Leveraged Buyouts and LBO Models

Question 1

key difference between a private equity firm’s acquisition of a company and a normal company’s acquisition of a company

Answer 1

-Private Equity Firm never plans to hold the company forever
Search is like home flipping:
- Search for undervalued companies
- Buy a company using a combination of debt and equity
- Private equity company runs the company for many years and then flips it
- Private equity then sells the investment and repays debt for hopefully a higher return

Question 2

What are you concerned about in an LBO? (Measurements)

Answer 2

IRR exceeding internal discount rate

Question 3

2 ways borrowing money helps

Answer 3

• Reduces up front costs

- Frees up cash to repay debts

Question 4

Ideal company for an LBO

Answer 4

• Large enough - Smaller deals are 5-10M
• Price is right
• Stable cash flows to service debt (pre-revenue biotech or startup would be the worst possible because they can’t pay back interest.)
• Stability

Question 5

Ideal LBO candidate (Income statement)

Fixed Costs, Revenue, margins, growth?

Answer 5

• Low fixed costs
• HIgh recurruing revenue
• High EBITDA margins
• Revenue growth not essential

Question 6

Ideal LBO Candidate (Balance sheet)

Answer 6

High fixed assets such as PP&E for use as debt collateral

Question 7

Ideal LBO Candidate (Cash Flow Statement)

Answer 7

• Stable cash flow needed above all
• Minimal capex spends (Mature company with lots of assets, but not spending on assets)
• Minimal working capital requirements also help, but tend to matter less.

Question 8

Ideal LBO Candidate (Valuation Multiples?)

Answer 8

• Lower to mid-range EBITDA multiples

Question 9

Ideal LBO candidate (Management Team)

Answer 9

• Strong CEO and CFO that have worked together for a long time and ideally are participating in the LBO by rolling over shares.

Question 10

Ideal LBO Candidate (Industry / Market Features)

Answer 10

• High barriers to entry or “stickiness” (facebook.)
• Strong competitive advantage
• Stable, growing industry
• Little risk of technological change
• Ideally a market leader in a relatively fragmented industry

Question 11

Ideal LBO Candidate (Financing Method and Debt Capacity)

Answer 11

Can support many tranches of deb as well as alternative debt structures depending on the companys needs.
- Relatively low % equity, perhaps around 20-30% depending on market conditions.

Question 12

Ideal LBO Candidate (Credit stats and ratios)

Answer 12

EBITDA / Net Interest Expense > 2.0x
(EBITDA-CapEx) > Net Interest Expense > 1.5x
- Total Debt / EBITDA dependendent on industry and market but usually 5-6x and far often lower than that

Question 13

Ideal LBO Candidate (Credit Rating)

Answer 13

Post-deal credit ratings dont take that much of hit that will cause interest rates to go up
- Credit ratings will always go down but ideally a drop from A to BB rather than AA to CCC.

Question 14

Advantages of a fragmented market

Answer 14

PE firms can make additional acquisitions to make the companies they acquire bigger and more valuable.

Question 15

Exit strategies / sources of returns

Target IRR?

Answer 15

• M&A exits are feasible
• Target IRR of 20-25%
• Avoid deals that are overly dependent on multiple expansion (EV / EBITDA must increase from 10x to 15x for the IRR to be above 20%

Question 16

Difference in holding time between LBO and M&A deal

Answer 16

• LBO PE firm sells after 3-5 years

Question 17

Leveraged buyouts vs M&A deals (Buyer)

Answer 17

• In an LBO, PE firm forms a shell company so debt is at that level.

Question 18

Leveraged buyouts vs M&A deals (Purchase Price)

Answer 18

• Based on per share premium and valuation methodologies in both
• In LBO you consider purchase price required to achieve specific IRR

Question 19

Leveraged buyouts vs M&A deals (Funding Source)

Answer 19

• M&A Buyers use cash, equity, debt

- LBO can only use cash and debt

Question 20

Leveraged buyouts vs M&A deals (Funding statement projections)

Answer 20

In M&A deal, you need projections for both buyer and seller

- In LBO you project only sellers financials

Question 21

Leveraged buyouts vs M&A deals (Synergies)

Answer 21

• Important in M&A but not in LBO

Question 22

Leveraged buyouts vs M&A deals (Relevant Analysis)

Answer 22

EPS accretion/dilution matters a lot in M&A deals but is irrelevant in
LBOs; the same goes for Contribution Analysis. You’ll look at Returns Attribution and
LBO Valuation Analysis in LBOs, but not in M&A deals.

Question 23

Leveraged buyouts vs M&A deals (Value to Society)

Answer 23

Most M&A and LBO deals tend to destroy value, but some M&A deals do lead to positive outcomes (e.g., Google / YouTube). Many leveraged buyouts, by
contrast, are based on “financial engineering” and don’t improve the company or add much value to the world at large.

Question 24

How to calculate proceeds to PE firm at end of LBO model?

Answer 24

Subtract net debt

Question 25

MOM Multiple vs IRR
1. Buy for 1,000 sell for 1,300 in one year

2. Buy for 1,000 sell for 9,000 9 years later

Answer 25

1. IRR = 30%, MOM = 1.3x
2. IRR = 15%, MOM = 3.0x

MOM is overall increase while IRR is time dependent

Question 26

When to use IRR vs MOM

Answer 26

in short periods (1 year), IRR is pointless, so use MOM

If holding for 5, 6, 7 years do IRR

Question 27

What is a hurdle rate and what is based on?

Answer 27

Target IRR for PE firms before they can start earning a performance bonus.

Question 28

Double your money scenario IRR questions

Answer 28

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.

For example, if you double your money in 3 years, 100% / 3 = 33%, and 75% * 33% = 25%

Question 29

Double your money in 3 years IRR

Answer 29

100% / 3 x 75% = 25% IRR

Question 30

Double your money in 5 years IRR

Answer 30

100% / 5 x 75% = 15% IRR

Question 31

Triple your money scenario IRR questions

Answer 31

200%/number of year * 65%

Question 32

Triple Your Money in 5 Years IRR

Answer 32

200%/5 * 65% = 25% IRR

Question 33

Triple Your Money in 3 Years

Answer 33

200%/3 = 66% x .67 = 45%

Question 34

3 Yr scenarios IRR final multiple

Answer 34

2/3

Question 35

5 Yr scenario IRR final multiple

Answer 35

63%