Private Equity

Question 1

What is a private equity sponsor (or financial sponsor)?

Answer 1

A private equity fund.

Question 2

What is an LBO and what’s the motivation behind it?

Answer 2

Company is bought with debt as less equity is needed and therefore returns can be higher; improves company operationally etc. and sells it for a profit.

Question 3

In a PE deal would you rather have 50 optimization in WC in year 4 and year 5 or 10 EBITDA improvement in year 5 (exit year)?

Answer 3

Rather have +10 in EBITDA usually; WC improvement increases FCF by 100 but EBITDA increase is multiplied by exit multiple (e.g. +10 * 10x EBITDA = +100) and increases FCF in year 5

Question 4

What makes an ideal LBO Candidate?

Answer 4

• Mature Industry
• Not very cyclical company
• Clean balance sheet with low amount of outstanding debt
• Strong management team
• Low WC requirements and steady cash-flows
• Low future Capex
• Feasible exit options
• Growth opportunities
• Strong market position
• Possibility of selling non-core or underperforming assets

Question 5

How would you build an LBO?

Answer 5

• EBITDA etc. from Business Plan
• Assumptions for Sources & Uses
• Modelling of financing tranches
• Modelling of IS up to NI
• Modelling LFCF
• Assumptions for Exit Multiple
• Calculation of Return

Question 6

What is the biggest problem in an LBO in building a debt schedule for an RCF (revolving credit facility) and how can it be solved?

Answer 6

Problem in calculating RCF is in times of losses, RCF is used but then interest also has to be paid and also changes cash flow again which leads to circular connections. It would be best to model the LBO on a quarterly basis instead of annually to get minimal time lag.

Question 7

How do you get to Entry and Exit Multiples?

Answer 7

Entry multiple from football field or by putting in goal IRR and calculating back to required Entry multiple. Exit multiple is usually assumed equal to Entry multiple because higher exit multiple is very aggressive assumption.

Question 8

Do you need to calculate NOPAT in an LBO?

Answer 8

No, never. It is a theoretical metric that is used in DCF but not in LBO.

Question 9

Do you need all 3 financial statements to model an LBO?

Answer 9

No

Question 10

Can you use LBO to determine today’s company value?

Answer 10

Yes, you need EV at Exit and Net Debt (as well as potential other relevant positions) to get Equity Value. This can then be discounted over planning horizon with LBO typical IRR of 20-30% to get PV of Equity. Assumes that company can’t be valued more than LBO makes of it.

Question 11

If debt is cheaper than Equity, what could be reasons to still finance through Equity?

Answer 11

• Debt becomes increasingly expensive the more you take on
• Equity makes capital structure more stable
• Relatively more equity costs are compensated by lower risk that reduces COE and COD.
• Maximum flexibility

Question 12

How are UFCF and LFCF calculated in an LBO?

Answer 12

EBITDA
- Capex
- WC
- Cash tax payments
\+ Any other non-cash items included in P&L
- Any other cash items not included in P&L
= FCF to Firm (UFCF)
- Interest payments
- Debt amortization
= FCF to Equity (LFCF)

Question 13

What returns do PEs expect?

Answer 13

20-30% (10-15% for Infra etc.)

Question 14

What’s the difference between PE and VC?

Answer 14

PE invests in mature businesses, VC in startups

Question 15

How would you finance an LBO?

Answer 15

As much debt as possible. Bank loan (“senior loan”) with additional second lien or mezzanine capital. Secondly, a HY Bond and third a combination of bonds and loan. Fourth you could combine senior loan, second lien and mezzanine capital into one unitranche loan.

Question 16

What is a dividend recap in an LBO?

Answer 16

Take on additional debt to boost returns and invest further. Other reason would be to get money out of company without selling equity if there is still a high upside on the investment or you just don’t want to sell it.

Question 17

What happens in the financial statements during a dividend recap?

Answer 17

• No changes in IS (possibly transaction costs)
• Liabilities and Cash increase shortly on BS and then decrease again after payout
• CFS reflects this BS effect. CF from financing shows inflow from debt and outflow from dividend
  After that, especially IS is touched. Interest increases, taxes and NI decrease. RE therefore grows at a slower rate. CF from Operations decreases as higher interest has to be paid.

Question 18

What are pros and cons of an LBO?

Answer 18

Pros:

• LBOs are detailed
• Central part of PE Deal
• Good cross-check for DCF and multiples
• Inputs usually available
• Recognizes change in capital structure
• No need for peer group

Cons:

• Needs lots of input parameters
• Volatile if cyclical business model
• Change in capital structure (debt repayment etc.) can be very time intensive
• Sensitive outputs
• Results not always intuitive
• Because of entanglement very time intensive

Question 19

How much debt is usually used in an LBO?

Answer 19

ND/EBITDDA usually between 5-7x depending on cyclicality and business model.

Question 20

What happens in the three statements during a dividend recap?

Answer 20

• Income Statement: Nothing

- Balance Sheet: Debt goes up, equity goes down and cancel each other out

Question 21

Why would a PE do a dividend recap?

Answer 21

To boost returns

Question 22

How does dividend recap affect 3 statements?

Answer 22

• No changes to IS
• BS: debt goes up, equity goes down (cancel each other out)
• CFS: CF from Financing: additional debt raised would cancel out Cash paid out to investors

Question 23

How do you pick purchase and exit multiples?

Answer 23

Using comparables. Sometimes you set purchase and exit multiples based on specific IRR target but this is just for valuation purposes if you’re using an LBO to value a company.

Question 24

PE firm acquires $100m EBITDA company for 10x using 60% debt. EBITDA grows to $150m by Y5 but exit multiple drops to 9x. Company repays $250m debt and generates no extra cash. What’s the IRR?

Answer 24

Entry: $400m equity to buy company
Exit: $1’350 EV (9 * $150). Remaining debt of $350 (600 – 250) will be repaid: $1’000 equity value
Multiple: 2.5x ($1’000 / $400) or 20% IRR (15% IRR = 2x; 25% IRR = 3x)

Question 25

What are the main value drivers in an LBO?

Answer 25

Sorted by largest to smallest driver (usually) - Multiple Expansion: Exit multiple > entry multiple - Leverage - Financials: Revenue, EBITDA, margin improvements

Question 26

You buy a $100 EBITDA business for 10x EBITDA and sell sell it for 10x EBITDA in 5 years. You use 5x Debt/EBITDA and repay 50% over the 5 years. How much does EBITDA need to grow to realize a 20% IRR?

Answer 26

Purch. Price of $1000 ($500 debt; $500 equity); 20% over 5 years corresponds to ~2.5x, so equity needs to grow to $1’250 ($500 * 2.5). Add $250 of remaining debt (after repaying $250) to get to exit EV of $1’500. Assuming 10x multiple EBITDA needs to grow to $150.

Question 27

Could a PE firm earn a 20% IRR if it buys a company for an EV of $1bn and sells it for an EV of $1bn after 5 years?

Answer 27

Yes, cash flows over those 5 years make this possible.

Question 28

How is the FCF in an LBO different from FCF in a DCF?

Answer 28

- LBO determines company’s ability to repay debt, not implied value of entire company - FCF in LBO starts with Net Income, not NOPAT as in DCF - FCF is end point in DCF, in LBO you have to go beyond it like minimum cash requirement, potential other obligations etc. to find out what’s possible to repay

Question 29

If a company has $10m in sales and $5m in EBITDA what is the most appealing option: 20% more units sold, 20% higher prices or 20% fewer expenses?

Answer 29

20% higher prices because it flows through to EBITDA; 20% more units incurs high variable costs; cutting expenses by 20% only increases EBITDA by $1m

Question 30

How do you use LBO to value a company and why is it considered a floor valuation?

Answer 30

You set a target return (e.g. IRR of 25%) and back-solve it to get your financials. Floor valuation because PE almost always pays less than strategist

Question 31

How is the BS adjusted in an LBO?

Answer 31

- Liabilities & Equities side adjusted: New debt is added, and Shareholders’ Equity is wiped out and replaced by contribution of PE - Asset side: Cash adj. for any cash used to finance transaction and Goodwill & Other Intangibles is used as a plug to balance both sides

Question 32

Strategist usually prefers cash payment, why does PE firm use debt in LBO?

Answer 32

- PE doesn’t want to hold company long-term; it’s using leverage to boost return rather than to think about cash as an expense - In LBO, debt is owned by the company, so the portfolio company bears risk; the strategist bears the full risk

Question 33

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

Answer 33

Yes, there are shortcuts, you don’t need full BS but some type of IS and CFS.

Question 34

Which transaction costs does a PE Investor need to consider when planning a transaction?

Answer 34

- Fee for IB that plans transaction - Legal fees - Fees for newly issued debt

Question 35

What is a Secondary LBO?

Answer 35

PE sells to other PE and also considers LBO investment.

Question 36

PE buys company for EV of €100m and pays €5m transaction costs. In 5 years, he sells it for €100m and also pays €5m transaction costs. Has he certainly lost money?

Answer 36

No, you don’t know how much cash it generated during the holding period. Also: dividend recap.

Question 37

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Answer 37

Usually through comparables and see how much debt you can still take on

Question 38

What’s the J-Curve in an LBO?

Answer 38

IRR effect over lifetime. In first few years, return is usually negative because of high transaction, legal etc. fees and Capex investments. These effects start to become profitable usually after first few years so that return is positive from year 3 on in most cases.

Question 39

What are PE Dachfonds?

Answer 39

Don’t invest in companies and don’t do LBOs. They are more like traditional investors that collect money and invest in funds including PE funds. Benefit of diversifying across PE funds but has to pay management fee twice.

Question 40

How much equity is usually used in an LBO?

Answer 40

30-50% measured on EV.

Question 41

How do you find out how much debt you can realistically use in an LBO?

Answer 41

- Compare yours to other LBOs that happened recently and how much debt they used - Ability to carry debt. Interest vs. EBITDA as well as amortization with operating CF.

Question 42

Why does it make sense for a PE to buy a public company and take it private?

Answer 42

- Undervalued - No private company that fulfills investment case - Cost savings for previously public company (less compliance, accounting etc.)

Question 43

What are the cons of a highly leveraged capital structure?

Answer 43

Very high risk of not being able to pay interest if cash flows are cyclical. Additionally, high interest payments leave less for capex and expansion becomes more difficult which could lead to falling margins. For a public company, high leverage could undervalue equity as investors avoid the additional risk which could attract hostile takeovers.

Question 44

What’s the difference between bank debt and HY debt?

Answer 44

- HY tends to have higher interest - HY rates are usually fixed, while bank uses floating - HY has incurrence covenants while banks use maintenance covenants. Incurrence prevents you from doing sth. (e.g. selling the asset), while maintenance require you to maintain sth. (Debt/EBITDA ratio) - Bank debt is usually amortized, whereas HY is paid as bullet at maturity

Question 45

Why would you use bank debt rather than HY?

Answer 45

- Concerned about interest payments or wants lower-cost option - Major Capex investment necessary - Doesn’t want to be restricted by incurrence covenants

Question 46

Why would PE prefer HY debt?

Answer 46

- Wants to refinance at some point - Not too sensitive returns to interest payments - No major expansion or Capex - Less covenants - When interest rates are low and investors look for higher yielding bonds

Question 47

Which financial covenants are usually agreed upon in an LBO?

Answer 47

DSCR (Debt Service Coverage Ratio) Covenant = Operating CF / (Interest + Amortization) ICR (Interest Coverage Ratio) = Adj. EBITDA / Interest Leverage Cov. = ND / Adj. EBITDA Capex Covenant

Question 48

What is Cash Sweep?

Answer 48

Contract with financing bank to use all excess cash to repay debt. They are often used until some metrics are fulfilled etc.

Question 49

How do PE firms boost returns in LBOs?

Answer 49

- Lower purchase price - Higher Exit multiple/price - Higher leverage - Higher growth rate (e.g. acquisitions, etc.) - Higher margins (cutting employees, consolidating, etc.)

Question 50

How would an asset write-up or -down affect an LBO model? How do you adjust the BS?

Answer 50

Very similar to merger model; key differences: - In LBO you assume existing Shareholders’ Equity is wiped out and replaced by equity the PE firm contributes. You also add Pref. Stock, Management Rollover etc. - In LBO you usually add a lot more tranches than in a merger model - In LBO you’re combining two companies’ BS

Question 51

Normally we care about IRR for equity investors in LBO but how do we calculate it for debt investors?

Answer 51

You simply use interest and principal payments as returns.

Question 52

Why might a PE allot some of a company’s new equity in an LBO to a management pool?

Answer 52

For same reason you have Earnouts in M&A: incentivize management. Difference is, there is no technical limit on how much management might receive from this option pool. In the LBO model, you would need to calculate per-share purchase price when PE exits the investment and calculate how much of the proceeds go to management team based on Treasury Stock Method. An option pool would reduce PE firm’s return but this should be offset by incentivized management

Question 53

Why would you use PIK (Payment In Kind) debt rather than other types of debt and how does it affect debt schedules?

Answer 53

PIK does not require cash interest payments. Rather it accrues to the loan principal, therefore it is riskier. To the debt schedule it is similar to HY debt with a bullet maturity. Interest payments are included on the IS but not on CFS because it’s a non-cash expense.

Question 54

What are examples of incurrence and maintenance covenants?

Answer 54

Incurrence: - Cannont take on more than $2b debt - Proceeds from asset sales must be used to repay debt - Cannot spend more than $100m on Capex each year Maintenance: - Debt/EBITDA cannot exceed 3.0x - EBITDA/Interest Expense cannot fall below 3.0x

Question 55

Just like normal M&A deal you can use stock or asset purchase in LBO. Can you also use Section 338(h)(10)?

Answer 55

In most cases no because Section 338(h)(10) requires buyer to be a C corporation. Most PE funds are LLCs or Limited Partnership and for their LBOs they create LLC shell companies.

Question 56

How do you calculate optional repayments on debt in an LBO model?

Answer 56

You are looking at optional repayments in Revolver or Term Loan (HY doesn’t have prepayment option). First you check how much cash flow you have available based on beginning cash, min. cash CF available for debt repayment from CFS and how much you use to make mandatory debt repayments. Then if you’ve used your Revolver, you pay off the maximum amount that you can with the CF available. With the still remaining cash, you can pay off Term Loan A, taking into account that you might have paid off some principal as part of Mandatory Repayments. Then you do the same thing with Term Loan B.

Question 57

Explain how a Revolver is used in an LBO model

Answer 57

You use a Revolver when the cash required for Mandatory Debt Repayments exceeds the cash flow you have available to repay them (Revolver = Max(0, Tot. Mandatory Debt Repayment – Cash Available to Repay Debt))

Question 58

How would you optimize the IS in an LBO model?

Answer 58

- Cost savings: laying off employees, etc. - New Depr. Expense: From any PP&E write-ups - New Amortization Exp.: written up intangibles and form capitalized financing fees - Interest Expense on LBO Debt: Cash and PIK interest - Sponsor Management Fees - Common Stock Dividend - Preferred Stock Dividend

Question 59

In an LBO is it possible for debt investors to get a higher return than the PE firm?

Answer 59

Yes, HY investors get around 10-15% and PE doesn’t necessarily generate high returns after repaying debt etc.

Question 60

Most of the time increased leverage means increased IRR; how could increased leverage reduce IRR?

Answer 60

Very rare but increased leverage could increased interest payments so much that return would decrease. You’d need a combination of: - Lack of CF or EBITDA growth - High interest payments - High purchase multiple to make high IRR even more difficult

Question 61

When you have two companies that are similar but with different valuation multiples, describe what could be the cause of that. (Blackstone)

Answer 61

Recent shocks (won lawsuit against the other), different management teams, first-mover advantage, patent.

Question 62

Which bond is more valuable, the one with only one payment at maturity or the one with periodic payment along the time till maturity? (Blackstone)

Answer 62

If the sum of the (non-discounted) cash-flows is the same, then the bond with periodic payments is more valuable, as the cash-flows that are discounted have a higher weight if they are paid earlier.

Question 63

If you had questions that no one had answers to, how would you handle it? (KKR)

Answer 63

Try to break the question down into smaller problems and then try to solve them (with or without the help of others).

Question 64

If your investment increased 20% and you now have $60 how much did you start with? (Blackstone)

Answer 64

If x * (1 + 20%) = 60 then x = 50

Question 65

If our firm wanted to sell one of our business units, how would you go about valuing that segment? (Blackstone)

Answer 65

Look at how much money we make and how we use synergies of incredibly smart people, strong network and good collaboration to invest in great businesses and collect fees from LPs. Project these generated cash flows by looking at fund investment cycles and see when fees are paid.

Question 66

Would you rather win the lottery today and get $1m lump sum now or earn $2,000 every month for the rest of your life? (KKR)

Answer 66

$2k for 60 years would be PV of (1/0.02 – 1/(0.02 * 1.02^60)) * 2k * 12 = ~840k Take the $1m because it is more and I can invest the money right away.

Question 67

How do we make money? (Blackstone)

Answer 67

By collecting fees from investors that trust us and give us their money to make great investments.

Question 68

When flipping a coin infinitely, is the pattern HHT or HTH more likely to appear? What is the probability that one appears before the other? (Blackstone)

Answer 68

HHT is more likely (2/3 vs. 1/3 for HTH) and more likely to appear earlier. If the sequence starts with T, you can ignore all of the T’s, until you have H’s. Then there are four possibilities (HHH, HHT, HTH, HTT). So you have the first H and afterwards if there is another H, you know that HHT will win, because either you choose the second sequence or the first which will eventually have a T too (e.g. HHHHT). HTH only wins for the third example, so we can ignore number four (HTT). Out of the three possibilities (HHH, HHT, HTH), HHT therefore wins the first two and HTH only the third.

Question 69

What does our business do? (Goldman Sachs Principal Investments)

Answer 69

Invest in great business with the aim of improving them and selling them for more than what we invested.

Question 70

You operate a trucking company that ships supplies between Las Vegas and Los Angles. How would you think about growing revenues? (Bain Capital)

Answer 70

Would have to look closer into the business model but some ideas: Increase fleet size, number of times driving back and forth, hiring more drivers, increasing truck capacity, buy competitors, drive more routes, increase efficiency (never drive empty trucks)…

Question 71

How would you decide on the expansion strategy for a food catering company subsidiary in France, considering the competitive environment (Bain Capital)

Answer 71

M&A (buy competitors), focus on specific segment (organic, high-protein, very high quality), lower prices, make deals with suppliers of current countries etc. 

Question 72

What is ENI (Economic Net Income)?

Answer 72

``` US GAAP requires consolidation of funds and investment vehicles which make operating performance of GP hard to determine. ENI should help with that. It is a pre-tax financial measurement. ENI = Fund-level fee revenue + Total Performance Fees + Total Investment Income + Interest & Other Income - Direct Base Compensation - Performance fee-related compensation (realized and unrealized) - G&A and Other Indirect Expenses - Interest Expense ```

Question 73

What are Distributable Earnings?

Answer 73

``` Similar to ENI but only includes cash-generating portion of the performance and investment related revenues and compensation expenses. It still includes some non-cash expenses (equity compensation from annual employee grants and depreciation). It is a pre-tax metric. Distributable Earnings = Fund-level fee revenue + Realized Performance Fees + Realized Investment Income + Interest & Other Income - Direct Base Compensation - Realized Performance fee-related compensation - G&A and Other Indirect Expenses - Interest Expense ```

Question 74

Let’s do a Paper LBO with the following assumptions: Holding period of 5 years, 22x Entry (10x Debt @3% bullet, 12x Equity), 20x Exit. Revenue is $100m and grows by 10% each year. Flat margins at 40%. 50% tax rate. Capex and D&A are 5% of revenue. WC outflow of 1 each year. What is your MOIC and IRR? (Blackstone)

Answer 74

Exactly 2x/15% IRR (Equity @ Exit is 960; Cum. FCF are 80)

Question 75

Let’s do another Paper LBO. $500m revenue growing at 5% p.a. over 5 years. 20% flat EBITDA margins. Exit 10x, $30m fees today. $500m debt that you can use. You generate $300 in FCF over the 5 years. How much money do you need to put in to get a 15% IRR? (Blackstone)

Answer 75

EBITDA in year 0 is 100, grows to 128 in year 5. Therefore, we have EV of $1280 and Equity of $1’080m (-500 debt +300 cum. FCF). We have to put in $540m of equity in the beginning to get 2x or 15% IRR. Don’t get confused with the $30m of fees. We pay $540m in equity and $500m in debt and have to do everything with it (Sources of $500m debt and $540 equity = $1’040; therefore Purchase Price needs to be $1’010m because we subtract $30m of fees).

Question 76

Follow-up question: If our exit multiple increases by 1x, how much higher will our IRR and MOIC be? (Blackstone)

Answer 76

Remember EBITDA in y5 is $128m, so EV increases by 128, bridge stays the same so equity will @Exit will be higher by 128m. Compaing the 128m to the 540m that we put in, we roughly get 0.25x in additional multiple (2x to 2.25x). We know 2x is 15% IRR and 2.5x is 20% IRR, so we have roughly 17.5%. Therefore, IRR increases by 2.5%.

Question 77

Now we have that additional turn on our exit EBITDA but only want to have 15% IRR. How much more or less equity do we need to put in now? (Blackstone)

Answer 77

Again our bridge stays the same but exit equity is higher because EV is higher. Exit equity is now roughly 1200 (1080 + 128), so applying the 2x multiple (15% IRR) gives us 600 in Equity. Compared to the initial 540, we need to invest 60 more.

Question 78

Assume everything stays the same (esp. in IS). What would happen if we have $50m of lease liabilities in the beginning. Would that mean we can pay more or less equity? (Blackstone)

Answer 78

Since we have $50m in the beginning that would mean they are included in our bridge as well. Usually, these liabilities are projected assuming the same growth as revenue (in our case 5%). After 5 years, we would therefore assume them to be $64m. This means, using our 2x multiple again, that we can put in $18m more in equity at the beginning (50 – 64 /2x) for the same amount of return. This holds true as long as our IRR is larger than the rate at which the liability grows (in our case the 5% revenue growth).

Question 79

You have a company with the following assumptions: $100m revenue (year 0) with 2% revenue growth, 20% EBITDA margin (growing by 1% p.a.). Capex and D&A stay $5m over 5 years. NWC doesn’t change and you don’t have any taxes. You have 10x entry and exit multiples and finance it with 50% debt @5% (bullet repayment). (Blackstone)

Answer 79

Revenue grows to 110 in year 5, EBITDA to 28 (calculate 20%, 21%...,25% of $100 first and then add respective increase in revenues). Subtract D&A and Interest ($5m each) to get to NI of 11, 13, 14, 16, 18. FCF equals NI because D&A = Capex and ∆NWC = 0. Of the $200m EV @ entry, you pay $100m using cash. At the end you have $28m in EBITDA x 10 = EV of 280. You subtract 100 in debt and add the 72 of cum. FCF which results in 252 (2.5x/20% IRR).

Question 80

What would be the unlevered return on the previous question? (Blackstone)

Answer 80

Since we don’t have any taxes, we don’t have any tax shield, which makes the question a lot easier to solve. We put in $200m equity in the beginning. At the end, we still have 280 in EV, subtract no debt but add a higher FCF than before. Before, we added 72, no we add an additional 25 (from 5 years of $5m interest payments). This results in an exit value of $377m. Dividing it by $200m gives us a 1.88x multiple, which is roughly 13% IRR.

Question 81

You have two oil drilling companies A and B. Both have the same P/E ratio and market cap. Company A drills in the Gulf of Mexico, while company B drills in Norway. Now we have an external shock that increases the oil price. Which company should we invest in? (Blackstone)

Answer 81

Since both have the same P/E ratio and market cap, it means that they have to have the same earnings. However, drilling in Norway is more expensive than in the Gulf of Mexico. Therefore, company B must have higher earnings. An increase in oil price would therefore lead to a larger increase in revenues for company B in absolute terms and a stronger increase in Net income. Therefore, we should invest in company B (even though it has lower margins).

Question 82

You have a company with 500 EV, 100 Net Debt on BS, 50 EBITDA, 50 Pension Liabilities and 50 Lease Liabilities. You buy it and can use up to 4x EBITDA of Debt with 5% fees on the debt and 10 in M&A fees. Who do you pay what? (Blackstone)

Answer 82

You want to look at the company on a cash-free/debt-free basis, so you subtract the 100 of net debt and are left with 400. You know that you can use 200 of debt (50 x 4) and have to pay 10 in fees for the debt. You subtract leases and pensions to get to 300 of equity. Your sources therefore consist of 300 purchase price, 50 lease liabilities, 50 pension liabilities, 10 in M&A fees and 10 in bank debt fees. Your sources have to equal 420 too so you use the 200 of debt that you have and 220 of equity.