What is spread?
Spread is the difference between a bond yield and the benchmark rate.
Bankers speak of spread when discussing a company’s cost of debt
Describe the difference between a bond issued at par, at discount or at a premium?
-Amount borrowed is principal
-Coupon rate is interest rate company will pay as % of outstanding nominal value
-Sometimes market rate will be higher or lower than coupon rate
At Par –> Coupon rate = yield to maturity
At Discount –> Coupon rate < market rate
At Premium –> Coupon rate > market rate
How would you value a convertible bond?
2 parts of converts:
-Value of bond
-Value of warrant (Black Scholes model)
Advantages and Disadvantages of High Leverage?
Adv.
1. Higher Equity Returns
2. Tax-shield
3. Discipline
Disadv.
1. Volatility (high portion of CF to pay debt)
2. Default risk
What multiples are traditionally stated as financial parameters for an LBO?
- Leverage ratio: Net Debt/ EBITDA (4.0-6.0x)
- Interest coverage ratio: EBITDA / Interest expense (2x)
- Equity Contribution: Equity/EV (40-55% recently before 20-30%)
A PE acquires a Company with EV of 100 and Debt of 60. After 3 years it exits the investment; at the point of exit, EV is 120. No debt repayments have taken place during the 3 years. What’s the IRR of the PE investment?
(1+ IRR)^3 = 60/40 = 1.5 IRR ≈ 16%
Since senior debt is cheaper, why don’t financial sponsors fund the entire debt portion of the capital structure with senior debt?
Senior lenders will only lend up to a certain point (usually 2.0x to 3.0x EBITDA), beyond which only costlier debt is available because the more debt a company incurs, the higher its risk of default.
The senior debt has the lowest risk due to its seniority in the capital structure and imposes the strictest limits on the business via covenants, which require secured interests.
Subordinated junior debt is less restrictive but requires higher interest rates than more senior tranches of debt.
How can a private equity firm increase the probability of achieving multiple expansion during the
sale process?
Building a higher quality business via:
- entering new markets through geographic expansion
- product development
- strategic add-ons
Could help a PE firm fetch higher exit valuations – and increase the odds of exiting at a higher multiple than entry.
Also, exit multiples can expand due to improvements in market conditions, investor sentiment in the relevant sector, and transaction dynamics (e.g., selling to a strategic).
If you had to pick, would you rather invest in a company that sells B2C or B2B?
All else being equal, the revenue quality would be higher for the B2B company.
- Higher likelihood of long-term contracts for customers that are businesses than consumers. Most individual consumers opt for monthly payment plans.
- Businesses have significantly more spending power than consumers and are overall more reliable as customers.
- Businesses also have more loyalty to a particular company with whom they partner. The primary cause of this low churn (i.e., revenue “stickiness”) is the switching costs associated with moving to another provider and overall being less sensitive to pricing changes
Imagine that you’re performing diligence on the CIM of a potential LBO investment. Which questions would you attempt to answer?
- Is there a strong management team in place and do they intend to stay on during the LBO?
- What value does the company’s products/services provide to their customers?
- Which factors make the company’s revenue recurring? Are there any long-term customer contracts?
- Where does the team see new opportunities for growth or operational improvements?
- What has been driving recent revenue growth (e.g., pricing increases, volume growth, upselling)?
- How is the threat of competition? Does this company have a defensible “moat” to protect its profits?
- What specific levers does the private equity firm have to pull for value creation?
- Is the industry that the company operates within cyclical?
- How concentrated are the company’s revenue and end markets served?
- Is there a viable exit strategy? Will there be enough buyer interest when the firm looks to exit?
Can a highly capital-intensive industry be appealing to PE investors?
In general:
Asset-light industries can often be attractive because they require less capital to be deployed to generate sales growth.
However, a highly capital-intensive industry could:
- Create a high barrier to entry that deters entrants,
- Confers stability,
- Increases the collective pricing power over customers.
Since a capital-intensive industry implies higher amounts of PP&E, this can
- Become beneficial when raising debt financing. As a result of having more fixed assets that can be pledged as collateral, the company can
receive better lending terms as the borrowing base has increased
How can value be created during a consolidation play?
- Increased Pricing Power:
Most customers will pay more for a stronger brand and complementary
product or service offerings bundled together, leading to greater pricing power. - More Bargaining Power:
Larger incumbents with higher market shares have more leverage when negotiating terms with suppliers, enabling them to extend their payables (leading to a more attractive cash conversion cycle), in addition to being able to make bulk purchases at discounted rates. - Lower Customer Acquisition Costs (CAC):
From improved software (e.g., CRM, ERP) and more
infrastructure-related integrations, CACs decrease due to increased scale and higher efficiency. - Improved Cost Structure:
Upon closing, the consolidated company can benefit from economies of scale and cost savings. The increased profitability could come from combined divisions or offices, removal of redundant functions, and reduced overhead expenses (e.g., marketing, accounting, IT).
From a limited partner’s perspective, what are the advantages/disadvantages of the private equity
asset class?
Adv.
1. The target IRR in excess of ~20-25%.
This type of return is relatively high compared to other asset classes, such as public equities (~10% return on average).
- Private equity managers are more active investors and closely work with their portfolio companies to create value and reduce costs.
Disadv.
1. PE-backed portfolio companies carry more bankruptcy risk, which is why a strong return is required to compensate investors for undertaking this risk related to leverage usage.
- Liquidity can be a deterrent to investors sometimes, as unlike investors in publicly traded stocks, a private
equity investor cannot sell their shares freely
In the distribution waterfall in private equity, what is the catch-up clause?
Classic PE Distribution Waterfall
1. The initial investment from the LPs will first be returned in full, along with any returns related to a fund’s pre-determined minimum hurdle rate.
–> 2. Then, 20% of the returns will be distributed to the GPs due to the catch-up clause.
- The remaining excess proceeds would then be split 80% to the LP and 20% to the GP. The percentages
can vary, but the 80/20 split is the industry standard
What is the difference between a recapitalization and an LBO?
A. LBOs are accounted for as an acquisition, meaning assets are written-up, and goodwill is recognized.
B. Recapitalizations are mechanically similar but are not accounted for as an acquisition – thus, the asset bases carryover and remain unchanged with no goodwill recognized.
Since no goodwill is recognized, negative equity
is often created because the offer price is often higher than the book value of equity.
Walk me through the mechanics of building an LBO model.
An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity and new borrowing as the two primary sources of capital. The specific effects analyzed by the model include an equity valuation of the pre-LBO company, the IRR to the various new debt and equity capital providers, and the effects on the company’s financial statements and ratios.
- Entry Valuation: The first step to building an LBO model is to calculate the implied entry valuation based on the entry multiple and LTM EBITDA of the target company. If the company is publicly traded, then the offer price per share could alternatively be used.
- Sources & Uses Table: The next step in the LBO model is to identify the uses of funds – how much the
previous equity holders will be paid, any pre-LBO debt that needs to get refinanced, as well as the
transaction and financing fees. Based on this, various assumptions will be made regarding the sources of
funds, such as the amount of debt raised and the residual amount being funded by sponsor equity. - Free Cash Flow Build: The operations are then forecasted over the 5-7 years expected holding period, and a complete 3-statement model is built so that the LBO debt assumptions correctly affect the income statement and cash flow statement.
In getting the proper cash flow forecast, it’s imperative to build a debt schedule that accurately modifies the debt balances and (paydowns)/drawdowns based on the flow of
excess cash or deficits. - Exit Valuation & Returns: Next, the exit assumptions need to be made – most notably around the exit
EV/EBITDA multiple. Based on this assumption and the state of the balance sheet at the presumed exit
date, the internal rate of return (“IRR”) and multiple of money (“MoM”) can be estimated for the sponsor. - Sensitivity Analysis: Lastly, scenarios and sensitivity analysis can be added to provide users with
different ways to look at the model’s output – one common sensitivity is to back into the implied pre-LBO equity value based on explicit sponsor hurdle rates and operating assumptions
How would you measure the credit health of a pre-LBO target company?
The two most common types of credit ratios used are leverage ratios and interest coverage ratios.
- Leverage ratio
- Parameters will depend on the industry and the lending environment
- Total leverage ratio (total debt/EBITDA) in an LBO ranges between 5.0x to 7.0x
- the senior debt ratio (senior debt/EBITDA) around 3.0x. - Interest coverage ratio
- As a general rule of thumb: the higher the interest coverage ratio, the better.
-The interest coverage ratio should be at least 2.0x in the first year post-buyout.
Why is LBO analysis used as a floor valuation when analyzing company value using several
valuation methodologies?
An LBO is called a “floor valuation” because it’s used to determine the maximum purchase
price the PE firm can pay to achieve the fund’s minimum IRR threshold.
If management decides to rollover equity, how would you calculate their new ownership stake and
proceeds received at exit?
First, the management rollover amount would be either a hardcoded input of the contribution amount in dollars or as a percentage of the new equity.
Rollover Equity = Total Equity × Rollover Equity %
The management’s ownership stake in the post-LBO company will be calculated as the rollover equity amount divided by the new equity amount, plus the rollover equity amount.
New Ownership Stake = Rollover Equity Amount /
(Rollover Equity Amount + New Equity)
At exit, the amount of proceeds received by multiplying the exit equity value by the implied ownership by the management team that rolled over their equity. Alternatively, this could be based on a percentage of the excess value creation over the initial equity investment or structured with a liquidation preference in which management doesn’t receive any proceeds unless a returns threshold is met.
Rollover Equity Proceeds = Exit Equity Value × Management Implied Ownership %
How does the accounting treatment of financing fees differ from transaction fees in an LBO?
- Financing Fees:
Financing fees are related to raising debt or issuing equity. These fees are capitalized and amortized over the debt’s maturity (~5-7 years). - Transaction Fees:
Transaction fees refer to the M&A advisory fees paid to investment banks or business brokers, as well as the legal fees paid to lawyers. Unlike financing fees, transaction fees cannot be amortized and are classified as one-time expenses deducted from a company’s retained earnings.
What does it mean when a debt tranche is denoted as 1st lien or 2nd lien?
Lien is defined as the seniority and the priority of payment to a debt holder relative to the other tranches.
A lien is a legal claim against the assets of a borrowing company (i.e., used as collateral) and the right to seize
those assets first in forced liquidation/bankruptcy scenarios.
1st Lien Debt:
The highest seniority, 1st lien, is fully secured by the company’s assets and has the first
claim to collateral in a liquidation/bankruptcy scenario (e.g., revolver, term loans).
2nd Lien Debt: Right below 1st lien loans sits 2nd lien where compensation is provided only if there’s
collateral value remaining once 1st lien lenders are repaid in full. These debt types are riskier and more
expensive for borrowers (e.g., high-yield bonds, mezzanine financing).
Tell me about the different classifications of term loans.
- Term Loan “A”:
TLAs refer to secured loans syndicated to banks and are typically packaged alongside a revolving credit facility. TLAs have shorter terms (~5 years),
carry higher amortization levels than other term loans, and are amortized evenly over their tenor (i.e., “straight-lined”). - Term Loan “B,” “C,” or “D”:
An institutional term loan (B/C/D) is a loan facility syndicated to institutional, non-bank investors such as hedge funds, CLOs, mutual funds, and insurance companies.
These term loans differ from TLAs in having longer terms while requiring no principal amortization before maturity – instead, they involve nominal
amortization with a bullet payment due at maturity. TL B/C/Ds are more prevalent in LBOs than TLAs, as
B/C/Ds have less strict covenants, longer terms, and require less principal amortization each year. The “B,”
“C,” or “D” designation is more indicative of the investor base than the priority rank
How does the coupon on a bond differ from the yield?
The coupon represents the annual interest rate paid based on the notional principal of the bond, while the
yield is the annual return on the bond, including the coupon payment adjusted for the premium or discount of the purchase price when held to maturity.
One difference is coupons are fixed for the bond’s term, whereas yields move with the markets.
What is a callable bond and how does it benefit the issuer or borrower?
A callable bond can be redeemed by the issuer prior to its maturity, with the decision being at the issuer’s
discretion.
A callable bond enables the issuing company to pay off the debt earlier if they have more free cash
flow remaining in the period and can refinance at lower interest rates.
From the investor’s perspective, a callable bond gives more optionality to the issuer, so the debt holders are
compensated with higher interest rates (compared to non-callable bonds).
