What is an LBO (leveraged buyout
- PE firm acquires a company using a combination of debt and equity
- Run for 5-7 years paying down debt using FCF + operational improveemnts.
- At the end exit with a higher return.
Describe concept of an LBO using real-life example
House Flip using borrowed money.
1) Found house on mkt selling for cheap, see you can buy and sell for more later.
2) Buy house but financed through mortgage lender with a small down payment.
3) Rent out each room to generate FCF, pay down mortgage and interest using FCF from tenants.
4) Remaining amount of FCF used to make renovations.
5) After 5 years, house sold for higher price than inital purchase since made improvements.
Why use leverage in LBO
1) Your risk is substantially lower
- If your investment goes wrong, effects lender greater
2) Debt is cheaper:
- Equity investors take on more risk (paid last in liquidation)
- Tax shield from debt
3) Leaves you more drypowder to make other investments + diversify portfolio
4) You have a mangified upside
- EQV will increase when net debt paid down
- Debt return is fixed, they dont see the upside
What is the typical capital structure of an LBO
1) Depend on the financing environment.
2) Was 80/20 but now more 60/40.
3) Senior Debt:
- Term Loans and revovlers
- Backed by collateral
- Lower, floating IR, maintenance covenants.
- Early repayment allowed, matruity 5-10 years
4) Junior debt:
- Senior notes, sub notes, mezz
- Not backed by collateral, higher IR and fees.
- No early repayment and longer maturity
4) Keep management team in an LBO so sponsor will reserve 3-20% of total equity to get management team to meet financial targets.
What are the main levers in an LBO that drive returns
1) Debt Paydown (delveraging):
- As debt is paid down, PE equity grows. (since EQV goes up with net debt going down)
2) EBITDA Growth:
- Operational improvements to margins, new growth strategies, and making accretive add ons.
- EV = Exit EBITDA * Exit Multiple
3) Multiple Expansion:
- Want to exit at higher multiple than entry
- Increase from improved sentiment, better economic conditions, or scale.
- Investors think its less risky, has more growth potential, scale is larger.
- do this through geogrpahic expansion, product development, strategic add on.
What is a good LBO candidate / the flipped is for risks.
1) Strong FCFs:
- Predictable FCF with high margins to pay the debt interests and debt paydown.
2) Recurring Revenue:
- Less risky cash flows so can pay down debt.
- SaaS company, LT contracts, G/S that is required by customers
3) Economic Moat:
- Allows for competitive advantage, higher barrier (patent, economies of scale, switching costs)
4) Favorable Unit Economics:
- High margins, low CapEx, min WC requirements.
- More stable FCF
- Can also show a competitive advantage
5) Strong, Committed Management Team:
- Proven track record, they are the ones executing plan
6) Undervalued (Low Purchase Multi)
- Opportunity through higher exit multiple, while risk is lower
7) Value add on opps.:
- Company is well run, but there are inefficiencies that can be improved.
Which industries attract more deal flow
1) Non-Cyclical/Low-Growth:
- Minimal risk
- Once organic growth has run out, you can use M&A to grow.
2) SaaS/Contractual:
- Recurring, stable revenue
3) High R&D Requirements:
- Incumbents in high R&D sectors would rather buy the technical products than build in house.
- Buy the company, exit for PE.
4) Favorable Industry Trends:
- Industry is growing, company grows without big changes or taking on risk.
What is the relationship between debt and purchase price
1) Lots of debt allows PE to buy companies they couldnt with just equity alone or with just a little debt.
2) Also saves dry powder for other investments.
How is maximum leverage used in an LBO:
- What is typical debt to EBTIDA
1) Typically has been 60/40 debt/equity.
2) Varies between industries, companies.
3) Debt/EBTIDA: 5x-7x (more recently 4-5x)
Why would a PE firm not raise leverage to maximum leverage even if had opportunity to.
1) Increased default risk: Even if think have FCF to pay down debt, can be a judgement call.
2) Negative Perception: PEs want to be seen as value adds, not overleveraging at companys expense.
3) Decrease Fund Returns: If company goes bankrupt, could make harder to raise funds.
What determines a company’s debt capacity
1) Industry and company trends, risks/mitigates.
2) Look at historical performance, sensitivity analysis in high levered scenarios.
3) Leverage ratios: Debt/EBTIDA (5x) and Interest Coverage Ratio (above 2x)
2) Comps to similar LBOs
How do PEs exit their investments
1) Sale to strategic -> will pay premium
2) Secondary buyout -> sponsor to sponsor
3) IPO
Whats is the one caveat of an IPO exit
- Takes time to IPO, then there is a 90-180 day share holding period.
What is a dividend recap
- PortCo has paid down portion of initial debt, allowing for more debt capacity.
- Sponsor raises new debt on a portCo
- Use that debt to pay themselves a dividend before exit.
- Boost IRR since its highly time sensitive, will get partial returns earlier.
Why is multiple expansion seen as less than ideal lever for value creation
- EBITDA growth and debt pay down is easier to develop a plan for.
- Depend loess on exiting at a higher multiple to earn money, which has many moving parts that are out of investor control.
Where is multiple contraction common
Large size companies, slow growth, unfavourable market conditions
How many years would it take to double a $100K investment at a 9% return.
Rule of 72, divide 72 by investments annual return.
72/9 = 8 years to double.
115/X = to see how long to triple
What does an LBO model show us
- “what-if” scenario
- How much debt a company can support
- The required equity investment
- Potential returns (IRR/MoM)
Walk me through step 1 of LBO
Calculate the Entry Valuation:
- Implied EV = Entry Multi * LTM EBTIDA.
- Entry multi is of a similar company.
Walk me through step 2 of LBO
Build a source and use table.
Sources:
“Where is funding coming from”
- Usually debt instruments
- Equity from sponsors
- Excess cash on BS
Uses:
- What will money be used on.
- Most significant = buyout of equity from targets existing shareholders.
- Transaction and financing fees.
Walk me through step 3 of LBO
FCF Projection:
- 5-7 year project
- 3 statements are projected so that impacts of LBO (debt assumptions) are tied to IS and BS.
- Build out a debt schedule.
Step 4 of an LBO
Exit valuation:
- Most importantly exit EV/EBITDA
- Once done, you can calculate projected IRR and MoM.
Step 5 of an LBO
Sensititivty Analysis:
- Entry/Exit multiples, Revenue, EBITDA, leverage
- See hurdles rates and operation assumption changes.
Full LBO Walk Me Through
Step 1: Calculate Entry EV:
- Based on entry multiple * LTM EBITDA.
Step 2: Source and Use Table Build:
- Sources: Debt, equity from sponsor, excess cash.
- Uses: Buyout of target equity holders, transaction and financing fees.
Step 3: Project FCF:
- 5-7 years
- 3 statement build out to ensure IS and BS are impacted based on LBO (debt assumptions)
- Debt schedule build out.
Step 4: Calculate exit valuation:
- Exit EV/EBITDA
- IRR and MoM
Step 5: Build sensitivity analysis
