LEVERAGED BUYOUTS

Question 1

What is a leveraged buyout?

Answer 1

The acquisition of a company, business or target using debt to finance a large portion of the purchase price with the remaining portion being funded through equity contribution from the financial sponsor.

Question 2

Why are LBOs used

Answer 2

They are used to realize an acceptable return on its equity investment upon exit through a sale or IPO of the target (20%+ annual return, after around 5 years)

Question 3

What is the debt:equity proportion for a typical LBO?

Answer 3

Debt: 60-70%
Equity: 30-40%

Question 4

What occurs during an LBO process?

Answer 4

The FCF is used to service and repay the debt (increasing the equity portion of the capital structure). The financial performance is increased through bolt-on acquisitions and business growth to further increase returns

Question 5

What is a CDO?

Answer 5

Collateralized Debt Obligation - asset-backed securities backed by interests in pool of assets.
CLO = c. loan obligation
CBO = c. bond obligation

Question 6

What are the characteristics of a strong LBO candidate

Answer 6

1. Strong Cash Flow Generation
2. Leading and Defensible Market Positions
3. Growth Opportunities
4. Efficiency Enhancement Opportunities
5. Low Capex Requirements
6. Strong Asset Base
7. Proven Management Team

Question 7

Why strong cash flow generation?

Answer 7

Debt investors require a business model that demonstrates ability to support periodic interest and debt repayments over the life of the loan/security.

• • strong / niche markets
• • stable consumer demand
• • Brand name
• • Established customer base
• • Long-term sales contracts

Question 8

Why leading defensible market position?

Answer 8

This reflects entrenched customer relationships, brand name, superior products, and favorable cost structures. Create barriers to entry and increase stability.

Question 9

Why Growth Opportunities?

Answer 9

Profitable top-line growth helps drive returns, generating cash available for debt repayment while also increasing EBITDA and enterprise value. It enhances the speed and optionality for exit (IPO).

Question 10

Why Efficiency Enhancements?

Answer 10

Enhancements in the form of operational efficiency generate cost savings and represent substantial value created for equity holders for exit. This can be lowering overhead costs, streamlining operations, reducing headcount, rationalizing supply chain, and implementing new management information systems

Question 11

Why Low Capex requirements?

Answer 11

Ideal candidates would not require substantial capital investment and thus limit cash outflow (and retain cash flow capabilities).

Question 12

Why Strong Asset Base?

Answer 12

A strong asset base can be pledged as collateral. This also tends to signify high barriers to entry because of substantial capital investment required.

Question 13

Why proven management team?

Answer 13

Talented management is needed as the firm operates under highly levered capital structure with ambitious performance goals. There is usually an aligned incentive for management with meaningful equity stake.`

Question 14

What does IRR measure?

Answer 14

It measures the return on sponsor’s equity during a time horizon (to produce a NPV = 0)

Question 15

How do sponsors aim to monetize their investments?

Answer 15

Strategic Sale
Financial Sale
IPO

The main goal of the sponsor is to achieve multiple expansion upon exit.

Question 16

How can a sponsor achieve a high multiple on exit?

Answer 16

Increase the target’s size and scale
Meaningful operational improvements
Repositioning of business toward more highly valued industry segments
Acceleration of the organic growth rate/profitability
Accurate timing of cyclical sector

Question 17

Why would a sponsor sell to a strategic?

Answer 17

1) Strongest potential bidder (due to synergies and benefit from lower cost of capital)

Question 18

Why would a sponsor IPO a target?

Answer 18

In an IPO exit, the sponsor sells a portion of its shares in the target. The sponsor will remain the largest equity stake but understands a future exit will come through follow-on offerings.

This gives the investor a liquid market for its remaining investment while also preserving any opportunity to remain with the firm long-term. And if Capital Markets are good, it could offer a compelling valuation.

Question 19

What is a Dividend Recapitalization?

Answer 19

A dividend recapitalization is where the target raises proceeds through the issuance of additional debt to pay shareholders a dividend. In doing so, the net debt of the company increases while the equity significantly decreases.

Question 20

How is the additional debt dealt with?

Answer 20

The debt may be issued as an add-on or as part of a refinancing of the existing capital structure.

Question 21

Why would you use a dividend recap?

Answer 21

It provides the equity holders a chance to retain all their stake in the company while recouping some or a lot of their initial investment.

Question 22

What are the tiers of debt?

Answer 22

Bank Debt (First / Second Lien)
High Yield Bonds (Senior Unsecured / Subordinated)
Mezzanine Debt (Subordinated / Preferred Stock)
Equity Contribution (Common Stock)

Question 23

What is a maintenance covenant

Answer 23

A maintenance covenant requires the borrower of debt to maintain a designated credit profile through compliance with certain financial ratios

Question 24

What is a revolving credit facility?

Answer 24

A revolver is a line of credit extended by the bank that permits the borrower to draw varying amounts up to a specified limit

Question 25

What is an Asset Based Lending Facility?

Answer 25

Type of revolver secured by first priority lien (A/R and inventory) and then second lien (PP&E). Subject to borrowing base formula to limit availability based on eligible assets.

Question 26

What are term loans and what are their types?

Answer 26

A loan with a specified maturity that requires principal repayment according to a defined schedule. Amortizing term loans (A): require substantial principal repayments throughout the lifetime Institutional term Loans (B) : larger than TLAs and amortize at a nominal rate (1% per year) with a bullet payment (large) at maturity. Since market for TLAs is up to 7 years they are typically used in LBOs.

Question 27

What are second lien term loans?

Answer 27

A floating rate loan secured by a second priority security interest in the assets. Ranks junior to first lien and TLAs or TLBs.

Question 28

What are high yield bonds?

Answer 28

Non-investment grade debt securities that obligate issuer to make interest payments to bond-holders at defined intervals. 100% bullet payment on maturity. Typically offer a higher coupon rate to compensate for the greater risk. Fixed interest rate.

Question 29

What is Payment in Kind (PIK) interest?

Answer 29

PIK toggle for interest is a feature that allows issuers to pay interest by issuer additional notes rather than through cash payments. This allows for cash retention and , increasing the coupon slightly (0.75%).

Question 30

What is a bridge loan?

Answer 30

Interim financing to bridge between issuance of permanent capital.

Question 31

What is mezzanine debt?

Answer 31

Mezzanine debt sits at a cost below equity and above high yield bonds. It offers greater flexibility in structuring terms conducive to issuer and investor and is prevalent in middle market transactions

Question 32

What is a club deal?

Answer 32

A club deal is the teaming up of sponsors into a consortium to reduce the amount of equity contributed per sponsor.

Question 33

What is a covenant?

Answer 33

It is a provision in a credit agreement to protect against the deterioration of the borrower's credit quality.

Question 34

What is an affirmative covenant?

Answer 34

It requires the borrower and its subsidiaries to perform certain actions such as maintaining corporate existence and books and records, regular financial reporting, maintaining assets, collateral, insurance, and paying taxes

Question 35

What are negative covenants?

Answer 35

``` The limit the borrower's ability to take certain actions (exception for baskets) including limitations on: Debt Dividends and stock redemptions Liens Dispositions of assets Investments Mergers and consolidations Amendments of debt Transactions with affiliates ```

Question 36

What are financial covenants?

Answer 36

They require the borrower to maintain a certain credit profile through compliance with specified financial ratios or tests on a quarterly basis. ``` Maximum Senior Security leverage ratio Total Leverage Ratio Minimum interest coverage ratio Minimum fixed charge coverage ratio Maximum annual capital expenditures Minimum EBITDA ```

Question 37

What are baskets?

Answer 37

These are exceptions to covenants that permit the borrower to take specific actions.