LBOs Flashcards
(13 cards)
What is an LBO?
A leverage buyout is an acquisition of a company or division of a company by a private equity firm using debt for a substantial percentage of the acquisition financing (60% avg.)
Why do private equity firms do LBOs?
They use significant amounts of leverage (debt) to help finance the purchase price therefore the PE firm reduces the amount of money (equity) it has to contribute but reaps all the benefits of increase in price. Reducing the amount of equity contributed will result in a substantial increase to the firm´s return upon exiting the investment.
What makes a good candidate?
Steady cashflows, limited business risk, limited need for ongoing investment (CAPEX), strong management, opportunity for cost reduction, high asset base (used for debt collaterals). The most important thing is steady cashflows as the company must have ability to generate cash flows required to support the high interest expense.
What would be a bad LBO candidate?
A firm with low or unsteady cash flows, high business risk, high cyclicality, large CAPEX and few salable assets
What are the key assumptions that go into making an LBO model?
All assumptions relating to operating performance such as revenue growth, costs, CAPEX and working capital requirements. A second assumption is the purchase assumptions including purchase prices, amount and types of debt being raised and amount of money contributed by the financial sponsor. A third set of assumptions are the exit assumptions including when the financial sponsor will exit its investment and at what valuation or valuation multiple.
What is an LBO model used for
It has three main purposes. The first is to analyse expected returns (IRRs) to the financial sponsor and other equity holders. A second purpose of the LBO model is as a valuation methodology. A third purpose is to analyse various credit statistics over the projection period to analyse the company´s ability to service its debt.
Walk me through an LBO model!!!
1) we want to make the transaction assumptions, what is the purchase price and how will the deal be financed
2) we create a table of sources and uses which should be equal using our assumptions. Uses is the amount of money required to effectuate the transaction including equity purchase price and existing debt being refinanced and transaction fees. The sources tells us from where the money is coming from including new debt and existing cash being used as well as equity contributed by the PE firm. Typically the amount of debt is assumed based on the state of capital markets and other factors. The amount of equity is the difference between the uses (total funding required) and other sources of funding such as debt.
3) we take the existing balance sheet of the company to reflect the transaction and new capital structure. In addition to changes in equity and debt, intangible assets such as goodwill and financing fees will be created.
4) now we create an integrated cash flow model for the company so we project the firm´s income statement, balance sheet and cash flow statement for a period of time. Balance sheet must be projected based on the newly created pro forma balance sheet and debt and interest projected on the post transaction debt.
5) when the model has been created we can make assumptions about the PE´s exit from its investment. A typical assumption is that exit is done after five years at the same EBITDA multiple so growth comes from cutting costs and increase in sales. Projecting a sale value allows us to calculate the value of the PE firm´s equity stake used to determine IRR.
6) IRR is usually the most important information but if we assume the required IRR for the PE firm then we can use the analysis for valuation purposes. We can also utilise the LBO model to analyse trend of credit statistics (leverage and interest coverage ratio) which is useful from the lender´s perspective
How do we use an LBO model for valuation?
We can use an LBO model for valuation by making several assumptions in addition to the operating assumptions that underline the model. These assumptions are the amount of debt raised in the transaction, the exit multiple, the time until the investment exit and the required return IRR to the financial sponsor. By making these assumption we know how much the sponsor will receive for its equity upon an exit and can back into the amount of money the sponsor can afford to put in the deal to earn its required IRR. By knowing the money invested by the sponsor and the amount of debt that can be raised to do the deal we can estimate the implied enterprise and or equity value today and use it for valuation
How do we increase IRR to a PE firm?
reducing the purchase price the PE has to pay, increase the amount of leverage in the deal to increase the price for which a company sells when the PE firm exists its investment (the assumed exit multiple), increasing growth rate to raise operating income/cash flow/ EBITDA will increase the exit price, decreasing operating costs in order to raise operating income etc. in the projections
How do sources and uses work?
In and LBO model both sources and uses must be equal. We assume uses equal the purchase price to buy 100% of existing equity holders, transaction fees and amount of debt that needs to be refinanced. Sources include the new debt being raised, cash from the company and financial sponsor´s equity contribution. By doing this and other assumptions we can find the amount of money the financial sponsor needs to contribute.
How do we create the pro forma balance sheet?
First we start with the most recent actual balance sheet for the target company. We then make adjustments such as reducing the balance sheet for any cash used to finance the purchase price and for the debt that needs to be refinanced and we increase the balance sheet for new debt. We wipe out old equity and include the financial sponsor´s equity contribution as new equity. We make adjustments for any changes to fixed assets or intangible assets including goodwill and financing fees. The pro forma balance sheet reflects all of these adjustments and must balance.
What are considerations to whether a PE firm should do the deal?
The most important consideration is the IRR, the model shows the firm can meet required IRR (20% usually). PE firm should consider reliability of its forecasts and risk of the company as it affects the ability to pay the debt in the future. The PE firm should also consider the likely exits for its investment in several years. PE firms will also consider doing a transaction if the acquisition will serve as a platform for future acquisitions or is a bolt-on acquisition.
What are some key credit statistics used when analysing an LBO?
Debt to total capitalisation, debt to equity and leverage and interest coverage ratios.
