LBO

How could a private equity firm boost its return in an LBO?

1. Reduce the Purchase Price. 2. Increase the Exit Multiple and Exit Price. 3. Increase the Leverage (debt) used. 4. Increase the company's growth rate (organically or via acquisitions). 5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.). These are all "theoretical"

Give me an example of a "real-life" LBO.

"Buying a house that you rent out to other people: Down Payment: Investor Equity in an LBO Mortgage: Debt in an LBO Mortgage Interest Payments: Debt Interest in an LBO Mortgage Repayments: Debt Principal Repayments in an LBO Rental Income from Tenants: Cash Flow to Pay Interest and Repay Debt in an LBO Selling the House: Selling the Company or Taking It Public in an LBO

A strategic acquirer usually prefers to pay for another company with 100% cash - if that's the case, why would a PE firm want to use debt in an LBO?

It's a different scenario because: 1. The PE firm does not hold the company for the long-term - it sells it after a few years, so it is less concerned with the higher "expense" of debt over cash and is more concerned about using leverage to boost its returns by reducing the capital it contributes upfront. 2. In an LBO, the company is responsible for repaying the debt, so the company assumes much of the risk. Whereas in a strategic acquisition, the buyer "owns" the debt, so it is more risky for them.

What variables impact a leveraged buyout the most?

Purchase and exit multiples (and therefore purchase and exit prices) have the greatest impact, followed by the amount of leverage (debt) used. A lower purchase price equals a higher return, whereas a higher exit price results in a higher return; generally, more leverage also results in higher returns (as long as the company can still meet its debt obligations). (revenue growth,ebidta growth factors are involved too less important)

Wait a minute, how is an LBO valuation different from a DCF valuation? Don't they both value the company based on its cash flows?

The difference is that in a DCF you're saying, "What could this company be worth, based on the present value of its near-future and far-future cash flows?" But in an LBO you're saying, "What can we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?" So both methodologies are similar, but with the LBO valuation you're constraining the values based on the returns you're targeting.

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?

You use it to value a company by setting a targeted IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR. This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than strategic acquirers would.

Walk me through a basic LBO model.

"In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you might also assume something about the company's operations, such as Revenue Growth or Margins, depending on how much information you have. Step 2 is to create a Sources & Uses section, which shows how the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required. Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, allocate the purchase price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance. In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments. Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm."

Bank Debt vs. High Yield Debt

-high yield debt tends to have higher interest rates than bank debt -high yield debt interest rates are usually fixed, whereas bank debt interest rates on floating...they change based on fed interest rate -high yield debt has incurrence covenants(prevent you from doing something such as buying factory) while bank debt has maintenance covenants which require you to maintain a minimal financial performance. -bank debt is usually amortized-principal must be paid off over time whereas high yield debt entire principal is due at the end (bullet)

Why would a private equity firm buy a company in a "risky" industry, such as technology?

Although technology is "riskier" than other markets, remember that there are mature, cash flow-stable companies in almost every industry. There are PE firms that specialize in very specific goals, such as: Industry Consolidation - Buying competitors in a market and combining them to increase efficiency and win more customers. Turnarounds - Taking struggling companies and improving their operations. Divestitures - Selling off divisions of a company or turning a division into a strong stand-alone entity. So even if a company isn't doing well or even if it seems risky, the PE firm might buy it if it falls into one of the categories that the firm focuses on. This whole issue of "risk" is more applicable in industries where companies truly have unstable cash flows - anything based on commodities, such as oil, gas, and mining, for example.

Changes That Reduce IRR:

Higher Purchase Price, More Equity, Lower Revenue Growth, Lower EBITDA Margins, Higher Interest Rates, Higher CapEx

What is an "ideal" candidate for an LBO?

Ideal candidates should: Have stable and predictable cash flows (so they can repay debt); Be undervalued relative to peers in the industry (lower purchase price); Not have much need for ongoing investments such as CapEx; Have an opportunity to cut costs and increase margins; Have a strong management team; Have a solid base of assets to use as collateral for debt. The first point about stable cash flows is the most important one.

Why use high yield debt vs bank debt

If the PE firm intends to refinance the company at some point or they don't believe their returns are too sensitive to interest payments they might use high yield debt. They might also use the high yield option if they don't have plans for major expansion or selling off the company assets.

Why might you use bank debt vs. high yield debt

If the PE firm or the company is concerned about meeting interest payments and wants a lower cost option they may use bank debt. they also may use bank debt if they are planning on major expansion or capital expenditures and don't want to be restricted by incurrence covenants.

What is a dividend Recap and why is it used?

In a divident recap, the company takes on new debt solely to pay a special divident to the pe firm that bought it. It does this primarily to boost returns because all else equal, more leverage means a higher return. In a recap, the pe firm is recovering some of its equity investment in the company .

What is a leveraged buyout, and why does it work?

In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of debt and equity (cash), operates it for several years, possibly makes operational improvements, and then sells the company at the end of the period to realize a return on investment. During the period of ownership, the PE firm uses the company's cash flows to pay interest expense from the debt and to pay off debt principal. An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons: 1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns. 2. Using the company's cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows. 3. The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to acquire it in the first place.

Tell me about the different types of debt you could use in an LBO.

Look at Chart on Desktop

Changes That Increase IRR

Lower Purchase Price, Less Equity, Higher Revenue Growth, Higher EBITDA Margins, Lower Interest Rates, Lower CapEx

How would divident recap impact 3 financial statements

No changes to income statement. Balance sheet debt would go up and shareholders equity would increase and they would cancel eachother out to remain in balance. On cash from statement there would be no changes anywhere except for financing, where the addtional debt raised would cancel out the cash paid to investors so net cash is unchanged.

How do you pick purchase multiples and exit multiples in an LBO model?

The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have been completed at. As always, you show a range of purchase and exit multiples using sensitivity tables. Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but this is just for valuation purposes if you're using an LBO model to value the company.

Why do PE firms use leverage when buying a company?

They use leverage to increase their returns. Any debt raised for an LBO is not "your money" - so if you're paying $5 billion for a company, it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from other people than it is on $5 billion of your own money. A secondary benefit is that the firm also has more capital available to purchase other companies because they've used debt rather than their own funds.