True
True or False:
High yield bonds typically have longer maturities than do bank loans.
IRR 23.7%
Max leverage $840
Initial equity investment $280
Assume LTM EBITDA of $140 million with $70 million in net debt. The financial sponsor can borrow up to 6x total debt to EBITDA. The sponsor is willing to own equity up to 30% of purchase price and is targeting an IRR of 25%.
The sellers want a price of $1,120.
The final year, year 5, assume:
No change in exit multiple
EBITDA $145 million
Net Debt $350 million
Will this deal work?
No, do not sell the assets because the change is not 5%.
Does the IRR increase 5% when selling the assets?
A financial buyer has just invested $1,500 million in a company buyout and used $4,500 million of debt financing. The buyer is planning to sell the company in 3 years for an 8x exit multiple.
If the buyer sells assets, the year 3 net debt balance will go down to $3,000 and EBITDA will be $770 million.
If the assets are not sold, year 3 EBITDA would be $800 million and net debt would be $3,500 million.
Increase debt to reduce equity value (before the transaction occurs)
Negotiate lower purchase price
If the projected IRR is not what the sponsor likes, what changes could be made to increase the IRR?
- $700 million
- $1,000 million
- $230 million
- 7.143x
Target:
EBITDA $140 million
Net debt $70 million
Acceptable leverage ratio 5.5x
- Calculate new debt
- Calculate max purchase price assuming 23% max equity investment
- Calculate dollar value of equity
- What would be the resulting EV/EBITDA multiple?
Senior debt
High Yield debt
Mezzanine debt
Sponsor’s equity
What are the 4 sources of capital in an LBO?
EV - Net Debt
Enterprise value can be the purchase price paid or the new EV based on the selling multiple.
A multiple applied to EBITDA.
What is the residual equity value formula?
What would be a selling multiple?
Choose investment A
Choose which investment has the higher IRR.
Both have current year EBITDA of $100 million. In both cases, the maximum amount of leverage allowed is 5.5x debt / current year EBITDA and the equity contribution is 30%. Investment A has an exit potential in projected year 3 with a 7.9x EBITDA exit multiple, $125 million in EBITDA and net debt of $500 million.
Investment B has an exit potential in year 5 with a 7.9x EBITDA exit multiple, $150 million in EBITDA and net debt of $450 million.
- a) incremental debt is added & company’s original equity is wiped out and new equity amount replaces it
b) cash and Goodwill, deferred tax liabilities
- How is the balance sheet adjusted in an LBO model?
- a) boost return
b) sometimes can be a cheap source of capital - a) purchase / exit multiple
b) amount of leverage
c) cash flow and its growth
d) time - Same way you do any other valuation, look at comparable companies, acquisition comparables, DCF, etc
- Why do you use leverage when buying a company?
- Which variables impact IRR the most in an LBO model?
- How do you pick purchase and exit multiples?
Capital Expenditures
What are typically the biggest cash outflows sponsors are concerned about in a LBO?
- It must be undervalued
- It must have stable cash flows
- Must have manageable investment needs (CapEx)
- Must have a viable exit strategy
- It must be in a stable industry
- It must have disciplined management
What are criteria needed for a company to be a suitable LBO investment?
(FV/PV)^(1/n) - 1
FV= Future residual equity value (not to be confused with future value formula)
PV= Initial equity investment
n= number of periods/years
What is the IRR formula? Explain the inputs.
IRR, which is the discount rate needed to get the NPV of the investment to 0. It is the discountrate that equates the PV of inflows to the PV of outflows.
Sale, IPO, or dividend recapitalization
How do PE investors measure their rate of return? Explain this.
What are the 3 ways PE firms realize a return on their investment?
Typically initiated by PE funds, it is the acquisition of a company using high amounts of debt and low equity.
LBO analysis is a set of tools used by the acquirer to determine what price it can pay for a target in order to achieve a particular return on its equity investment.
LBO buyers are financial buyers.
Describe an LBO.
What is LBO analysis?
Are LBO buyers strategic or financial?
5.6x
Calculate the pro forma (post-deal) leverage (Total Debt/EBITDA), of the newly indebted LBO target assuming EBITDA of $100 million, a transaction purchase price multiple of 8x, and an equity contribution of 30% of purchase price.
Existing debt is typically refinanced.
New Debt = Total Debt Capacity - Refinanced existing debt
(Total debt capacity = leverage multiple x EBITDA)
Given that target companies already have existing debt, what happens to that existing debt? Also, what is the formula used to derive new debt?
- Will the target company’s cash flows be able to support the repayment of principal and interest?
- Senior debt and subordinate debt lenders. Senior debt lenders command the lower interest rate due to securitizing the loan of the target company’s assets, etc. Also, it is the first to be paid back in the event of bankruptcy, liquidation, etc.
- What is the main concern of lenders in an LBO?
- Who are the 2 main lenders in an LBO? Who commands a lower interest rate and why?
Total Debt Capacity / % Debt Contribution
What is the max purchase price formula?
- a) make assumptions about purchase price, debt/equity %, interest rate on debt and other variables
b) create a sources/uses section indicating how the transaction is financed and what the capital is for
c) adjust the company’s balance sheet for incremental debt / equity and additional Goodwill
d) project forward the company’s financial statements with attention to how much debt is paid off
e) derive exit multiple and derive residual equity value
- Walk me through a basic LBO model
De-leveraging
Essentially paying down debt.
Operational improvements to improve cash flow
- sales growth
- margin improvements
Multiple expansion
This is to increase the selling multiple when the sponsor wants to exit the investment. For example, say the purchase multiple is 7x, but due to operational efficiencies and debt reduction, the company could be acquired for 8x given market conditions.
What are the 3 main goals of a PE firm once a deal has been executed? Explain each goal.
A house flipper.
A person takes out a mortgage with little equity and purchases a house. It improves the house by performining maintenance, interior design, etc. The buyer rents the house to occupants, and the buyers uses those rental payments to pay off the mortgage. Once the mortgage has been paid off, it sells the home. Thus, it generates returns on the little equity it initally put in.
What is a non-corporate example of an LBO?
Total Debt Capacity = Max Leverage multiple x EBITDA
What is the Total Debt Capacity formula?
Leverage and coverage ratios.
Leverage
Total Debt/EBITDA
Senior Debt/EBITDA
Coverage
EBITDA/Interest expense
(EBITDA - CapEx)/Interest expense
What are the 2 types of ratios applied to target company to assess credit risk? Show the formulas.
