be shorter (~5 years up to 10 years)
- the investors tend to be more conservative.

2) Unsecured Debt (“High-Yield Debt”/“Junior Debt”)
- consists of Senior Notes, Subordinated Notes, and Mezzanine
- is not backed by collateral
- interest rates tend to be higher and fixed rather than floating
- there is no amortization, and it uses incurrence covenants (e.g., the company can’t sell Assets above a certain dollar amount)
- Early repayment is not allowed, maturity periods tend to be longer (8-10+ years)
- investors tend to be hedge funds, merchant banks, and mezzanine funds.

Question 45

Why do the less risky, lower-yielding forms of Debt amortize? Shouldn’t amortization be a feature of riskier Debt to reduce the risk?

Answer 45

• Amortization reduces the credit risk but also reduces the potential returns. Since risk and potential returns are correlated, amortization should be a feature of less risky Debt.

But if there’s amortization or optional repayment, that balance declines to less than $100 million by the end, so the investors earn less than a 10% IRR. But the investors also assume less risk because they earn back their capital earlier in the period.

The other issue with early repayment is that it credits interest-rate risk for the lenders: they’ll have to redeploy their capital elsewhere, but what if interest rates have fallen?