What is a leveraged buyout, and why does it work?
In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of
Debt and Equity, operates it for several years, and then sells the company at the end of the
period to realize a return on its investment.
During the ownership period, the PE firm uses the company’s cash flows to pay for the interest
expense on the Debt and to repay the Debt principal.
LBOs work because leverage amplifies returns: If the deal performs well, the PE firm will realize
higher returns than if it had bought the company with 100% Equity.
But leverage also presents risks because the returns will be even worse if the deal does not
perform well.
Walk me through a basic LBO model (without the full financial statements).
In an LBO model, in Step 1, you make assumptions for the Purchase Price, Debt and Equity,
Interest Rate on Debt, and other drivers such as the company’s revenue growth and margins.
In Step 2, you create a Sources & Uses schedule to show how much Investor Equity the PE firm
contributes and how items like the transaction fees and the company’s Cash balance affect this
contribution.
In Step 3, you project the company’s Income Statement and its partial Cash Flow Statement
down to Free Cash Flow.
Then, in Step 4, you use the Free Cash Flow, Beginning Cash, and Minimum Cash to determine
how much Debt principal the company repays each year. You then link the Interest Expense on
this changing Debt balance to the Income Statement so that FCF deducts the Interest.
Finally, in Step 5, you make the exit calculations based on an assumed EBITDA Exit Multiple, and
you calculate the IRR and Money-on-Money multiple based on the proceeds the PE firm earns
at the end vs. its Investor Equity in the beginning.
Which assumptions impact a leveraged buyout the most?
The Purchase Price and Exit assumptions, usually based on EBITDA multiples, impact a
leveraged buyout the most.
A lower Purchase Multiple results in higher returns, and a higher Exit Multiple results in higher
returns.
After those, the Debt used, based on a percentage of the Purchase Price or a multiple of the
initial EBITDA, makes the biggest impact.
If the deal performs well, more leverage will make the numbers even better, and vice versa if it
does not perform well.
Next, the company’s revenue growth, EBITDA margins, and cash flow profile also make an
impact because they influence the exit proceeds and the Debt repaid in the holding period.
Finally, the interest rates, principal repayments, and other terms attached to the Debt may
make a difference, but they tend to be less significant than the other drivers.
How do you select the Purchase Multiple and Exit Multiple in an LBO model?
Typically, you assume a share-price premium for public companies and check the implied
Purchase Multiple against the valuation methodologies to ensure it’s reasonable.
For example, you might assume a 30% premium to the company’s share price of $10.00, which
implies an EBITDA multiple of 10x.
For private companies, you determine the Purchase Multiple via the standard valuation
methodologies (comparable companies, precedent transactions, and the DCF analysis).
The Exit Multiple is often close to the Purchase Multiple but could be higher or lower
depending on the company’s growth rates, margins, and ROIC upon exit.
In robust models, you always sensitize these assumptions and consider the outcomes across
different ranges.
What is an “ideal” candidate for an LBO?
Almost any deal can work at the right price. Assuming the price is reasonable, ideal LBO
candidates should also:
* Have stable and predictable cash flows (so they can repay Debt);
* Have relatively modest requirements for CapEx and other ongoing re-investments;
* Operate in an industry that is at least modestly fragmented (to enable add-on
acquisitions);
* Have opportunities to cut costs and increase margins;
* Have strong management teams;
* Have solid asset bases to use as collateral for Debt;
* Have realistic exit paths, with returns driven by varied sources (e.g., EBITDA growth and
Debt repayment rather than only multiple expansion).
Walk me through the Free Cash Flow calculation in an LBO model. How is it different from
EBITDA, and why do we need both?
In an LBO, Free Cash Flow = Net Income + D&A +/- Change in Working Capital – CapEx.
You could also calculate it starting from EBITDA like this:
Free Cash Flow = EBITDA – Net Interest Expense – Cash Taxes +/- Change in Working Capital –
CapEx.
FCF differs from EBITDA because EBITDA ignores Interest Income, Interest Expense, Taxes,
Working Capital, and Capital Expenditures – but all these items affect a company’s cash flow in
real life and, therefore, how much Debt it can repay.
EBITDA is a quick proxy for cash flow from operations for the core business, ignoring capital
structure, but FCF is “the real thing” and factors in the capital structure because of the Net
Interest Expense deduction.
Explain how a company’s Free Cash Flow and the Debt principal it can repay in an LBO are
related.
A company’s repayment of Debt principal is related to its Free Cash Flow, but it is not the same
thing because all companies have Minimum Cash requirements and start with different
amounts of Cash in each period. The general formula is:
Cash Flow Available for Optional Debt Repayment = Beginning Cash + Free Cash Flow –
Minimum Cash – Mandatory Debt Repayments.
You can ignore the last part if there are no required principal repayments.
What are the different exit strategies in an LBO? Which one do most PE firms prefer?
The main strategies are M&A and IPO exits. In an M&A exit, the PE firm sells the company to
another PE firm or a normal company in the industry (called a “strategic”).
In an IPO exit, the PE firm takes the company public and sells off its stake gradually over time
(selling the entire stake upfront in the IPO would be a huge negative signal).
In certain emerging and frontier markets, some PE firms also use Dividend Recapitalization
strategies to “exit” by having the company issue ever-increasing Dividends, but this works only
if the company’s Dividend Yield reaches very high levels
PE firms almost always prefer M&A exits because they are clean and simple and result in immediate proceeds. IPO exits take longer and carry more risk because of the need to sell the
stake over several years.
How could a private equity firm boost its returns in an LBO?
The main returns drivers are Multiple Expansion, EBITDA Growth, and Debt Paydown and Cash
Generation, so a PE firm could boost its returns by improving any of these.
In practice, this means:
* Multiple Expansion – Reduce the Purchase Multiple (e.g., by negotiating a lower price)
or increase the Exit Multiple (likely via higher ROIC or growth rates).
* EBITDA Growth – Increase the company’s revenue growth rate or boost its EBITDA
margins by cutting expenses.
* Debt Paydown and Cash Generation – Boost Free Cash Flow by reducing CapEx and
Working Capital requirements, cutting expenses, and aiming for higher growth. In some
cases, using more initial Debt could improve returns from this source (e.g., if the
company comfortably repays all the initial Debt currently).
How do you determine how much Debt a PE firm might use in an LBO and how many
tranches there would be?
You look at recent, similar LBOs and use the median Debt / EBITDA levels from them as
references; you could also look at highly leveraged public companies in the industry and check
their Debt / EBITDA levels.
For example, if the median Debt / EBITDA for LBOs has been 5x, with 2x Term Loans and 3x
Subordinated Notes, you might use these figures for your deal.
Then, you would test these assumptions by projecting the company’s leverage and coverage
ratios (Debt / EBITDA and EBITDA / Interest) over time.
If they hold up reasonably well – e.g., the company’s interest coverage ratio always stays above
2x – you might use the original numbers. If not, you would try different assumptions.
How do you determine how much Debt a PE firm might use in an LBO and how many
tranches there would be?
You look at recent, similar LBOs and use the median Debt / EBITDA levels from them as
references; you could also look at highly leveraged public companies in the industry and check
their Debt / EBITDA levels.
For example, if the median Debt / EBITDA for LBOs has been 5x, with 2x Term Loans and 3x
Subordinated Notes, you might use these figures for your deal.
Then, you would test these assumptions by projecting the company’s leverage and coverage
ratios (Debt / EBITDA and EBITDA / Interest) over time.
If they hold up reasonably well – e.g., the company’s interest coverage ratio always stays above
2x – you might use the original numbers. If not, you would try different assumptions.
Can you describe the different types of Debt a PE firm might use in a leveraged buyout?
Broadly speaking, Debt is split into Secured Debt and Unsecured Debt, which some people also
label “Bank Debt” and “High-Yield Debt” or “Senior Debt” and “Junior Debt.”
Secured Debt consists of Term Loans and Revolvers, is backed by collateral, tends to have
lower, floating interest rates, may have amortization (required principal repayments), and uses
maintenance covenants such as limits on the company’s Debt / EBITDA and EBITDA / Interest.
Early principal repayment is allowed, maturity periods tend to be shorter (~5 years up to 10
years), and the investors tend to be more conservative.
Unsecured Debt consists of Senior Notes, Subordinated Notes, and Mezzanine and 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 (the company is restricted from taking specific
actions, such as selling certain assets).
Early repayment is not allowed, maturity periods tend to be longer (8-10+ years), and the
investors tend to be hedge funds, merchant banks, and mezzanine funds.
How do you use a Revolver in an LBO model?
You draw on the Revolver when the company doesn’t have enough cash flow to make its
Mandatory Debt Repayments while maintaining its Minimum Cash balance.
For example, let’s say the Beginning Cash is $50, the Mandatory Repayments are $100, the FCF
is $75, and the Minimum Cash is $100.
In this case, Cash Flow Available for Debt Repayment = $50 + $75 – $100 – $100 = ($75).
Therefore, the company must draw on its Revolver for $75 to boost its cash flow to make the
$100 in Mandatory Repayments while maintaining the $100 in Minimum Cash.
The company will then pay interest and fees on this additional borrowing and repay the
Revolver balance as soon as possible.
How do you set up the Mandatory and Optional Debt Repayments in an LBO model?
Mandatory Principal Repayment for a tranche of Debt is based on the percentage that
amortizes each year, the initial amount of Debt raised, and the amount of Debt remaining.
You should take the minimum between Amortization % * Initial Amount and the Debt
Remaining because you never want to repay more than the remaining balance (e.g., 20% *
$100 million = $20 million per year, but if only $10 million is left, repay only $10 million).
The Optional Debt Repayment formula is similar, but it’s based on the minimum between the
Cash Flow Available right now and the Debt balance remaining right now.
For example, if, after Mandatory Repayments, the company has $100 million in cash flow and
$250 million of Debt remaining, it would repay $100 million.
But if it had only $50 million remaining, it would repay the remaining $50 million.
How do you use an LBO model to value a company, and why does it set the “floor
valuation”?
You use it to value a company by setting a targeted IRR, such as 25%, and then using Goal Seek
in Excel to determine the price the PE firm could pay to achieve that IRR.
For example, if the exit multiple is 11x, which means $1,000 in Exit Equity Proceeds for the PE
firm, Goal Seek might tell you that the firm could pay $328 in Investor Equity to achieve a 25%
IRR over 5 years.
At a 50 / 50 Debt / Equity split, that means a Purchase Enterprise Value of $656 (ignoring fees).
This method produces a “floor valuation” because it tells you the maximum amount a PE firm
could pay to realize a minimum IRR. Other methodologies are not constrained in the same way.
Would you rather achieve a high IRR or a high MoM multiple in a leveraged buyout?
It depends on the time frame. Over a short period, such as 6 months, a high IRR, such as 50%, is
meaningless because you’ve barely made money (~1.25x multiple).
But over a long period, such as 10 years, a high MoM multiple, such as 3x, means less because it
corresponds to a ~12% IRR.
Limited Partners judge private equity funds by their IRRs, but they also don’t want the money
to be returned to them too quickly.
So, the best answer is: “PE firms care more about IRR because that’s how they’re measured, but
over short time frames, it’s better to earn a high multiple, and over longer time frames, it’s better to earn a high IRR. Also, if the PE firm has already exceeded its hurdle rate, it will focus more on MoM multiples.”
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Finance Concepts10
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Accounting Concepts18
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Accounting Calculations18
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Equity Value & Enterprise Value – Concepts12
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Equity Value & Enterprise Value – Calculations12
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Valuation Methodologies10
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Common Tech Questions WSO33
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DCF - Method25
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DCF - Calcs10
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Merger Model - Concepts13
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Merger Model - Calculations0
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LBO Concepts16
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Infra9
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