- Walk me through a LBO model
- LBO: an acquisition where a significant portion of the purchase price is financed through debt, and the remaining equity comes from the investor or private equity firm.
1. Make assumptions about: - purchase price
- debt/equity ratio
- interest rate on debt
- operational assumptions
2. Create sources & use section: - sources: how you finance the transaction
- uses: how the capital is used
- investor equity: The amount of money the investor or private equity firm contributes.
3. Adjust for the new Debt and Equity figures; add goodwill and other intangibles on the asset side
4. Project out the company’s B/S, I/S, and C/F; calculates how much debt is paid off each year based on available cash flow
5. Calculate: make assumptions about the exit of the company (usually using EBITDA multiple); the return on the investment is calculated based on the equity investors receive when they exit.
- Why would you use leverage when buying a company?
To boost your return, and have more capitals to purchase other companies
- What variables impact an LBO model the most?
- Purchase multiple & exit multiple
- Amount of levered debt
- Operational characteristics (EBITDA margins and Revenue Growth)
- How do you pick purchase multiples and exit multiples in an LBO model?
- Look at comparable companies and precedent transactions; show range using sensitivity tables
- sometimes set the purchase and exit multiples based on IRR (internal rate of return) you are trying to achieve (higher IRR = low purchase & high exit multiples)
- What is an “ideal” candidate for an LBO?
- Stable and predictable cash flows
- low-risk businesses
- not much need for long-term investments and CAPEX
- opportunity to cut expense & boost margins
- strong management team
- How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?
Valuing a company with a LBO model: setting a targeted IRR and back-calculating the maximum purchase price that would achieve that return. The resulting purchase price is the “floor valuation” because PE firms almost always pay less than strategic acquires do.
- Give an example of a “real-life” LBO.
Taking a mortgage to buy a house.
- Downpayment = Investor Equity in an LBO
- Mortgage = debt in LBO
- Mortgage interest payment = Debt Interest in an LBO
- Mortgage Repayments: Debt Principal Repayments in an LBO
- Selling the House: Selling the Company / Taking It Public in an LBO
- Can you explain how the Balance Sheet is adjusted in an LBO model?
- Liabilities & Equity side is adjusted
- new debt is added on
- S/E is wiped out and replaced with investor equity - Asset:
- Cash is adjusted for the amount that is used to finance the transaction
- Goodwill and Other Intangibles are the “plug” to make up for the difference
- Why are Goodwill & Other Intangibles created in an LBO?
THe premium to its fair market value; in LBO, act as a plug to make up for the difference between assets side and liabilities & s/e side
- 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?
- If the PE wants to hold the firm in short term: reduces the amount of equity they need to contribute, thereby amplifying their returns
- The debt is placed on the target company’s balance sheet, limiting the PE firm’s risk.
- Do you need to project all 3 statements in an LBO model? Are there any “shortcuts?
- How would you determine how much debt can be raised in an LBO and how many tranches there would be?
Look at comparable LBOs, companies similar in:
- size
- industry
- 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?
- look at the “debt” comps to figure out the types, tranches, and terms of debt comparable peer companies have used
- general rules: never lever a company at 50x EBITDA; usually 5-10x EBITDA
What is the difference between bank debt and high-yield debt?
- high-yield debt: higher interest rates
- high-yield debt: usually fixed interest rates
- high-yield debt: incurrence covenants; bank debt: maintenance covenants. Incurrence covenants prevent you from doing something (e.g., selling assets; buying a factor), whereas maintenance covenants require you to maintain a minimum financial performance
- “You can’t issue more debt if your DEBT/EBITDA is over 6x
- “Your Debt/EBITDA ratio must always stay below 5x.”
- bank debt: usually amortized (principal paid off over time); high-yield debt: entire principal is due at the end
- Why might you use bank debt rather than high-yield debt in an LBO?
- PE firm is concerned about meeting interest payment
- If they want major expansion/CAPEX and don’t want to be restricted by incurrence covenants
- Why would a PE firm prefer high-yield debt instead?
- If the PE firm wants to refinance the company (because high-yield debt only requires you to pay at the end) ==> more cash available in the short run
- No plans for major expansion
- Why would a private equity firm buy a company in a “risky” industry, such as technology?
- Industry consolidation: buy competitors
- Turnarounds: taking struggling companies and make them become profitable again
- Divestitures: sell parts of the acquired companies or taking a division and turning it into it own profitable entity
- How could a private equity firm boost its return in an LBO?
- Lower purchase price
- Increase exit price
- Increase leverage
- Increase Revenue growth rate
- Increase margins by reducing expenses
- What is meant by the “tax shield” in an LBO?
Because the interest expense is tax-deductible ==> save money on taxes & increase cash flow
What is a dividend recapitalization (“dividend recap”)?
The company borrows solely to pay a a special dividends to the PE that acquired it.
It would be like if you made your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds.
Why would a PE firm choose to do a dividend recap of one of its portfolio companies?
Boost investment
How would a dividend recap impact the 3 financial statements in an LBO?
- I/S: no change
- B/S:
- Debt increase
- S/E decrease - C/F:
- No change in CFO & CFI
- CFF: debt cancel out the cash paid ==> unchanged
