LBO Valuation Crash Course

How would you come up with the internal rate of return (IRR?

MOIC ^ (1 / investment period) - 1

What are the two main covenants?

Maintenance & Incurrence

A Private Equity firm enters an LBO investment with $15 million of equity. It exits 5 years later with an equity value of $45 million. What is the LBO's MOIC or "Money on Money" return and IRR? a. MoM: 25%, IRR: 3.0x b. MoM: $30 million, IRR: 200% c. MoM: 3.0x, IRR: 25% d. MoM: $45 million, IRR: 25%

MoM: 3.0x, IRR: 25% Feedback: MoM: 45 / 15. IRR: excel function spits out 25%

What makes preferred stock unique from mezzanine financing?

They both have PIK baked into them but preferred stock is not an interest rate rather than mezzanine is linked to our interest schedule.

What is the difference between Bank Debt and High-Yield Debt?

This is a simplification, but broadly speaking there are 2 "types" of Debt: "Bank Debt" and "High-Yield Debt." There are many differences, but here are a few of the most important ones: • High-Yield Debt tends to have higher interest rates than Bank Debt (hence the name "high-yield") since it's riskier for investors. • High-Yield Debt interest rates are usually fixed, whereas Bank Debt interest rates are "floating" - they change based on LIBOR (or the prevailing interest rates in the economy). High-Yield Debt has incurrence covenants while Bank Debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.) while maintenance covenants require you to maintain a minimum financial performance (for example, the Total Debt / EBITDA ratio must be below 5x at all times). • Bank Debt is usually amortized - the principal must be paid off over time - whereas with High-Yield Debt, the entire principal is due at the end (bullet maturity) and early principal repayments are not allowed. Usually in a sizable leveraged buyout, the PE firm uses both types of debt.

If High-Yield Debt is "riskier," why are early principal repayments not allowed? Shouldn't investors want to reduce their risk?

This isn't the right way to think about it - remember that investors need to be compensated for the risk they take. And now think about what happens if early repayment is allowed: • Initially, the investors might earn $100 million in interest on $1 billion worth of debt, at a 10% interest rate. • Without early repayment, the investors keep getting that $100 million in interest each year paid directly to them. • With early repayment, this interest payment drops each year and the investors receive increasingly less each year - and that drops their effective return. All else being equal, debt investors want companies to keep debt on their Balance Sheets for as long as possible.

What about "Excess Cash"? Why do you sometimes see that in a Sources & Uses table?

This represents the scenario where the company itself uses its excess cash (i.e. if it only requires $10 million in cash but has $50 million on its Balance Sheet, $40 million is the excess cash) to fund the transaction. This always shows up in the Sources column. It's just like how you subtract Cash when calculating Enterprise Value: an acquirer would "receive" that Cash upon buying the company. You do not always see this item - it's more common when the company has a huge amount of excess cash and has no real reason for having it.

First thing you want to do when building out your LBO model?

You want to go from your Enterprise value to Equity value as we build out our entry assumption. So find out the EBITDA

How do you get the % premium / discount to current price?

"Equity Value" / Share price as of last close (Stock Market Price)

What differentiates transaction fees from financing fees?

Is that financing fees get amortized over the life of the debt. Therefore, carry some tax deductibility.

In a given year, a company has $2 million of cash flow available after mandatory debt service, a beginning cash balance of $500,000, and has a required minimum cash balance of $750,000. How is its free cash flow available for optional debt paydown?

$1.75M Because "Cash Flow + Beginning Cash - Required Cash Balance"

A Private Equity firm acquired a company at 5.0x EBITDA with 3.5x of leverage in an LBO. If the company's EBITDA was $10 million, approximately what was the equity invested in the deal ignoring all transaction and debt origination fees?

$15 million

How would you come up with multiple on invested capital?

(IRR % + 1) ^ Investment Holding Period

What is some typical EBITDA adjustments you'll usually add back?

- Non-recurring or one-time charges - Additional planned expenses (Ex. Planned new hires if business is understaffed) - Pro forma adjustments (Cost cutting initiative that has not been fully realized or was implemented partway through the LTM period, or an acquisition that was completed partway the LTM period so full year of added financials are not realized)

What do you need to build out a purchase agreement table to build Goodwill Creation?

- Book value of equity - Assets that needs to be written up (Usually you get this from associates) - (-) New Deferred Tax Liability - Equity Purchase Price - (-) Fair Market Value - New Goodwill Created - Useful Life of Assets - D&A - Tax Rate

An LBO delivers higher returns than if the PE firm used 100% cash for which reasons?

- By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns. - Using the company's cash flows to repay debt principal and pay debt interest also produces a better return than keeping the cash flows. - 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.

What is maintenance covenants? And what are some examples?

- Ensure the borrower is maintaining sufficient profitability and cash flow to service debt payments and not default. Example - Total Debt / LTM EBITDA must remain below 5.0x - Debt / Equity must never exceed 2.0x - Interest coverage ratio cannot fall below 3.0x Important: These metrics will be periodically tested every quarter. The borrower must routinely proven its compliance with its maintenance covenants to avoid falling default

What is incurrence covenants? And what are some examples?

- Prevent the borrower from taking specific actions that could put the lenders' payback at risk. Example - May not issue additional debt, particularly if it were to hold higher seniority in the capital structure than that of the covenant holder. - Restrict from spending cash on certain large capital investments or M&A activity - Cannot issue common dividends without lenders' approval Important: Will only be tested if the borrower takes certain action (borrow debt), rather than being tested on a regular basis.

What is some of the core debt metrics used when valuing how much leverage a company can get?

- Interest Coverage: EBITDA / Total Interest Expense (This is a way to measure a company's ability to service debt cost and a ratio greater than 2x signals health but anything lower than 1x means the company can't service interest payments and is in quite a bit of trouble - EBITDA-CAPEX Interest Coverage: - Fixed Charge Coverage: EBITDA - Capex - Change in NWC - Cash taxes / Interest + Amortization (This allows lenders to access the company's overall ability to service debt needs)

What is the most common transaction fees?

- Legal fees - Accounting fees - Other Third party consultants - M&A Fees

What is the typical Mezzanine debt?

- Second Lien - Subordinated Debt - Preferred Stock

What makes a good LBO?

- Target company is undervalued - Steady, predictable, and high free cash flow and defensible competitive position to sustain debt payments - Stable industry with positive trends and minimal technological disruption - Competitive advantage to prevent margin erosion from competitors - Opportunities for operational improvements and cost savings are a plus - Minimal capex needs preferred - Recurring revenue models often sought - Strong management team - Discernible Exit Opportunities - If a business grow so large you'll have to probably IPO - Fragmented Space - Being a larger player with minimal competition creates a "moat" - Roll-up opportunities ("buying down" your multiple - Using the cash flow to buy up smaller businesses in the same industry)

What is the most common financing fees banks and lending institutions require for underwriting & issuing debt for the transaction?

- Underwriting fees - Original Issue Discount (OID) - Financing fees are amortized over tenor of debt

A company had an NOL of $2 million in one year and an NOL of $500,000 the next year. The next year, the company operated at a profit of $1 million. What is its taxable income?

0 because the company will not have to pay taxes given that the company has a carryforward for NOLs of $2mm and the carryforward rule applies for two years forward before depreciating.

Rank the order of seniority for debt tranches.

1. Revolver 2. Term Loans 3. Senior Notes 4. Subordinate Debt (High Yield Bonds) 5. Mezzanine Financing 6. Preferred Stock (Not actually debt but investors treat it like debt item since you have to pay dividends)

For really cheap deals, say buying a business for 7x - 8x times, lending institutions will generally require that the financial sponsor put in at least what percent of equity.

30%

How much of our interest expense is tax-deductible until 2022 under 2017's Tax Reform?

30% of EBITDA is allowed to be subtracted for taxes

Debt assumption generally caps out at what multiple of your LTM EBITDA?

6x - 7x

Why is revolver is first on the debt schedule to get paid back firdt?

A revolver is a form of senior bank debt that acts like a credit card for companies and is generally used to help fund a company's working capital needs. A company will "draw down" the revolver up to the credit limit when it needs cash, and repays the revolver when excess cash is available (there is no repayment penalty).

What is Internal Rate of Return?

A time-weighted metric that tells you what your compounded rate of return would be if you invested your money today and it grew at that rate over your investment horizon

In our sensitivity table, we saw that once our leverage exceeded a certain point, our returns started falling. Why? a. Exit multiples get compressed when a company has too much debt b. Additional leverage has to be funded with higher yield debt which is more expensive c. Debt is more expensive than equity d. This implied that the company may go bankrupt with too much leverage

Additional leverage has to be funded with higher yield debt which is more expensive Feedback: Incorrect - Exit multiples are agnostic to capital structure

What drives returns in an LBO?EBITDA growth a. Lower entry multiple b. Multiple arbitrage c. All of the above

All of the above

What is multiple Expansion?

Basically when a company valuation increase with the EBITDA not changing

Why when you trying to figure out the "cash interest expense" why do you take the "total interest expense" minus the "mezzanine financing PIK interest"?

Because mezzanine debt typically do not require payment during the term of debt, only at the end of the term.

What is the reason Deferred Financing Fees & OID ties in to debt?

Because this now a "Contra-debt" which means carries a debit balance rather than a credit balance, which is the opposite of the normal balance carried by liabilities.

What is the reason for Revolver being first in the order of seniority of debt to be paid?

Because we should review our revolver as the first line of defense in case our free cash flow goes negative. In this case we would need to draw on our revolver to shore up our finances, then once we cash flow positive again we will first repay that back.

Given revenue and EBITDA, what additional information would you need in order to calculate levered free cash flow of a business?

Come up with your own entry multiple - What is the revenue growth rate? - What is the best way to go about the company's D&A? - What is the leverage multiple? - What is the cost of debt if any leverage? - What is the holding period of the investment? - What is the Tax Rate? - What is the CapEx? - What is the NWC?

What is the main components to the Entry Valuation?

EBITDA @ Acquisition EBITDA Multiple Enterprise Value (-) Total Debt (+) Cash Equity Value Fully Diluted Shares Outstanding Offer Price per Share % Premium / (Discount) to Current Price

At the time of exit, a company's LTM EBITDA was $14 million. What was its valuation if the Exit Multiple was 7x? a. Enterprise value of $98 million b. Equity value of $98 million c. Enterprise value of $2 million d. Equity value of $2 million

Enterprise value of $98 million

What is the formula for a company's "Offer Price per Share"?

Equity Value / Fully Diluted Shares Outstanding

How can we quickly calculate goodwill in an LBO?

Equity purchase price - book value of equity

Not having the option to pay down debt means that we are required to paydown its principal amount if we have the cash flow available to do so. True or False?

False. Because the option to pay down a debt is available to issuers who may want to pay down the principal payment ahead of schedule, which is what we would like to do in an LBO. If the option is available, it is up to the issuer to decide whether to utilize it or not.

If our PIK rate on our preferred equity is 5%, the company is paying a 5% cash dividend yield on outstanding preferred shares. True or False?

False. Because Paid-in-Kind interest (PIK) is a non-cash interest expense.

Accelerated CapEx Expensing decreases EBITDA and increases EBIT. True or False?

False. EBITDA is not impacted by accelerated depreciation as depreciation is added back to EBITDA. EBIT will be decreased due to the additional depreciation expense.

In a LBO, mandatory amortization requirements are serviced _____________, and then any remaining cash flow is used to pay down remaining outstanding balances (assuming prepayment is allowed) -> This often referred to a "CASH SWEEP"

First

Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example, what happens when you have Existing Debt, a Revolver, Term Loans, and Senior Notes?

First off, note that you must make all mandatory debt repayments on each tranche of debt before anything else. So there is no real "order" there - you simply have to repay what is required. The "order" applies only when you have extra cash flow beyond what is needed to meet these mandatory debt repayments: • Revolver: You borrow additional funds here and add them to the balance if you don't have enough cash flow to meet the mandatory debt repayments each year; you use any extra cash flow each year to repay this Revolver first, before any other debt. • Existing Debt: This comes first, before the new debt raised in the LBO, when setting aside extra cash flow to make optional repayments. • Term Loans: Payments on these come after paying off the Revolver and any existing debt. • Senior Notes: These come last in the hierarchy, and typically optional repayment is limited or not allowed at all. To track this in an LBO model, you need to separate out the Revolver from the mandatory repayments from the optional repayments, and keep track of the cash flow that's available after each stage of the process.

What is excess cash and why is it important?

Is the difference between existing cash and minimum cash. You do want to have some minimum cash because you still will need this post transaction to fund overhead and net working capital needs.

What is a critique of IRR?

IRR does not capture risk (Think about the sharpe ratio: Returns / Risk (Volatility)) Two investments with a 20% IRR may have very different risk profiles Example: A recurring revenue software business versus a retail business

Which of these is a critique of IRR?

IRR does not factor in the size of an investment or project IRR ignores the cost associated with reinvestment or redeploying capital

Why would a PE firm prefer High-Yield Debt instead?

If the PE firm intends to refinance the debt 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 High-Yield Debt if they don't have plans for a major expansion effort or acquisitions, or if they don't plan to sell off the company's assets.

Why might you use Bank Debt rather than High-Yield Debt in an LBO?

If the PE firm is concerned about the company meeting interest payments and wants a lower-cost option, they might use Bank Debt. They might also use Bank Debt if they are planning on a major expansion or Capital Expenditures and don't want to be restricted by incurrence covenants.

What does it mean when you hear cash-free/debt-free deal?

In simple terms, this means the seller keeps all cash and pays off all debt at the time of the sale of a business.

What does mezzanine financing allows for a business?

It allows a business to obtain capital through loans without offering any COLLATERAL. Also, if the business defaults on the loan the lender can CONVERT its loan into an ownership stake by exercising warrants or options built into the deal.

Generally speaking financial sponsors like management rollover some equity for what reason? And typically what percent does the management rollover be?

It demonstrate faith in the long-term viability of the business. And they won't rollover no more than 10% because the sponsor wants to retain voting control.

What is Disallowed Interest Carryforward?

Interest expense over the 30% EBITDA limit that can potentially be used to reduce our tax burden in future years

What is the best way to think of "Original Issue Discount" OID?

Is an added cost to issuing debt when you're dealing with financing a transaction.

Why does leverage magnify returns for private equity funds?

Less of the PE funds own capital is required to enter into an investment

Would subordinated debt ever have optional paydown?

No

If prepayment is prohibited can you still engage in a cash sweep?

No because a cash sweep consist of making payments before but if prepayment is not an option then it's nothing you can do.

When trying to figure out the company's Total Debt of the company do you grab the long-term debt only?

No. You want to grab the short term debt as well which could show up as current portion of long term debt.

How do you treat Noncontrolling Interests (AKA Minority Interests) and Investments in Equity Interests (AKA Associate Companies) in an LBO model?

Normally you leave these alone and assume that nothing happens - so they show up in both the Sources and Uses columns when you make assumptions in the beginning. You could assume that the private equity firm acquires one or both of these, in which case they would only show up in the Uses column - similar to refinancing Debt.

How long is the financing fees & OID amortized for?

Over the life of the debt rather than expensed immediately at the time occurred like transaction fees are.

How is PIK interest beneficial to a borrower?

PIK interest benefits the borrower by providing the optionality to push back interest payments on debt. In turn, lenders are compensated by the accrual of the periodic interest expense towards the ending balance.

What is PIK Accrual and when do you usually see it?

Payment-in-kin (PIK) accrues the interest to the principal amount so there is no cash outflow in the period due. This additional principal must be paid off at the maturity of the loan, though. You see this when you start dipping into really risky structures and especially in to mezzanine financing.

What is goodwill?

Portion of the purchase price attributable to the excess of the fair market value of net assets and liabilities assumed in an acquisition.

How does Preferred Stock fit into these different financing methods? Isn't it a type of Debt as well?

Preferred Stock is similar to Debt and it would match the "Mezzanine" column in the table above most closely. Just like with Mezzanine, Preferred Stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt. It's not included in the table above due to space constraints.

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, EBITDA margins, interest rates and principal repayment on Debt all make an impact as well, but they are less significant than those first 3 variables.

How do we typically adjust equity in an LBO transaction?

Sponsor equity + management rollover - transaction fees - pretransaction equity

Would you rather have a 20% IRR over a 10-year time horizon or a 25% IRR over a 5 year time horizon?

The 20% over 10 years because once you put your money out you have to go through the effort of reallocating it to a new investment and who's to say you'll be able to do so for 25% again Also, it takes time to allocate capital and you could be sitting on the cash for to long

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 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.

Let's walk through a real-life example of debt modeling now... let's say that we have $100 million of debt with 5% cash interest, 5% PIK interest, and amortization of 10% per year. How do you reflect this on the financial statements?

To simplify this scenario, we'll assume that interest is based on the beginning debt balance rather than the average balance over the course of the year. • Income Statement: There's $5 million of cash interest and $5 million of PIK interest, for a total of $10 million in interest expense, which reduces Pre-Tax Income by $10 million and Net Income by $6 million assuming a 40% tax rate. • Cash Flow Statement: Net Income is $6 million lower, but you add back the $5 million in PIK interest because it was a non-cash charge. Cash Flow from Operations is down by $1 million. Since there's 10% amortization per year, you repay $10 million of debt each year (and presumably the entire remaining amount at the end of the period) in the Cash Flow from Financing section - so cash at the bottom is down by $11 million. • Balance Sheet: Cash is down by $11 million on the Assets side, so that entire side is down by $11 million. On the other side, Debt is up by $5 million due to the PIK interest but down by $10 million due to the principal repayment, for a net reduction of $5 million. Shareholders' Equity is down by $6 million due to the reduced Net Income, so both sides are down by $11 million and balance. Each year after this, you base the cash and PIK interest on the new debt principal number and adjust the rest of the numbers accordingly.

What is the purpose of the "Offer Price per Share"?

To validate if we're offering a premium or a discount to the current price. And whether our EBITDA multiple is a fair one. First you want to focus on the shares dilution component

Many early-stage LBOs will not even have a balance sheet as you cans till build to returns without including one. True or False?

True

S&P estimates as much as 30% of EBITDA in recent deals to be in the form of adjustments. True or False?

True

You should always assume the existing debt would get refinanced. True or False?

True

Floating rates is usually tied to senior tranches and will move with market conditions. True or False?

True. Such as Revolver & Term Loan

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

Unlike "normal" debt, a PIK loan does not require the borrower to make cash interest payments - instead, the interest accrues to the loan principal, which keeps going up over time. A PIK "toggle" allows the company to choose whether to pay the interest in cash or have it accrue to the principal. PIK is riskier than other forms of debt and carries with it a higher interest rate than traditional Bank Debt or High-Yield Debt. Adding it to the debt schedules is similar to adding High-Yield Debt with a bullet maturity - except instead of assuming cash interest payments, you assume that the interest accrues to the principal. You include this interest on the Income Statement, but you need to add back any PIK interest on the Cash Flow Statement because it's a non-cash expense.

How do you add a yes or no for plugs?

You will go to customer formatting then you will type "Yes";;"No" in a cell and make sure to multiply it at the end to whatever formula you're using

Where would you get your basic shares outstanding from?

You will use the final year of the historical number for "ending basic shares outstanding:

Why does WACC and IRR differ?

WACC is the minimum rate of return required to make an investment worthwhile ("threshold"). IRR is the actual rate of return on an investment

What is the difference between IRR and WACC?

WACC: It is the minimum expected return one must expect given the risk profile of the asset / company IRR: Is the actual rate of return on an investment

Since when you purchase a business any NOLs that exist you can inherit with that acquisition, where can you find out if a company have any?

You can look at the company 10-k

How do you find the dilution from stock options & restricted stock units for a company?

You can use CapiIQ or BamSec and go to the company filings (10-k). You could just Ctrl + F "Stock Options"

Should or should you not invest in a project if IRRR < WACC?

You should not

If in a given year, a company generates $100 million of EBITDA and has $40 million in interest expenses, it can only deduct $30 million from its taxable income (30% of EBITDA). However, that left over (disallowed) $10 million does not go to waste. If the company generates $100 million of EBITDA the next year and only incurred interest expenses of $20 million, it can carryforward how much?

the $10 million from the previous year and reduce its taxable income by $30 million (20 + 10 = 30% EBITDA)

What is generally assumption for minimum cash?

~2 months of SG&A expense or 4% of revenue. You want to have enough cash to fund ongoing critical expenses of the company to tie you over should you face unexpected decline in revenue or other tough events.