Leveraged Finance Interview Technical Questions

raising money for companies

leveraged finance divisions of investment banks are still about....

What happens when you sell the asset for 8x EBITDA?

on a firm basis, it has a neutral impact, but it is de-leveraging on a senior debt basis.

How to unlock value

- underperforming outlets can be closed and the real estate sold - industrial companies can be improved with new machinery and tighter supply chains - payrolls can be reduced - debt can be restricted - variety of expenses can be cut through using different vendors or items - new customers / contracts can be pursued - fix may involve disbanding th company, either in part or altogether - focus on core business and sell off other divisions - perhaps there just aren't enough synergies within the company, so the divisions can be sold off to rivals (so long as it generates capital or the potential of higher profit down the road)

Methods of Committing Capital

-Best Efforts/Arranged (make a market in security- don't commit capital- garner a minimum amount of orders) -Back Stopped (place a ceiling on borrowing cost) -Bought Deal (agree to all terms of a bond issue and commit to full amount of funds required)

Facility Fees

-Charged on the entire amount of the credit facility -Calculated on 360 day basis -Payable quarterly in arrears -Usually apply to investment grade borrowers only

Commitment Fee

-Charged on the unused portion -Calculated on 360 day basis -Payable quarterly -Usually apply to non-investment grade borrowers only

Contractual Subordination

-Clearly states subordinated ranking indenture (e.g. senior subordinated, junior subordinated, etc) -Subordinated debt holders expressly agree in the contract to be paid out after senior debt

Effective Subordination

-If two senior note holders rank "pari passu" or equal in right of payment, but only one secured, the unsecured senior note holder is "effectively" subordinated since the secured security holder has first claim to any cash flows in a liquidation of assets -Unsecured creditors are subordinated to secured creditors to the extent of the value of the secured creditor's collateral

Spread/Margin

-Paid on the drawn amount -If the loan includes a facility fee, the drawn spread is the sum of the facility fee and the spread

Best efforts deal

-Structure a transaction and assist the issuer on marketing but if a deal cannot be struck with the market there is no obligation to provide the financing -fees tend to be lower than those paid in a fully underwritten deal because of lack of execution certainty- bears no balance sheet risk (but there is always a reputation risk)

Senior Secured Debt

-Typical bank debt (revolving credit facility, term loans) or vendor debt -May include "second lien" term loans or senior secured notes

Senior Unsecured Notes

-Typical for high yield (and even investment grade) bonds -Equal ranking in capital structure as Senior Secured Debt, but junior in terms of allocation of value -May include cash-pay notes or discount (PIK) notes (as long as "Senior" Discount Notes)

Utilization Fees

-charged to the borrower when the amount drawn exceeds a particular threshold (usually >33%) -the fee is added to the Drawn Spread to arrive at an All-in-Fully Drawn Spread

Redeemable exchangeable PIK preferred stock

-dividends are paid for a set period of time (sometimes until maturity) with additional preferred stock (PIK) -May be mandatory redeemable at maturity or exchangeable into debt, each at the Company's option, before maturity

Discount (zero coupon) note

-issuer receives gross proceeds equal to percentage of the par value of the instrument -instrument accretes to par value over a 5 yr period through additions of unpaid interest expense

Straight cash pay note

-most common high yield debt instrument -issuer receives gross proceeds equal to the face value of the bond assuming the bond is priced at par -cash coupon payments are required, from 6 months after issuance through maturity

What are the ways in which a company can spend available cash / FCF?

1. pay down dent 2. issue dividends 3. buy back stock 4. invest in the business (capex) 5. engage in acquisitions

Mega funds

10 billion or so in assets

Outside top firms

2 billion - 5 billion

7. Synergies and potential for expense reduction

A PE firm looks at a target and thinks how can I improve this company? Reducing expenses is one if the first strategies to be employed. LBOs have been criticized for tactics like aggressive layoffs for the sake of improving efficiency. PE firms work closely with management to find ways to increase profits as quickly as possible. Sometimes, follow-on acquisitions or combinations with existing portfolio companies are made to extract synergies.

Why do PE multiple sand EBITDA multiples yield different valuation results? Why use EBITDA instead of PE?

EBITDA multiples represent the value to all stakeholders, while the PE multiples only represent the value to equity holders. Three reasons to use EBITDA for an LBO are 1. it can be used for firms reporting losses 2. it allows you to compare firms regardless of leverage 3. because it represents operational CF

Senior Subordinated Debt

-(Note: says "Senior" but not included in Senior Debt due to "Subordinated" provision) -Typically unsecured high yield bonds

Convertible Subordinated Notes

Case by case, but typically they are structurally subordinate to most outstanding debt

8. Large amount of tangible assets for loan collateral

More collateral enables lower-interest financing. This lowers interest payments and lowers the amount of cash needed to repay debt. Potential loan collateral includes current assets such as cash and inventory, as well ask long-term assets like PP&E.

Junior Subordinated Debt

This is contractually "junior" and "subordinated"

PE Sale

Fixed up company sold to someone else, generally a larger public or private company. Can be sold to a strategic company (corporation) or to a financial player (another PE firm who will reuse it as an investment opportunity) May opt for a sum of its parts strategy, selling off the company piecemeal - popular when a PE firm purchases a distressed or even bankrupt company that has more than one operating unit. Broken off and sold - competitors likely to pay a premium to buy up market share at the expense of a one-time rival

The terms of a deal

- Both sides can use Wall Street analysts and broader media to bolster or hurt the target's share price - Future of top management at the target firm must be taken into account - Projections of cost savings Advantages of PE: - They can preserve the target company's identity - Not getting swallowed up by a larger rival - Current management gets opportunity to right the ship without the scrutiny that comes from being a publicly traded company - Since dot com bubble, investors increasingly insistent that companies make their numbers. If they miss estimates, the stock is punished - Drive to make their numbers has hampered their ability to make the necessary long-term investments to drive long-term growth of their businesses - Instead they hit their numbers and store up cash on their balance sheets to use for share buyback programs and high dividends to appease public shareholders

OID/Upfront fee

- Payable at closing date -On event driven transactions, upfront fees payable may be made in several installments -Underwritten deal; paid to the lead arranger, which then shares with the syndicate, "skimming" the remainder -Best efforts deal; paid to the syndicate directly by the borrower

Finding cash - where do they get it?

- Reasonably dependable sources of capital for its funds - Major banks, pension funds, hedge funds, and other Wall Street stalwarts -Major universities and charities (endowments generally not used for operational purposes) -Private wealth management organizations sometimes pool the money of some of their high net-worth clients -Managing directors and ownership of the PE firm

Private owner side of a deal

- To have private owner willing to invest for even a 3-5 yer time frame would seem like a vacation - Puts free capital back into the business - Compelling mix, even for the healthiest company - Infusion of capital from PE can bring about big changes in a short amount of time - Private owners can handle the more unpopular chores related to a turnaround, including layoffs and dealign with past creditors - Can help top management save face especially if they were responsible for distressing the company in the first place - Top manager can still leave with rep intact by creating shareholder value for buyout, usually getting a bid with a hefty premium over the current share price

Enacting the deal

- Work together to create a buyout effort - Detailed plan for the company over the life of the buyout firm's involvement - Prove they can bring additional value to the company - Don't want to spell out how exactly they can unlock billions of value -

Underwritten "committed" deal

- entire commitment upfront and seeks to syndicate the credit prior to funding -must provide the funds, even if less than the committed amount is syndicated -Higher upfront underwriting fees reflects risk that the market will not accept the terms and conditions laid out -Acquisition financings are done on a firm committed basis, as asset sellers want to know the financial sponsor or corporation buying the asset will have sufficient funds to consummate the transaction at closing -Purchase agreements typical do not include a "financial out"

Leaving the PE mark

- inefficient processes are tossed out without second thought - activities and supply chains are streamlined - company's workforce is often cut back - new initiatives - some cases, new products - set definitive goals for improvement and lead the company to make these goals a reality - targets set and reached through eh leadership of PE firm's consultants and hand-picked managers - neither the time not he inclination to be sentimental about their new purchases - take time to get the employees to buy into he new program --> leads to more efficient outcome

Considerations when evaluating impact of decision to use debt in the capital structure

1. Achieve highest ROE for existing shareholders 2. Maintaining financial and corporate flexibility 3. Minimizing dilution to existing shareholders and achieving optimal all-in cost of capital 4. Accessing markets in a timely fashion in order to meet funding requirements 5. Maintaining a sound capital structure to ensure future access to capital (RFDAC)

5 Debt Financing Alternatives

1. Bank Debt 2. Investment Grade or High Yield Bonds 3. Mezzanine debt (loans or bonds) 4. Convertible securities (preferred stock or bonds) 5. PIK preferred stock

6 general external sources of capital available

1. Bank Debt 2. Senior Notes 3. Senior Subordinated Notes 4. Convertible Securities 5. Preferred Stock 6. Common Stock

Internal Process

1. Capital Markets Overview -briefing session with capital markets team 2. GCPCCC -10-15 pg memo; approval only for committed financing 3. Credit Committee 40-50pg memo; need approval; meet w/ capital markets 4. Talk sheet/sales force teach-in -10-15 summary on legal size paper, used to sell deal 5.NBFO (revolver only) -approval to commit capital; done by cb and coverage

Committed Financings

1. Commitment letter -10-15 pg letter similar to engagement letter but has additional detail; commits BS to a bank or bond bridge 2. Term sheet -15-20 pg document that attaches as exhibit to commitment letter; sets forth indicative terms by which SunTrust will commit to transaction 3. Fee letter -Done as a separate letter and includes flex terms and fees for committed deal

Three specific ways to increase equity value

1. EBITDA / earnings growth 2. FCF generation / debt paydown 3. Multiple expansion

What are the three ways to create equity value?

1. EBITDA / earnings growth 2. FCF generation / debt pay down 3. Multiple expansion

External Process

1. Engagement letter -required to indemnify against deal liability 2. Confidential Informational Memo -public marketing document with business highlights 3. Private Supplement -brief 10 pg presenting and CIM supp. with projections and related commentary, distributed to private investors 4. Term Sheet -10-15 pg term sheet from lawyers for lenders at launch 5. Investor/ rating agency press -30-40 pg presentation that reviews trans and bus 6. Credit Agreement -Outlines all loan mechanics and covenants; 80-150pgs 7. Security Agreement -sets forth provisions and mechanics of the collateral provided to lenders 8. Other legal docs & opinions

If I handed you an offering memorandum, what are some of the things you'd think about?

1. How would you value the company 2. Is this company a good LBO candidate 3. Understand business - operational points like capex, WC needs, margins, customers, etc 4. Examine industry, growth opportunities, question whether the sponsor or management could capitalize on those opps 5. What would be the appropriate cap structure and is that achievable in current markets? 6. RISKS

Considerations of an LBO

1. Increase risk due to additional leverage 2. Need for return monetization within a certain timeframe 3. More hands-on ownership than what public shareholders exercise

What are some of the due diligence questions that you would ask?

1. Industry questions to determine if it is an industry that the sponsor would want to be in 2. Determine how well positioned the company is within its industry 3. Ask about market rivalry whether the industry is growing, what the company's market share is, what the primary strategy for production competition (brand, quality, price?) is 4. Barriers to entry or economics of scale, supplier /buyer power, threat of substitutes, etc. 5. Company's own operating performance 6. Zero in on growth, what is projected and how much is attributed to growth of the industry versus market share gains. 7. What is the resilience of this company to downturns? 8. What demographies is the revenue focused in and how will these change? 9. Whats the proportion of fixed to variable costs? 10. How well are the assets utilized? 11. Ask about capex, growth versus maintenance 12. Ask how NWC is managed 13. How well do you collet on AR and manage AP? 14. Financials - how much cash is available right now? What are the projected financials? 15. Are there non-core or unprofitable assets or business lines? Is there opportunity for improvement or rationalization? 16. Quality of management - backgrounds? Can we replace? 17. Legal and regulatory risks? 18. What's the exit strategy? Is the industry consolidating so that a sale might be made easier?

Bank Debt- timeline of a transaction

1. Internal process -Approves involvement in the financing 2. Origination/execution process -Deal team secures mandate form client and prepares/positions financing to be marketed to lenders

Advantages of an LBO

1. Opportunity to execute long-term strategy outside of the short-term focus of the public markets (examples - acquisitions, cost reductions, capital investments) 2. Use of levered capital structure to increase equity returns. Debt is tax deductible and private equity firms can put up less equity to purchase a firm. 3. PE firms bring a sense of urgency to the entire business, disciplining the company to quickly seize opportunities. 4. Incentive compensation schemes align management incentives to the sponsors 5. The company gets a stable shareholder base of long-term investors 6. The company now has the capability to leverage PE firm's networks to reach new customers or improve supplier relationships 7. Declined regulatory governance (Sarbanes-Oxley)

Given that there is no multiple expansion and flat EBITDA, how can you still generate a return?

1. Reduce interest expense 2. Improve tax rate 3. Depreciation tax shield 4. Simple act of leverage 5. Pay down debt 6. Pay a dividend 7. Reduce capex 8. Reduce working capital requirements 9. Reduce change in other

What are the potential investment strategies for an LBO fund

1. Sale (to strategic or another financial buyer) 2. IPO 3. Recapitalization (re-leveraging by replacing equity with more debt in order to extract cash from the company)

High Yield Bond Options

1. Straight Cash Pay Note 2. Discount (zero coupon) note 3. Redeemable exchangeable PIK preferred stock

Advantages of LBO financing?

1. as the debt ratio increases, equity portion shrinks to a level where one can acquire a company by only putting up 20-40% of the total purchase price 2. interest payments on debt are tax-deductible 3. by having management investing, the firm guarantees the management team's incentives will be aligned with their own

Let's say you run an LBO analysis and the resulting return is below the required return threshold of your PE firm. What drivers to the model will increase the return?

1. increase leverage 2. reduce purchase price (decrease the amount that the firm has to pay) 3. increase exit sale price or multiple (increases the return on the investment) 4. increase the growth rate (raises operation income/cash flow/EBITDA in the projections) 5. decrease costs (also raise operating income/CF/EBITDA in the projections)

Two options for financing operations and strategic objectives

1. internally generated cash flow 2. external capital provided by third party investors

Structural Subordination

All holding company ("Holdco") debt is subordinated to all operating company ("Opco") securities since Opco debt is at a different entity that is "closer" to the cash generating assets of the issuer

Exit strategy

At some point the PE firm will want to close out the investment and reap the returns 1. Sale 2. IPO 3 . Recapitalization

What is the difference between bank loan and high-yield debt covenants?

Bank loans are more strict. For looser covenants, high-yield debt is rewarded with higher interest rates. Covenants can restrict economic activities, finance activities or accounting measurements. Economic activities restricted would include the sale of assets, capex, changes in corporate structure. Finance activities restricted could include issuance of additional debt and payment of cash dividends. Covenants often tracks accounting measurements such as interest coverage, current ratios, minimum EBITDA.

LBO investment criteria

Companies that are able to service the large amount of debt and or are improved to create more value at the time of exit. Target IRRS of 20-30% 1. Steady and predictable cash flow 2. Clean balance sheet and little debt 3. Defensible/strong market conditions 4. Strong management team 5. Minimal future capital requirements 6. Limited working capital requirements 7. Synergies and potential for expense reductions 8. Large amount of tangible assets for loan collateral 9. Digestible assets 10. Viable exit strategy

What do private equity firms do?

Create funds and finance them, find potential investments, line up additional financing, make the deal, fix up the company and determine the exit strategy.

If you have a company with a P/E multiple of 10x and cost of debt at 5%, which is cheaper for an acquisition?

Debt. the cost of equity is approximately the inverse of P/E so 1/10 = 10%. The cost of debt is 5 which is lower and therefore chapter.

A company runs two operational subsidiaries. One sells coffee and one sells donuts. You won 100% of the coffee and 80% of the donut. The coffee sub generates 100 million of EBITDA. The donut sub generates 200 million of EBITDA> donut companies are worth 5x EBITDA. The parent share price is 10 and there are 100 mm shares. The company has cash of debt of 500 million and cash of 200. What's the EV / EBITDA of this company?

EV = market cap + net debt + minority interests Market cap - 10*100mm = 1,000 million. Net debt = Debt less cash = 500-200 = 300 mm. Minority interest in donut co = 5.0x *2 * (1-80%) = 200 mm. You could take minority interest from BS. However, a finance professional always chooses market value over book value. EV = 1000 + 300 + 200. Total EBITDA is 100+200. Therefore EV/EBITDA = 1500/300 = 5x.

Assume the following - EBITDA of 10, FCF of 15, Entry/exit multiples of 5x. Leverage 3x. At time of exit, 50% of debt is paid down. Generate 3x return. 20% of options are given to management. At what price must you sell?

Entry = 10*5 = 50 3x leverage = 30 Equity at entry = 50 - 30 = 20 To get 3x return equity must be = 20*3 = 60 at exit. Pay down 50% of debt = 15 must be paid down 15 exists at exit 20% of equity given to management = 60/x = 80/100 = 6000/80 = 75 equity value. 75+15 = 90 at exit.

All together - buy a company for 100 million with 40 / 60 D / E and a 10x EB / EBITDA. So EBITDA = 10 million. Sponsor puts in 40 million. Five years later you double that to 20 million in EBITDA and pay down 10 million of debt and sell it at 11.0x.

Exit price = 220 million or 11.0*20 million. You're left with debt of 50 million = 60 million - 10 million Now you have an ending equity value of 170mm (220 million - 50 million) which is 4.25x greater than the original investment of 40 million. Benefited from a ll three types of strategies. IRR of 34%.

Finding the diamond in the rough

Explore companies through they public filings and Wall Street analysts' research and go to them indecently with the potential of a takeover. Perhaps they didn't see the potential for the kinds of major improvements a private equity firm propose. Sometimes a company is the perfect adjust to another of the private equity firm's portfolio companies, and the firm seeks to create a private merger between the two, which would boost the value of both once they're rolle out into the market. Occasionally a PE firm will spot opportunity in a previously announced deal between two public companies of an LBO by a competitor. Creating value is the whole idea. PE firm's demonstrated expertise must fit well with the target company's opportunities.

Finding the right investments

Find appropriate investments Takes between weeks and years Funds resources are generally put into relatively safe investments in the mean time (high grade corporate bonds, blue-chip equities or Treasuries) Investors need to be reassured that the fund can put their capital into action as efficiently as possible PE firms depend on the major investment banks for basic research and then go though daily reports with a fine-toothed comb for signs of possible investment Some potential targets are easy to spot - the companies that put themselves up for sale, will attract interest, though there are by no means certain. Also companies that privately court private equity bidders. Generally these contacts aren't made via press release, but are done quietly with the head ofM&A an major Wall Street firm making a call to a private equity firm's managing director.

PE IPO

Hires investment bank to underwrite the offering IB does an assessment of what it thinks the enterprise is now worth (ideally more than what the bought it for) Come to a consensus value Give institutional investors and Wall Street analysts a road show (advertising how it has improve and what it's worth now, what it will be worth of years to come) Generally, PE firm will retain large chunks of equity int he company, floating anywhere from 20-90% of the stock not eh open market. The proceeds of the IPO usually go to the private equity firms. Sometimes only float minority of the outstanding shares, leaving them with effective control of the company. May unwind its position over time though. May hold stake to see how much it appreciates, however, budding even more value for its own stakeholders. PE firms partial to IPOs because they bring about returns in several stages. When the firm releases stock to the public, it receives the returns. It then gets to see its remaining stake appreciate, and can participate in dividend and stock buyback programs as well.

Preferred Stock

If convertible, in-the-money convertible preferred more likely to be viewed as equity

Temporal Subordination

If subordinated debt matures before more senior debt, the more senior debt is considered to be "temporally" subordinated since cash will leave the issuer to pay the subordinated debt holders before the more senior debt holders

Two investment opps - company A and company B. Which is a better opportunity? Assumes everything is the same except for the given information. Exit multiple is the same as entrance multiple. Company A - Revenue: 100, EBITDA 20, Annual revenue growth: 5% for next five years, Purchase price: 5x EBITDA/4x debt and 1x equity Company B - Revenue: 100, EBITDA 20, Projected annual revenue growth: 10% over next five years, Purchase price: 6x EBITDA / 4x debt and 2x equtiy

Ignoring compound growth - EBITDA for company A in year 5 will be about 25 million. (20 * (1+ (5%*5) EBITDA for company B in year 5 = 30 million. (20 *(1+10%*5). You purchased A for 100 million (20 *5) and B for 120 (20+6x), You sold Company A for about 125 (25 *5) and B for 180 (30*6). This creates a profit of 25 million and 60 million respectively. You invested 20 million of equity in A so your return is 1.25x (25/20). Company B = 1.5x (60/40). Thus you know B is ab better investment. Also the higher EBITDA will increase the amount of debt being paid down, which increases the equity return more.

1. Steady and predictable cash flow

Interest payments on debt come due at predetermined dates - the target's cash flow needs to match so it can pay the bills. Steady and predictable cash flows allows more debt to be raised.

3. Defensible / strong market positions

Investors need to be assured that the acquired company will make money. The LBO target needs to be in a position where it can generate large profits. A market position that is guarded by high barriers to entry makes a more attractive LBO candidate because it owes the risk of cash flows.

You have a company with 3x senior leverage and 5x junior leverage, what happens when you sell a business of 9x EBITDA?

It's a de-leveraging transaction because the pro forma company will have a lower total debt / EBITDA ratio.

Given 100 million initial equity investment, five years, IRR of 25% whats the exit EBITDA if sold at a 15x multiple?

Knowing IRR of 25% is approximately 3x equity return, the ending equity value is therefore 300 million (3x *100_, so the exit EBITDA must be 300/15x = 20 million.

Which valuation will be higher or lower all else the same? DCF or LBO?

LBO is lower as it's discounted at a higher cost of equity

2. FCF generation / debt paydown

LBO theory premised on the large amount of debt used to acquire targets. Using the company's cash flows to pay down the debt increases the equity that goes back to the sponsor. FCF available to pay down debt is basically after tax EBIT plus D&A, less, capex, less increase in NWC, less interest. PE firms use as much of this CFC as possible to pay down debt. They will also aim to increase FCF if possible, such as the previous strategy of increasing EBITDA / earnings as well as decreasing capex and working capital needs.

high yield bonds and leveraged loans

LevFin's most common products....

Getting financing

Major deals are far greater in value than the total value of a typical private equity fund Putting the leverage back in a leveraged buyout... - Rare that a PE firm will simply buy a company outright with its own money - Evne the biggest PE funds could only manage to buy accompany on the small end of the large cap sale - It's never wise to put all your money in a single investment - PE firms raise seed money essentially - To get the rest, PE firms enlist bank and hedge funds

Creating a fund

Multiple funds running at the same time - some are specialized in distressed debt or venture capital. Firm has to find cash

Why invest in PE?

Operate much like a mutual fund in that each participate or entity receives a return on its investment commensurate with the performance of the fund PE requires major commitments of time for each investment - you can't your money back of anywhere from three to five years for starts PE fund won't be able to execute on its strategy without assurance that the money will be there May be regular payouts to its investors, but in most cases, investors may have to wait the full term before getting their returns. It's because of this wait, in part, that private equity investors start levering up their new acquisitions almost immediately upon purchase. Yes, some of the capital is used to expand the business and make the changes that will bring about greater profits - but some is used simply to give investors a chunk of their money back shortly after the investment is made.

Working with hedge funds

PE firms have increasingly paired with hedge funds, essentially coming together with pools of private capital to buy out a company. The hedge fund, instead of getting a fixed amount for its investment, will often go along for the ride, hoping for the same outsized returns the private equity investors will get.

Loans for PE

Plenty of options --- 1. Simple bank loan - PE firm promises to repay the bank the money borrowed with a certain amount of interest. Generally backed by either the private equity firm's own resources or more likely the value of the enterprise to be purchased. In theory, if they defaulted, bank could go after the purchased company. In reality, doesn't usually happen, the two sides iron out a solution which can involve the bank pouring even more money into the target company. 2. In many other cases, the PE firm will float a corporate bond, based on the perceived value of the enterprise to be purchased. Recently, PE firms have sought to ever up their new companies as much as possible. That's not simply because they want as much capital as they can get to expand the companies. At least some of that leverage goes back to the private equity fund as a "special dividend" for the people who just bought the company. Much of that new debt stay's on the target company's books through the private takeover period and on through the exit strategy.

4. Strong management team

Private equity firms aren the business of finance, not operations. While many firms employ consultants an operation specialists, most PE firms rely not eh management of the company to actually execute the company improvements. Significant due diligence is spent interviewing the management team, who provides insights on where value can be extracted and how realistic projects are. PE firms will change management if they feel the current team cannot perform. To align management incentives with their own, PE firms often incorporate options as part of pay so that management shares in the equity upside.

9. Digestible assets

Provide the acquirers with extra means to raise cash to pay off debt. Such assets can include equipment, land, brands, etc.

1. EBITDA / earnings growth

Purchase and exit price is based on the company's earning prospect. You'll more often see the price quoted as a multiple of EBITDA, so EV/EBITDA> Multiples vary by industry. Expect higher multiples with higher growth industries. Therefore, if you buy in at 6.0x EB/EBITDA and exit at the same multiple, you can realize a return by increasing the denominator, EBITDA, so that the numerator increases. As long as the relative a mount of debt is not higher at exit, then the equity portion of that numerator, equity value, will increase. EBITDA can be increased by any of the line items, like increasing sales, improving gross margins, lowering operating costs, etc.

Recapitalization

Refinances the cap structure so that the private equity firm is leveraging to replace equity with more debt Extracts cash from the company Route is used if an immediate exit strategy is not the opportune at the time

Sarbanes Oxley requirements

Requires reporting companies to -conduct quarterly evals of changes that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting -include in the form 10k, a statement from management regarding the effectiveness of internal controls over financial reporting and the independent auditors attestations report on management assessment The CEO and CFO must certify -The referenced report does not include any untrue statement of a material fact or omit to a material fact necessary to make the statement not misleading -financial statements fairly present the financial condition, results of operations and cad flows of the Company for periods reported -Such officer is responsible for establishing and maintaining disclosure controls and procedures and internal controls over financial reporting -Such officer has evaluated the effectiveness of all disclosure controls and procedures The CEO, CFO, and BOD may be subject to liability for violations of requirements

10. Viable exit strategy

Return only occurs if it's realized, through a sale, IPO, or recapitalization. When determining the purchase price of an acquisition, the PE firm needs to think about how the exit multiple will compare to the entrance multiple. At minimum, they would like it to be the same, and at best, they would like it to be higher Funds usually exit after 3-5 years.

3 principal tranches included in bank financing

Revolver Term Loan A Term Loan B, C

6. Limited working capital requirements

Same as capex - increases in working capital decreases the FCF available to pay down debt and benefit the equity holder

3. Multiple expansion

Selling a company for more than you bought it is always desirable. Again since prices are usually quoted as a multiple of EBITDA, this strategy is described as multiple expansion. Multiples can change based on market conditions, like the boom periods, which saw historically high multiples, while exiting this year (2009) may see multiple contractions. Note that the previous strategies of operational improvements can sync to multiple expansion as multiples are linked to growth prospects and operating performance

Bank Debt

Senior secured term loan or revolving credit facility with floating payments

2. Clean balance sheet with little debt

Significant pre-exisitn obligations to other debt holders will make new layers of debt from the buyout fund riskier to pay off. A cleaner balance sheet allows cash to go towards the new debt of an LBO. little debt combined with a heavy asset base will yield a higher credit rating, which lowers the interest rate not he new debt.

In an LBO if cost of debt is 10%, what is the minimum return required to breakeven?

Since interest is tax deductible, the breakeven return is the after-tax cost of debt. Assuming a tax rate of 40%, the breakeven return is 6%.

Walk me through sources and uses

Sources contain the variable tranches of cap structure: 1. Bank debt 2. Junior subordinated notes 3. Convertible preferred 4. Hybrids 5. Sponsor equity 6. Cash belonging to the target 7. Proceeds from options exercised at the target are a source Sues 1. Purchase of the company (assets or shares) 2. Purchase of target's options 3. Refinancing debt 4. Transaction costs (banker and lawyer fees)

5. Minimal future capital requirements

Sponsors prefer not to make future, large cash outlays to keep the company running and growing. They would rather use every bit of cash to pay off debt.

Some characteristics of a company that is a good LBO candidate

Steady cash flows, strong management, opportunities for earnings growth or cost reductions, high asset base (for collateral to raise more debt), low business risk, and low need for ongoing investments (capex and working capital) MOST IMPROTANT - steady cash flows

Once a deal is announced

Target's management gets to enjoy the subsequent boost in share price From there final negations take place, PE firm gets a complete accounting of the company's operations and financial health, and the final details on layoffs, compensation, operational adjustments and finance are all ironed out.

What determined your split between bonds and bank in the deal? If there is a higher growth capex portion of total capex, would you want the same split?

Typically, you'd like as much bank debt as possible because it's cheaper than regular bonds. However, this mostly depends on how much a bank is willing to loan. Next, the sponsor and debt holders have to negotiate the agreements / covenants they can live with. The more senior the debt, like the bank debt, the more restrictive it tends to be. Bank debt also usually requires collateral to be pledged. Finally, the timeline of debt payback needs to be evaluated. Bank deb usually has a shorter maturity so the bank needs to ensure that the company will be able to face its liabilities when due or else face bankruptcy. Growth capex is more favorable than maintenance capex. It's flexible. Maintenance capex needs to be paid every year just to keep the company running, whereas growth capex can be stalled in times of downturn. Also, growth capex implies investments, which yield higher cash flows in the future, that can be used to support more debt.

High Yield Debt

Unsecured senior or senior-subordinated notes paying a fixed rate cash coupon with bullet redemption at par

Why do private equity firm sure leverage when buying a company?

Using more debt to finance the purchase of a company allows the PE firm to use less of their money (equity) to pay for the deal. If the investment is successful, the higher th leverage, the higher the return when exiting the investment.

Would you rather have an extra dollar of debt pay down or an extra dollar of EBITDA?

You would rather have the extra dollar of EBTIDA because of the multiplier effect. At exit, the EV is dependent on the EBITDA times the exit multiple. An extra dollar of debt pay down increases your equity value by only one dollar; an extra dollar of EBITDA is multiples by the exit multiple, which results in greater value creation.

leveraged loans

a loan given to companies that already have a lot of debt