LBO

Why might you recommend AGAINST a deal even if the IRRs and MoM multiples are favorable in the Downside, Base, and Upside cases? "

Issue with the INDUSTRY. Lack of good exit strategies Credit market won't support the deal No buyer in the future, hard to exit at good returns"

How do you use an LBO model to value a company, and why does it set the "floor valuation" for the company? "

LBO model is used to value a company at a set IRR, e.g. 25% and then using Goal Seek in Excel to determine the purchase price that the PE firm could pay to achieve that IRR e.g. For example, if the exit multiple is 11x, which translates into $1,000 in Equity Proceeds for the PE firm, Goal Seek in Excel might tell you that the firm could pay $328 in Investor Equity to achieve a 25% IRR over 5 years. At a 50% Debt / Equity split, that translates into a Purchase Enterprise Value of $656. Floor valuation because it shows MAXIMUM amount a PE firm would pay to realize the IRR"

How is a leveraged buyout different from a normal M&A deal? "

LBO: company will be sold after 3-5 years to realize IRR & MoM multiple PE firm can only use Debt and Equity (cash) to fund deals, whereas M&A can use cash, debt, stock LBO does NOT care about synergies and EPS accretion/dilution "

IRR calculation "

(Exit proceed/investor equity)^(1/# years) -1 Quick approximation to calc IRR: - to double money: take 100%/ # years * ~75% - to triple money: take 200%/# years * ~65% If get scenario like Dividend recap or IPO exit, Average # years for PE to receive the Equity Proceeds: e.g. go public in Yr 4, takes PE firm 3 years to sell entire stake, equity proceed will arrive on average in Yr 5"

Approximation shortcut for IRR in LBO "

- to double money: take 100%/ # years * ~75% - to triple money: take 200%/# years * ~65% Double in 3 years = 25% IRR Double in 5 years = 15% IRR Triple in 3 years = 45% IRR ~44% Triple in 5 years = 25% IRR ~26%"

Why do PE firms use leverage when buying companies? "

1. Amplify return (not increase) 2. More capital available to buy other companies since it will not use up all the funds for acquiring one company"

How might a PE firm reduce its downside risk if a leveraged buyout does not perform well? "

1. Avoid acquiring companies trading at relatively high multiples and to focus on companies that are undervalued in some way 2. Use more Debt to boost return, acquiring smaller stake helps in extreme Downside where IRR turns negative 3. Company with Tangible Asset - could be sold off, non-core that could be sold off to reduce risk 4. Improve operation to reduce risk - change/ push management to cut underperforming division/ cut cost"

How would you present an investment recommendation on a potential LBO candidate? "

1. Clear yes or no recommendation, stating 3-4 main reasons what support decision 2. Qualitative market factors and numbers that support -> summary output from LBO model, demonstrate it works even in the Downside cases 3. Address risk factors, why I might be wrong, how to mitigate 4. Restating recommendation and support"

Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause controversy? "

1. Company could use cash to reduce purchase price for PE firm 2. Increase ownership stake of existing investors who choose to roll over their shares, since excess cash reduces the investor equity that PE firm needs to contribute" "

Can you walk me through how you might make an investment decision based on the output from an LBO model? "

1. Determine investment criteria: e.g. Aiming for 20% IRR and 2.5-3X MoM in the base case, 1.5X min in Downside in x years 2. Build projections and look at LBO model output in the Base case 3. If the number doesn't work out -> No. If yes, build the Downside case to test everything else 4. If seems to easy to lose money in Downside case -> No, but the worst case multiple is above 1X, may still work 5. Make decision and back it up with qualitative criteria (whether or not it works)"

How would you review a Confidential Information Memorandum (CIM) or other marketing materials and decide whether to pursue an acquisition of a company? "

1. Exec summary for industry, size, possible valuation 2. Historical and projected financial statement to see LBO math if it works. If possible to earn 20% IRR 3. Market, industry overview -> industry growth rates, competitors, company vs. competitors 4. Read the whole thing, management team, customer and suppliers, product & services"

What makes an industry more appealing or less appealing to invest in? "

1. Growing + fragmented, target co is clear leader, can make more acq 2. High barrier to entry (if the market is less fragmented) Clear no: highly consolidated, in decline, highly speculative (astroid mining), high technological change and low barrier to entry -> make cash flow unstable"

What are the main differences in an IPO Exit vs. an M&A Exit? "

1. IPO exit, the PE firm cannot sell its entire stake at once. Instead, it sells a much smaller percentage, such as 20-30%, in the initial deal, and then sells the rest of its shares over time. 2. IPOs also tend to be priced based on forward P / E multiples rather than trailing EV / EBITDA multiples, which could be better or worse depending on the company. 3. It's arguably easier to earn a higher IRR in an M&A exit; a firm might achieve a similar MoM multiple in an IPO exit, but the IRR might be very different depending on the timing."

What are the different exit strategies available to a private equity firm in a leveraged buyout, and what are the advantages and disadvantages of each one? "

1. M&A, sell to another company/ PE firm, clean break 2. IPO, sells off shares gradually overtime - take longer time to sell, more risk if company share price drops; can't sell all at once or it will send negative signal to investors. 3. Dividend Recap - company issue Dividends to PE or take additional Debt to issue Dividends, PE firm earns the deal proceeds gradually over time - hard to earn acceptable IRR (only option if M&A and IPO markets are underdeveloped, or has legal/PR issue preventing it from M&A and IPO)"

Walk me through a basic LBO model. "

1. Make assumptions for purchase price, debt and equity, interest rate on debt, other variables e.g. revenue growth and margins 2. Create Source & Uses schedule to show exactly much the PE firm contributes in investor equity 3. Create Purchase Price Allocation schedule to calc. goodwill 4. Project IS, BS and CF, determine how much Debt repays each year based on FCF 5. Make assumptions about EXIT, assuming and EBITDA Exit Multiple, calc IRR and Money-on-money multiple (RoR) based on proceeds the PE firm earns at the end"

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

1. Multiple expansion (reduce purchase multiple, increase exit multiple) 2. EBITDA growth - revenue and margin growth, cost cutting 3. Debt paydown and cash generation (increase leverage (Debt), increase cash by cutting Capex and WC requirement) 4. Have control - easiest way is to use more debt "

How do you project Free Cash Flow and Cash Flow Available for Debt Repayment in an LBO model? "

1. Net Income + D&A +/- CiWC - CapEx to determine FCF in LBO (never add back stock-based compensation - create additional share, dilute PE's ownership, easier to calc as cash expense) (maybe factor in deferred tax, but will not make huge difference) 2. CF available for debt repayment similar to FCF but ++ company's beginning cash balance and -- Minimum cash balance and other obligations (e.g. repayment of assumed debt)"

Why might a PE firm have to use an IPO rather than an M&A deal to exit an LBO? "

1. No buyer interested/ willing to pay the price the PE is seeking 2. Too big to be sold (biggest player) 3. Industry stagnant or declining"

Can you explain the legal structure behind a leveraged buyout and how it benefits the private equity firm? "

1. PE firm forms a holding company to acquire another company. 2. Bank and lenders provide debt to this holiding company so that the debt is at HoldCo. level 3. So that PE firm is NOT on the book for the debt it uses for the deal, the Target Co. accountable to repay it"

How is the "Free Cash Flow" in an LBO model different from the FCF in a DCF? "

1. Purpose: LBO is to gauge capability of company to repay debt, not implied value of company 2. Based on Net income: LBO FCF starts with Net Income, not NOPAT, so it includes Net Interest Expense; but this is not a LFCF (LFCF have both Net interest expense and debt principal, not LBO FCF which only has Net interest expense) 3. FCF is not the end point, it adds beginning cash balance, minus min cash and other obligations"

Since an LBO is based on Free Cash Flow, why do you focus on EBITDA and EV / EBITDA in the assumptions? "

1. Quick and reasonable approximation of Cash Flow from Operation. 2. Can use even if company has negative Net Income (due to high interest expense for example) EV/EBITDA is stable over time vs. EqV-based multiples (e.g. P/E, EqV/FCF) that change as company repays debt; If use EqV-based multiples, need to adj exit multiple rather than starting out at a figure close to purchase multiple"

How can you determine how much Debt a PE firm might use in an LBO and how many tranches there would be? "

1. Recent similar LBO and use MEDIAN Debt/EBITDA levels as ref 2. Look at highly leveraged public co. to check their Debt/EBITDA lvl 3. Test assumptions by projecting co's leverage (Debt/EBITDA) and coverage (EBITDA/Interest) ratios over time If it hold up well (>2X), stick with the numbers, otherwise adjust"

Can you describe the different types of Debt a PE firm might use in a leveraged buyout, and why it might use them? "

1. Secured Debt - term loans, revolvers, backed by collateral, tend to have lower, floating interest rate, may have amort, uses maintenance covenants e.g. restriction on company's EBITDA, Debt/EBITDA, EBITDA/Interest Early repayment allowed, short maturity, investors tend to be banks 2. Unsecured Debt - Senior Notes, Subordinate Notes, Mezzanine, not backed by collateral; higher and fixed interest rate, no amort, uses incurrence convenants (e.g. company cannot sell asset over $x). Early repayment not allowed, maturity longer, investors tend to be hedge funds, merchant banks, mezzanine banks"

What's the true purchase price in a leveraged buyout? "

1. Start with Equity Purchase Price - cost of acquiring all the company common shares 2. Create a Source and Uses schedule to calc true price depending on the treament of cash, debt, transaction fees and equity rollovers If Debt is assumed (new debt replace old) - no effect on purchase price. If repays debt with investor equity or combo of debt + investor equity, increase effective price Use excess cash to fund deal reduces true price, as do Equity rollovers True price is NOT EXACTLY Purchase Entreprise Value because of the factors above"

Can you explain how to adjust the Balance Sheet in an LBO model? "

1. Unlike M&A model - DON'T COMBINE the Seller's BS with Buyer's BS because Buyer is a shell company 2. Write down company's Shareholder's equity and replace with Investor's equity, create goodwill and other intangible assets, adjust deferred tax-related item 3. Add new debt and adjust debt on L&E side of BS, adj cash on Asset for deal funding and transaction fee, write up or down Asset Values 4. Deduct one-time Transaction fees from Retaining Earnings and Financing fee from the book value of new Debt issued"

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? "

1. plan to sell after a few years, less concern with expense of Debt but concern with using Debt to amplify its return by reducing capital it contributes upfront 2. company acquired responsible for repaying debt - less risk on PE firm "

A private equity firm acquires a $200 EBITDA company for an 8x EBITDA multiple using 50% Debt. It wants to sell the company in 3 years, but it's difficult to find buyers, so the firm decides to take the company public instead. If this company's EBITDA increases to $240, and it repays ALL the Debt over 3 years, and the PE firm takes it public and sells off its stake evenly in Years 3 - 5 at a 10x EBITDA multiple. How does the IRR change if, after going public, the company's share price drops by approximately 10% per year in Years 4 and 5?" "

10% share price decline each year means EBITDA multiple falls from 10X to 9X and then 8X. Average EBITDA multiple sell its stake is therefore 9X (not 10X) Equity proceeds = 240*9= 2160 Multiple = 2160/800^(1/4)-1 = 2.7^(1/4)-1 Approx = 2.5X in 5 years = 20% IRR, 2.5 times in 3 years = 35% IRR, in between but slightly closer to 35% because 2.7X > 2.5 Hence, it is ~ 30% IRR"

What's the approximate IRR if a PE firm acquires a company using $500 of Investor Equity, sells it for $1,000 in Equity Proceeds in Year 3, and receives a Dividend of $250 in Year 2? "

2.5X in 2.5 year = >>35% based on approximation. Answer= 39% 2X in 3 years = 25% IRR 3X in 3 years = 44% IRR" "

Could a private equity firm earn a 20% IRR if it buys a company for a Purchase Enterprise Value of $1 billion and sells it for an Exit Enterprise Value of $1 billion after 5 years? "

20% IRR in 5 yr = between 2X and 3X, 2.5X Highly levereged at entry and pay off debt before exit, it is possible e.g. 40% equity at entry, 400m, and exit at 1b = 2.5X"

How does a stub period affect all the calculations in an LBO model? "

A "stub period" means that the deal closes not at the end of the company's fiscal year, but in between fiscal years (e.g., at the end of a quarter or a month). If there's a stub period, you have to "roll forward" the company's last Balance Sheet to the transaction close date and make all the adjustments based on that Balance Sheet instead. You also have to project the company's financial statements, or at least its cash flow and Debt repayment and Cash generation, for the months that comprise this stub period, and use the Balance Sheet figures from the end of the stub period for the first full year in the model. You also have to use XIRR rather than IRR to calculate the deal's IRR because of this irregular period in the beginning."

Walk me through the impact of a $1,000 Shareholder Loan with 10% PIK Interest, and explain why PE firms use Shareholder Loans in leveraged buyouts. "

A Shareholder Loan lets a PE firm label its Investor Equity "Debt" and use it to reduce the company's taxes. 10% PIK Interest lets a PE firm "deduct" for tax purposes a 10% IRR per year. On the Income Statement, you record 10% * $1,000 = $100 in PIK Interest initially, and add back that $100 on the CFS since it is non-cash. This $100 in PIK Interest accrues to the Shareholder Loan's principal. The Shareholder Loan keeps increasing each year, as does the PIK Interest shown on the Income Statement. The company's taxes decrease because this PIK Interest is a tax-deductible non-cash expense. Upon exit, this "Shareholder Loan" still counts as Equity, so the PE firm must repay all the real Debt first, and it still earns the Equity Proceeds. The only difference is that you'll allocate a portion of the Equity Proceeds to this Shareholder Loan.

If an acquirer writes-up the value of the intangible assets of the target, how is goodwill impacted?

A higher write-up of intangible assets means less goodwill will be created on the date of the transaction. During a LBO, intangible assets such as patents, copyrights, and trademarks are often written-up in value. Recall that goodwill is simply an accounting concept used to "plug" the difference between the purchase price and fair value of the assets in the closing balance sheet - so, a higher write-up means the assets being purchased are actually worth more Goodwill cannot be amortized by publicly-traded companies under US GAAP - however, private companies can opt to amortize goodwill for tax reporting purposes. This question is in reference to the purchase accounting on the closing date of the transaction.

Walk me through how the Balance Sheet and IRR in an LBO change with a $100 leveraged dividend recap and $2 in financing fees. "

BS: Asset: Cash -2 in financing fees (-2); L&E: New Debt = 100-2= 98 (deduct financing fee from BV of debt) Retained Earnings -100 (dividend issued to PE firm) (-2) = both side balanced. IRR calc, reflect 100 in dividends to PE firm, boost the IRR"

Why do the less risky, lower-yielding forms of Debt amortize? Shouldn't amortization be a feature of riskier Debt to reduce the risk?

Amortization reduce credit risk and reduce potential returns - feature of less risky debt

What is an "ideal" candidate for an LBO? "

Assume price is right and co. is undervalued vs. peers: 1. Stable, predictable cash flow (able to repay debt) 2. Not have much need for ongoing investment (e.g. CapEx light) 3. Opportunity to cut cost and increase margins 4. Fast-growing and highly fragmented industry (can make add-on acq.) 5. Strong management team 6. Strong base of asset as collateral for Debt 7. Realistic path to exit (Driven by EBITDA growth and Debt paydown rather than multiple expansion)"

What does "assuming" or "refinancing" Debt mean, and how do these two options affect an LBO model? "

Assuming Debt = PE firm keeps existing debt in place or replace with new identical debt, no impact on investor equity Refinancing Debt = PE firm repays using Investor Equity or some combo IE and New Debt; shows up on Uses side of S&U; usually use New Debt because using investor equity will reduce returns"

How is an LBO valuation different from a DCF valuation? Don't they both value the company based on its cash flows? "

Both based on cash flow. LBO valuation - constrain value based on the returns we are targeting DCF shows valuation of a company based on its PV of cash flow LBO shows how much we would pay for a company if we want to achieve an IRR in x years?"

Why might a company's FCF in an LBO model differ from its Cash Flow Available for Debt Repayment?

Cash Flow Available for Debt Repayment has additional components - The Beginning Cash, Minimum Cash, and Other Obligations

How does a Returns Attribution Analysis for an LBO affect your investment decision? "

Certain returns sources are more favorable If depends on EBITDA growth, CREDIBLE. Easier to grow a company business than to increase its multiple Debt paydown and cash generation is in the middle, worse than EBITDA growth because it indicates the deal depends on financial engineering more than core business growth. If deal is predicted on Multiple Expansion -> skeptical because it is highly speculative, hard to materialize."

What's the point of assuming a Minimum Cash Balance in an LBO? How might you estimate this Minimum Cash Balance if the company doesn't disclose it?" "

Company need min cash to continue running their operation; Look at historical cash balance trends, or cash as % total expenses and see how that fiture trended in the past e.g. cash between 5-10% COGS+OpEx -> assume min cash balance"

Which Key Metrics and Ratios might you calculate in an LBO, and what do they tell you? "

Debt/EBITDA, EBITDA/Interest, FCF Conversion - show how a deal performs overtime, riskiness of deal, what the risks are, how could PE boost returns If a co. goes from 5x Debt / EBITDA to 3x in 1-2 years, perhaps the PE firm could use more Debt in the beginning, or it could do a Dividend Recap at that stage to boost its returns. And if the company's FCF Conversion increases from 10% to 30%, the deal is more attractive because it's a sign that more of the returns come from Debt Paydown and Cash Generation."

Why might a PE firm have to resort to a Dividend Recapitalization for its exit in an LBO?

Dividend Recap - company issue Dividends to PE or take additional Debt to issue Dividends, PE firm earns the deal proceeds gradually over time - hard to earn acceptable IRR (only option if M&A and IPO markets are underdeveloped, or has legal/PR issue preventing it from M&A and IPO)

How do you use a Revolver in an LBO model? "

Draw on revolver when company doesn't have enough CF to meet Mandatory Debt Repayments (similar to bank overdraft) if the company needs to repay $150 million in Debt principal, but it has only $100 million in Cash Flow Available for Debt Repayment, it would draw on $50 million from its Revolver to make up for the deficit and repay the full amount. The company will then pay interest and fees on this additional borrowing, and it will repay the Revolver balance as soon as it can do so."

What are the levers for a private equity investor to increase the IRR on an investment?

Earlier Receival of Proceeds: e.g. dividend recapitalization, sooner than anticipated exit, opted for cash interest (as opposed to PIK interest), annual consulting fees paid to the sponsor Increased FCFs Generation: achieved through revenue and EBITDA growth, better margin profile. Read more: EBITDA vs FCFs. Multiple Expansion: exiting at a higher multiple than the initial purchase multiple (i.e. "buy low, sell high")

A PE firm acquires a business for a 12x EBITDA multiple, using 5x Debt / EBITDA, and plans to sell it in 5 years. The company's initial EBITDA is $100, and it grows to $200 by Year 5. Repaid 75% debt. what exit multiple do we need for a 25% IRR? "

Entry = 100*12x = 1200, equity = 1200-500=700 Debt = 5X Debt/EBITDA = 500 Debt at exit = 500*.25 = 125 Exit = Ebitda 200*?x Equity proceed = 200*x - 125 IRR 25% in 5 years, means the Equity proceed/investor equity is tripled Equity proceed = 700*3 = 2100 Exit EBITDA multiple = (2100+125)/200 = 11.1X"

A PE firm acquires a business for a 12x EBITDA multiple, using 5x Debt / EBITDA, and plans to sell it in 5 years. The company's initial EBITDA is $100, and it grows to $200 by Year 5. If there's no Debt repayment and no additional Cash generation, what exit multiple do we need for a 25% IRR? "

Entry = 100*12x = 1200, equity = 1200-500=700 Debt = 5X Debt/EBITDA = 500 No debt repayment at exit Exit = Ebitda 200*?x Equity proceed = 200*x - 500 IRR 25% in 5 years, means the Equity proceed/investor equity is tripled Equity procedd = 700*3 = 2100 Exit EBITDA multiple = (2100+500)/200 = 13X"

A private equity firm acquires a $200 EBITDA company for an 8x EBITDA multiple using 50% Debt. It wants to sell the company in 3 years, but it's difficult to find buyers, so the firm decides to take the company public instead. If this company's EBITDA increases to $240, and it repays ALL the Debt over 3 years, and the PE firm takes it public and sells off its stake evenly in Years 3 - 5 at a 10x EBITDA multiple, what's the approximate IRR? "

Entry = 200*8= 1600, equity = 800 Debt = 800 Sell in 3 years, but hard to find buyer, instead IPO. At Exit EBITDA = 240, Exit Equity proceed = 2400 ALL Debt repaid Sell stakes evenly in Year 3-5 at 10X EBITDA multiple Actual = 2400/800^(1/4) -1 = ~32% Approximate: IRR = 2400/800^(1/3) -1 = triple in 3 years =~44% IRR = 2400/800^(1/5) -1 = triple in 5 years = ~26% Find average = (44+26)/2 = 35%" "

A PE firm acquires a company with $100 in EBITDA, which grows to $150 by the end of 7 years, at which point the PE firm sells the company for a 10x EBITDA multiple. The PE firm uses $500 of Debt initially, and the company has $300 of Net Debt remaining upon exit. If the PE firm realizes an approximate IRR of 10% on this investment, what was the purchase multiple?" "

Entry: 100*PM, Equity = 100*PM - 500 Debt at exit = 300 Exit: 1500, Equity proceed = 1500-300 = 1200 IRR = 1200/(100PM-500) ^(1/7)-1 = 10% Calc, multiple is approx 2X, 100PM-500 = 600, PM = 11X"

A PE firm acquires a $200 million EBITDA company using 50% Debt, at an EBITDA purchase multiple of 6x. The company's EBITDA grows to $300 million by Year 3, and the exit multiple stays the same. Assuming the company pays its interest and required Debt principal but generates no additional Cash, what is the MINIMUM IRR? "

Entry: 200m EBITDA * 6 * .5 equity = 600m Debt = 6* .5 *200 = 600m Exit: 300m * 6 = 1800m Assume no payment in debt, equity proceed at exit = 1800-600m = 1200m IRR = 1200m/600m^1/3 - 1 = Double in 3 years = ~25%, 26% (min)"

A PE firm acquires a $200 million EBITDA company using 50% Debt, at an EBITDA purchase multiple of 6x. The company's EBITDA grows to $300 million by Year 3, and the exit multiple stays the same. Assuming the company pays its interest and required Debt principal but generates no additional Cash. How does the IRR change if the company repays ALL its Debt but nothing else changes? "

Entry: 200m EBITDA * 6 * .5 equity = 600m Debt = 6* .5 *200 = 600m Exit: 300m * 6 = 1800m Assume no payment in debt, equity proceed at exit = 1800m IRR = 1800m/600m^1/3 - 1 = Triple in 3 years = ~45%, 44% " "

You buy a $100 EBITDA business for a 10x EBITDA multiple, and you believe you can sell it in 5 years for a 10x multiple. You use 5x Debt / EBITDA to fund the deal, and the company repays 50% of that Debt over 5 years. By how much does EBITDA need to grow over 5 years for you to realize a 20% IRR?" "

Entry= 1000, equity = 500 Exit in 5 years at: 10X multiple of EBITDA Debt = 5X Debt/EBITDA = 500 at entry, left 250 at exit Equity proceed at exit = 10xEBITDA - 250 If 20% IRR in 5 years, it means (equity proceed/investor equity is ~2.5X) **Double in 5 years = 15% Triple in 5 years = 25% Equity proceed = 2.5*500 = 1250 10xEBITDA = 1250 + 250 (debt) = 1500. EBITDA = 150 EBITDA grew to 150 over 5 years"

You're setting up the Transaction Assumptions for an LBO, but you don't have any information on the Debt Comps. How might you estimate the interest rates on Debt? "

Estimate Interest rate on debts by using Default spreads - same as calc for CoD in WACC Yield of 10 year bonds of a country, calc company interest coverage ratio to get a sense of its credit rating; OR use actual credit rating; Look up default spread based on credit rating and add to 10-year bond rate e.g. leverage ratio after deal = 5X, correspond to BB+ rating = spead of 4.0% 10 year bond = 3.0%, add 4+3 = 7%"

A PE firm acquires a $100 million EBITDA company for a 10x purchase multiple and funds the deal with 60% Debt. The company's EBITDA grows to $150 million by Year 5, but the exit multiple drops to 9x. The company repays $250 million of Debt in this time and generates no extra Cash. What's the IRR? "

Exit = 150m*9 = 1350m Entry = 100m*10 = 1000m, Equity upon entry = 400m Debt amount= 600m, Company repaid 250m, left 350m debt upon exit Equity proceed to the PE firm at exit = 1350-350 = 1000m IRR = 1000/400^(1/5)-1 = 2.5 time over 5 years (between 15% to 25%, approx 20% IRR)"

Would you rather have an extra dollar of Debt paydown or an extra dollar of EBITDA in an LBO?

Extra dollar on EBITDA; because it pays for Debt paydown AND increase company's Exit Entreprise Value (TEV) by multiple of that dollar

After reading a company's CIM, you decide to meet with the CEO. What are the top 3 questions you would ask him/her? "

Focus on things NOT in CIM e.g. projection doesnt give detail on revenue and expense numbers, and if deal dependent on add-on acquisition: 1. What are driving these assumptions for revenue growth and op margin (if differ from historicals) 2. What's the big picture strategy, what do you see as the best sources of growth? 3. Tell us about competitors and smaller companies in market that might be open for acquisition?"

What IRR and MoM multiple do PE firms typically target? "

IRR at least 20-25%, ~2X return on public equity in developed country; MoM depends on time frame. usually over 5 years, 20% IRR = 2.5X; if hold longer period, may have higher multiple. Also target diff numbers for Base, Upside, Downside cases, aim to avoid losing money at all cause"

What might trigger "Multiple Expansion" in an LBO, and is this assumption ever justified? "

If a company's Return on Invested Capital (ROIC) improves and its WACC stays the same, then its FCF and FCF Growth should both increase, which should, theoretically, boost its exit multiple. Some PE firms aim for Multiple Expansion in deals, but it's very tough to predict and depends heavily on market conditions as well. Even if a PE firm improves a company's ROIC significantly, the exit multiple might stay the same or fall if the overall market has declined."

When might a PE firm use a leveraged dividend recap in a leveraged buyout? "

If the company pays off a significant amount of Debt midway through the holding period or becomes able to support more Debt at that point (e.g., its EBITDA increases significantly and it can support another 1-2x of Debt). If a deal performs well, a dividend recap will boost the IRR because it allows the PE firm to earn proceeds from the deal earlier on; the MoM multiple won't change by as much."

Why would a PE firm use Subordinated Notes instead of Secured Debt? "

If the company potentially cannot comply with the maintenance convenants in term loans (e.g. EBITDA projected to decline), If company avoid/cannot pay cash interest - can Pay-in-kind interest so that interest accrues to loan principals"

How is Purchase Price Allocation different in LBO models? Does it matter more or less than in M&A deals? "

Impact far less, because LBO are based on Cash Flow, Debt Repayment and IRR from acquiring and then selling a company. New items created in PPA e.g. D&A on Asset Write Ups, affect the company EPS but barely make an impact on cash flow, therefore LBO models leave these out"

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

In a LBO, PE firm acquires a firm using a combination of D & E, improve operations for several years & create value, sell at the end of period to realize a return on investment. During period of ownership, PE firm uses the company cash flows to pay for the interest expense on the debt and repay debt principal. Leverage amplifies (not increase) returns, but also risk (if the company doesn't perform well)"

Why might a private equity firm create a management option pool in an LBO, and how does it affect the model? "

Incentivize the management team to perform while giving up relatively little in exchange If a deal performs well and the Exit Equity Value exceeds the initial Investor Equity, a small percentage of the Equity Proceeds will go to management, barely reducing the IRR for the PE firm while greatly increasing the IRR for the management team. If the deal does not perform well, and the Exit Equity Value is below the initial Investor Equity, nothing is paid out to management and the PE firm loses nothing."

What does the "tax shield" in an LBO mean?

Interest on Debt reduces a company's taxes because the Interest is tax-deductible. However, the company's cash flow is still lower than it would have been WITHOUT the Debt - the tax savings helps, but the additional Interest Expense still reduces Net Income. (tax only has marginal impact)

How do you set up the formulas for Mandatory and Optional Debt Repayments in an LBO model? "

Mandatory Principal Repayment = % amortizes each year, the initial amount of Debt raised, and the amount of Debt remaining. Minimum between Amortization % * Initial Amount and Debt Remaining because you never want to repay more than the total remaining Debt (e.g., 20% * $100 million = $20 million per year, but if only $10 million is left, repay just the $10 million). Optional debt = min between CF available at the current point and amt debt available at current point after Mandatory Repayments, the company has $100 million in cash flow and $250 million of Debt remaining, it would repay $100 million. But if it had only $50 million remaining, it would repay that entire remaining $50 million."

Is it always accurate to add Cash and subtract Debt when calculating the Proceeds to Equity Investors at the end of an LBO? "

NO. These assumptions may not be true Assume PE repay all the debt it used to acquire the company. Assume PE take all the company's cash upon exit (need to leave min cash bal)"

Why might you decide IN FAVOR of a deal even if the IRRs and MoM multiples are NOT favorable across the different cases? "

Numbers are bortherline. For example, if the Base Case IRR is 18%, and the MoM multiple is 1.3x in the Downside Case, you might look at the projections, realize the company generates a huge amount of Excess Cash, and argue that the company could distribute this Excess Cash or do a Dividend Recap to boost the IRR above 18%. You could also argue that a different capital structure that lets the company repay more of the Debt would result in a higher IRR, making the deal math more favorable as well."

Walk me through the impact of a 10% option pool in an LBO if the initial Investor Equity is $500 and the Exit Equity Value is $1,000. "

Options are in-the-money, because exit equity value >> initial investor equity Cash payment to PE firm to exercise option is 10%*500 = 50 Proceeds to management = 10%/(110%)*(1000+50) = 9%*1050 = 95 PE firm receives: Exit equity value of 1000+50 in cash - 95 in proceeds = 955 IRR and MoM multiple will decline only slightly"

How do add-on acquisitions affect the IRR and financial statements in an LBO? "

PE firm uses additional Debt and Equity to acquire other companies and combines them with the original company. Additional Debt and Equity on the Combined Balance Sheet and the acquired companies' revenue, expense, and cash flow contributions on the statements. The IRR could increase or decrease depending on the numbers; higher-yielding add-on acquisitions (e.g., the EBITDA / Purchase Enterprise Value is high and above the original company's) tend to increase IRR, while lower-yielding ones tend to decrease it."

Would you rather achieve a high IRR or a high MoM multiple in a leveraged buyout? "

PE firms care more abt IRR since that's how they are measured. But over short time frames, it's better to earn high multiple, and over long time frames, better to earn high IRR. Also, if PE has already exceeded its hurdle rate, should focus more on MoM multiples Dependent on time frame. Short time, 6 mo, a high IRR of 50% is meaningless because it barely made money (1.25X multiple) Long time, 10 yrs, high MoM such as 3X is meaningless because it corresponds to 12% IRR LP judge PE by their IRRs, but don't want the money to be returned to them quickly"

How do the transaction and financing fees factor into the LBO model? "

Pay upfront in Cash, increasing the purchase price, but accounting for these fees differes Legal & Advisory fee deducted from Cash and Retained Earning Financing Fee (cover debt) are deducted from Debt and Cash on the other side of BS. Book val of debt declines as a result, company pays interest on the face value of debt (before the fees)"

How might you convince the management team of a company to agree to a leveraged buyout? "

Perceived benefits of LBO -> 1. Can execute LT plans, away from scrutiny of quarterly earnings call and public markets 2. Management can have larger stake of company if offer equity rollover or other incentives/ additional profits from achieving/ exceeding the IRR or MoM 3. Board's fiduciary duty to consider any serious acquisition offer"

Could a private equity firm ever earn a 20%+ IRR if it buys a company using Investor Equity of $1 billion and gets back exactly $1 billion in Equity Proceeds at the end of 5 years? "

Possible mathematically but difficult in reality The company needs to pay extremely high dividends or do dividend recaps during the 5-year holding period. Most company cannot pay anything close to 20% dividend yield"

How do you select the purchase multiples and exit multiples in an LBO model? "

Public company: Assume share-price premium and check implied purchase multiple against valuation methodologies to make sure it's reasonable e.g. 30% prem to co's share price of $10, EV/EBITDA multiple 10X...? Private company: determine purchase multiple by comparable companies, precedent trasactions and DCF; exit multiple is similar to purchase multiple but depending on company's FCF growth and ROIC at the end Use range of purchase and exit multiples to analyze the transaction via sensitivity tables"

What assumptions impact a leveraged buyout the most? "

Purchase Price and Exit Assumptions (EBITDA multiples) % Debt (higher leverage = better performance) Revenue growth, EBITDA margins, interest rate, principal repayments on debt"

If a company has $10 million in revenue and $5 million in EBITDA, is it most appealing as an investment candidate if it plans to grow by selling 20% more units, raising its prices by 20%, or cutting its expenses by 20%? "

Raising price by 20% =flows through to EBITDA +2m (assume company have pricing power and have less competition Selling 20% more = +2m, will incur higher variable cost, EBITDA<+2m Cost = 5m; cut 20% cost = +1m"

How does an Equity Rollover affect the Sources & Uses schedule in an LBO? "

Reduces amount of debt and investor equity that are required to do the deal Reduces ownership for PE firm after the deal takes place"

Why might a PE firm choose to use Term Loans rather than Subordinated Notes in an LBO, if it has the choice between two capital structures with similar levels of leverage? "

Term loans - less expensive, less interest rate, flexibility with its cash flow since optional repayment are allowed - have maintenance covenants, better if the company planning to make acquisitions, divest assets, spend huge amt on CapEx, which are not allowed on subordinated notes"

If there's an Equity Rollover in an LBO, could the IRR to management/existing investors ever be different than the IRR to the PE firm? "

The management/existing investors could realize a different IRR only if they rolled over their shares at a different purchase price or something else changed their ownership - such as options, incentive plans, or early distributions of their proceeds. But if the PE firm acquired 80% of the company, existing investors rolled over their shares for 20% of the company, and nothing else changed in between, the IRRs should be the same."

In an LBO, is it better for the company to repay Debt principal with its excess cash flow or for it to issue Dividends to the PE firm? "

There won't be much difference in terms of MoM multiples: Any cash flow that the company does not use to repay Debt goes to Dividends instead. The PE firm earns its proceeds earlier, so the IRR is higher."

If a LBO target had no existing debt on its closing balance sheet, would this increase the returns to the financial buyer?

Upon the completion of a LBO, the firm has essentially wiped out the existing capital structure and recapitalized it using the sources of funds that were raised. When calculating the IRR and cash-on-cash returns, the companies' debt balance pre-investment does NOT have a direct impact on returns.

What is PIK interest and what are its typical features?

form of non-cash interest, meaning the borrower compensates the lender in the form of additional debt as opposed to cash interest. PIK interest typically carries a higher interest rate because it has a higher risk to the investor (i.e. delayed payments result in less certainty of being paid). From the perspective of the borrower, opting for PIK conserves cash in the current period and thus represents a non-cash add-back on the CFS. However, PIK interest expense is an obligation that accrues towards the debt balance due in the final year and compounds on an annual basis.

How would you model a "waterfall returns" structure where different Equity investors in an LBO receive different percentages of the returns based on the overall IRR? For example, let's say that Investor Group A receives 10% of the returns up to a 15% IRR (Investor Group B receives 90%), but then receives 15% of the returns (with Investor Group B receiving 85%) beyond a 15% IRR. How does that work? "

• First, check what the IRR is for the Equity Proceeds generated in the deal. For example, let's say the deal generates $500 million in Equity Proceeds; you do the calculations and find that $500 million equates to an 18% IRR for this period. • Next, you determine the Equity Proceeds that represent a 15% IRR. Here, you run the numbers and find that $450 million equates to a 15% IRR. • You allocate 10% of this $450 million, or $45 million, to Investor Group A, and 90%, or $405 million, to Investor Group B. • Then, you allocate 15% of the remaining $50 million ($500 million minus $450 million) to Investor Group A and 85% to Investor Group B."