Walk me through a basic LBO model.
- Make assumptions about Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; consider revenue growth or margin assumptions if you can.
- Create S&U for financing the deal
- Adjust company’s B/S for new debt and equity, as well as adding Goodwill & Other Intangibles to Assets to make it balance.
- Project the company’s I/S, B/S and CF/S; determine how much debt is reapid each year, based on available CF and required interest payments.
Why would you use leverage when buying a company?
To increase your returns:
- Increases returns on your invested capital
- Frees up capital for other investments
What variables impact an LBO model the most?
- Purchase and exit multiples
- Leverage used
- Operational stuff - revenue growth, EBITDA margins
How do you pick purchase multiples and exit multiples in an LBO model?
Look at public company comps and LBO comps, then show a sensitivity range for these multiples.
May set purchase and exit multiples based on a target IRR, but this is just for valuation purposes.
What’s an ideal LBO candidate?
Businesses with:
- Stable and predictable cash flows
- Low-risk profiles
- Low reinvestment needs (capex, etc.)
- Opportunity to cut costs
Also nice to have:
- Strong management
- Assets to collateralize
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?
By setting a targeted IRR, then back-solving in Excel to determine what purchase price the sponsor could pay to achieve that IRR.
Floor b/c sponsors pay less than strategics.
Give an example of a real-life LBO.
Taking out a mortgage to buy a house:
- Down payment = investor equity
- Mortgage = LBO debt
- Mortgage Interest = LBO debt interest
- Mortgage Repayments = principal repayments/amort
- Selling the House = selling / IPO’ing company
Can you explain how the B/S is adjusted in an LBO model?
- L + E = add new debt, wipe out S/E and replace with new investment
- Assets = cash is adjusted for any used to finance deal, then plug Goodwill to balance B/S
Why are Goodwill & Other Intangibles created in an LBO?
Like an other acqs., to plug premium to FMV paid.
If strategics like to pay in cash, why would sponsors want to use debt?
- Not a long-term holder - doesn’t care about net interest expense effects of cash/debt. Wants to juice returns.
- In an LBO, target assumes the debt risk but not the sponsor, whereas a strategic acquirer would assume.
Do you need to project all 3 statements in an LBO model?
Not necessarily - there are shortcuts.
- Full B/S often isn’t shown - just debt balances
- Full CF/S not shown - just CFAFD
How would you determine how much debt can be raised in an LBO and how many tranches there would be?
Look at LBO comps for terms and tranches, screening for size and industry.
What’s the difference between bank debt and HY?
Big differences:
- HY tends to have higher rates
- Fixed vs floating rates
- HY has incurrence covenants vs maintenance in bank
- Mandatory amort. vs bullet maturity
Why might you use bank debt vs HY in an LBO?
Bank debt could be cheaper; covenants are also more permissive of expansion / capex.
Why might a sponsor use HY instead?
If they intend to refi the company or if they think interest won’t affect returns; or if no big capex plans.
Why would a sponsor buy a company in a risky industry, like tech?
There are mature, cash flow-stable companies in most industries.
May be trying to:
- Roll-up the industry
- Turnaround thesis
- Divestiture plan
How could a PE firm boost its return in an LBO?
- Lower Purchase Price
- Raise Exit Multiple / Exit Price
- Increase leverage
- Increase company’s growth rate (organic / acq.)
- Increase margins by cutting expenses
What’s meant by the “tax shield” in an LBO?
Interest on debt is tax-deductible, so LBO debt reduces taxes.
What’s a dividend recap?
Company incurs new debt to pay the sponsor a special dividend, enhancing the sponsor’s returns by reducing equity.
Why would a sponsor choose to dividend recap a portfolio company?
To boost returns!
How would a dividend recap affect the 3 F/S in an LBO?
- I/S - nothing
- CF/S - large dividend and influx of debt in CFF
- B/S - cash changes, debt changes, equity changes
