Why would a PE firm choose to do a dividend recap of one of its portfolio companies?
- Primarily to boost returns.
- Remember, all else being equal, more leverage means a higher return to the firm.
- With a dividend recap, the PE firm is “recovering” some of its equity investment in the company
- And the lower the Invested Equity amount the easier to earn a higher return on a smaller amount of capital
Why would a PE firm prefer high-yield debt instead?
- The PE firm intends to refinance the company at some point
- They don’t believe their returns are too sensitive to interest payments
- They don’t have plans for major expansion or selling off the company’s assets
Do you need to project all 3 statements in an LBO model? Are there any shortcuts?
Yes here are the shortcuts:
- Create some form of Income Statement
- Track how the Debt Balances change
- Show cash is available to repay debt by creating type of CFS to show how much
* 4. You do not need to create a full Balance Sheet*
A. Bankers sometimes skip this if they are in a rush.
B. Full Balance Sheet is not strictly required, because you can just make assumptions on the Net Change in Working Capital rather than looking at each item individually.
How do you pick purchase multiples and exit multiples in an LBO model?
The same way you do it anywhere else:
- Look at what comparable companies are trading at
- Look at the multiples similar LBO transactions have had
- Show a range of purchase and exit multiples using sensitivity tables
* Sometimes you set purchase and exit multiples based on a specific IRR target that you’re trying to achieve – but this is just for valuation purposes if you’re using an LBO model to value the company.*
Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?
Dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions
To figure out the numbers, you would look at:
1. “Debt Comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently
2. The rules: for example, you would never lever a company at 50x EBITDA
A. Even during the bubble leverage rarely exceeded 5-10x EBITDA
How could a private equity firm boost its return in an LBO?
- Lower the Purchase Price in the model.
- Raise the Exit Multiple / Exit Price.
- Increase the Leverage (debt) used.
- Increase the company’s growth rate (organically or via acquisitions).
- Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.).
Note: These are all “theoretical” and refer to the model rather than reality – in practice it’s hard to actually implement these.
Can you explain how the Balance Sheet is adjusted in an LBO model?
- First, the Liabilities & Equities side is adjusted –
A, The new debt is added on
B. The Shareholders’ Equity is “wiped out” and replaced by however much equity the private equity firm is contributing.
- On the Assets side we then have adjustments
A. The Cash is adjusted for any cash used to finance the transaction
B. The Goodwill & Other Intangibles are used as a “plug” to make the Balance Sheet balance.
- Depending on the transaction, there could be other effects as well – such as capitalized financing fees added to the Assets side.
Why are Goodwill & Other Intangibles created in an LBO?
- They represent the premium paid to the “fair market value” of the company
- They act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side
How would a dividend recap impact the 3 financial statements in an LBO?
- No changes to the Income Statement.
- On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change.
- On the Balance Sheet, Debt would go up and Shareholders’ Equity would go down and they would cancel each other out so that everything remained in balance.
We saw that a strategic acquirer will usually prefer to pay for another company in cash – if that’s the case?
Why would a PE firm want to use debt in an LBO?
It’s a different scenario because:
- The PE firm does not intend to hold the company for the long-term
A. It usually sells it after a few years, thus, it’s less concerned with the “expense” of cash vs. debt
B. It’s more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront.
- In an LBO, the debt is “owned” by the company
A. Thus, they assume much of the risk
B. Whereas in a strategic acquisition, the buyer “owns” the debt so it is more risky for them
Why would a private equity firm buy a company in a “risky” industry, such as technology?
Although technology is more “risky” than other markets, remember that there are mature, cash flow-stable companies in almost every industry. So even if a company isn’t doing well or seems risky, the firm might buy it if it falls into one of these categories. There are some PE firms that specialize in very specific goals, such as:
1. Industry consolidation – buying competitors in a similar market and combining them to increase efficiency and win more customers.
2. Turnarounds – taking struggling companies and making them function properly again.
3. Divestitures – selling off divisions of a company or taking a division and turning it into a strong stand-alone entity.
Give an example of a “real-life” LBO.
The most common example is taking out a mortgage when you buy a house. Here’s how the analogy works:
1. Down Payment: Investor Equity in an LBO
2. Mortgage: Debt in an LBO
3. Mortgage Interest Payments: Debt Interest in an LBO
4. Mortgage Repayments: Debt Principal Repayments in an LBO
5. Selling the House: Selling the Company / Taking It Public in an LBO
What is meant by the “tax shield” in an LBO?
The interest paid on debt is tax-deductible - so the PE firm saves money on taxes and increases cash flow as a result of having debt from the LBO
Note, however, that their cash flow is still lower than it would be without the debt…
Saving on taxes helps, but the jump in Interest Expenses still reduces Net Income over what it would be for a debt-free company.
What is the difference between bank debt and high-yield debt?
This is a simplification, but broadly speaking there are 2 “types” of debt: “bank debt” and “high-yield debt.”
There are many differences, but here are a few of the most important ones:
1. High-yield debt tends to have higher interest rates than bank debt
A. Hence the name “high-yield”
2. High-yield debt interest rates are usually fixed
A. Whereas bank debt interest rates are “floating” – they change based on LIBOR or the Fed interest rate
3. High-yield debt has incurrence covenants
A. While bank debt has maintenance covenants
B. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.), while maintenance covenants require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times)
4. Bank debt is usually amortized – the principal must be paid off over time
A. Whereas with high-yield debt, the entire principal is due at the end (bullet maturity)
B. Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt.
Again, there are many different types of debt – this is a simplification, but it’s enough for entry-level interviews
What is an “ideal” candidate for an LBO?
“Ideal” candidates have:
- Stable and predictable cash flows
- Low-risk businesses
A. Not much need for ongoing investments such as Capital Expenditures
- An opportunity for expense reductions to boost their margins
* *A strong management team also helps, as does a base of assets to use as collateral for debt.*
* *The most important part is stable cash flow.*
How would you determine how much debt can be raised in an LBO and how many tranches there would be?
- You would look at Comparable LBOs
- See the terms of the debt
- How many tranches each of them used
- You would look at companies in a similar size range and industry
A. Use those criteria to determine the debt your company can raise
Walk me through a basic LBO model.
Step 1 is making assumptions about:
- Purchase Price
- Debt/Equity ratio
- Interest Rate on Debt
- You might also assume something about the company’s operations, such as Revenue Growth or Margins, depending on how much information you have.
Step 2 is to create a Sources & Uses section:
- Shows how you finance the transaction and what you use the capital for
- This also tells you how much Investor Equity is required
Step 3 is to adjust the company’s Balance Sheet for:
- New Debt and Equity figures
- Add in Goodwill & Other Intangibles on the Assets side to make everything balance.
Step 4 to project out the company’s:
- Income Statement, Balance Sheet and Cash Flow Statement
- Determine how much debt is paid off each year
A. Do this based on the available Cash Flow and the required Interest Payments.
Step 5 you make assumptions about the exit after several years:
- Usually assuming an EBITDA Exit Multiple
- Calculate the return based on how much equity is returned to the firm.
What variables impact an LBO model the most?
- Purchase and Exit Multiples have the biggest impact on the returns of a model
- The amount of leverage (debt) used also has a significant impact
- Lastly, operational characteristics such as revenue growth and EBITDA margins
How do you use an LBO model to value a company?
Why do we sometimes say that it sets the “floor valuation” for the company?
You use it to value a company by:
- Setting a targeted IRR (for example, 25%)
- Then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR
• This is sometimes called a “floor valuation” because PE firms almost always pay less for a company than strategic acquirers would.
Why would you use leverage when buying a company?
- To increase your returns
A. Remember, any debt you use in an LBO is not “your money”
i. Example:
If you’re paying $5 billion for a company, it’s easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.
- The firm has more capital available
A. Capital is used to purchase other companies because they’ve used leverage
What is a dividend recapitalization (“dividend recap”)?
- Company takes new debt solely to pay a special dividend out to the PE firm that bought it
- It would be like if you made your friend take out a personal loan just so he could pay you a lump sum of cash with the loan proceeds
- As you might guess, dividend recaps have developed a bad reputation, though they’re still commonly used.
Why might you use bank debt rather than high-yield debt in an LBO?
- If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt
- If they are planning on major expansion or Capital Expenditures and don’t want to be restricted by incurrence covenants, they might use bank debt
-
Financial Accounting - Basic31
-
Financial Accounting - Advanced15
-
Equity Value & Enterprise Value - Basic15
-
Equity Value & Enterprise Value - Advanced3
-
Valuation - Basic34
-
Valuation - Advanced14
-
Discounted Cash Flow - Basic32
-
Discounted Cash Flow - Advanced7
-
Merger Model - Basic24
-
Merger Model - Advanced22
-
LBO - Basic22
-
LBO - Advanced12
-
All Basic Shuffled158
