PE - Technicals and Definitions
What are the primary levers in an LBO that drive returns?
1) Deleveraging Through the process of deleveraging, the value of the equity owned by the private equity firm grows over time as more debt principal is paid down using the cash flows generated by the acquired company. 2) EBITDA Growth Growth in EBITDA can be achieved by making operational improvements to the business's margin profile (e.g. cost-cutting, raising prices), implementing new growth strategies to increase revenue, and making accretive add-on acquisitions. 3) Multiple Expansion Ideally, a financial sponsor hopes to acquire a company at a low entry multiple ("getting in cheap") and then exit at a higher multiple. The exit multiple can increase from improved investor sentiment in the relevant industry, better economic conditions, and favorable transaction dynamics (e.g. competitive sale process led by strategic buyers). However, most LBO models conservatively assume the firm will exit at the same EV/EBITDA multiple it was purchased at. The reason being that the deal environment in the future is unpredictable and having to rely on multiple expansion to meet the return threshold is considered to be risky.
LBO
A LBO is a transaction where is a business is acquired using debt as the main source of consideration
Why is an LBO analysis often referred to as a "floor valuation"?
An LBO model provides a "floor valuation" for an investment as it is used to determine what the financial sponsor can afford to pay for the target while still realizing the typical +15% IRR. In other words, the question being answered from the perspective of the private equity investor is: What is the maximum amount that we can pay while still meeting our fund's return hurdle?
What is the "Sources & Uses" section of an LBO model?
The "Sources & Uses" section outlines the amount of capital required to complete the transaction and how the proposed deal will be funded. The "Uses" side answers: What does the firm need to buy and how much will it cost? The most significant usage of funds in an LBO is the buyout of equity from the targets' existing shareholders. Other uses include transaction fees paid to M&A advisors, financing fees, and oftentimes the refinancing of existing debt (i.e. replacing the debt). On the other hand, the "Sources" side answers: Where is the funding coming from? The most common sources of funds are various debt instruments, the equity contribution from the financial sponsor, excess cash on the balance sheet, and management rollover in some cases.
Internal Rate of Return (IRR)
The IRR is the discount rate that makes the Net Present Value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.
Debt Service Coverage Ratio (EBITDA - Capex) / (Interest + Principle)
The ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt. less than 1 suggests an inability to serve the company's debt. (ex. 0.9 means that there is only enough net operating incomes to cover 90% of annual debt and interest payments). ideal DSCR is 2 or higher.
Capital Structure
refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets
What is the basic intuition underlying the usage of debt in an LBO?
The typical transaction structure in an LBO is financed using a high percentage of borrowed funds, with a relatively small equity contribution from the private equity sponsor. As the principal of the debt is paid down throughout the holding period, the sponsor will be able to realize greater returns upon exiting the investment. The logic behind why it is beneficial for sponsors to contribute minimal equity is due to debt having a lower cost of capital than equity. One of the reasons the cost of debt is lower is because debt is higher up on the capital structure - as well as the interest expense associated with the debt being tax-deductible, which creates an advantageous "tax shield". Thus, the increased leverage enables the firm to reach its returns threshold easier. Private equity firms, therefore, attempt to maximize the amount of leverage while keeping the debt level manageable to avoid bankruptcy risk. Another side benefit of using higher amounts of debt is that it leaves the firm with more unused capital (i.e. "dry powder") that could be used to make other investments or to acquire add-ons for their portfolio companies.
What attributes make a business an ideal LBO candidate?
- Steady, Predictable Cash Flow Generation - Operates in Mature Industry with Defensible Market Positioning - Business Model with Recurring Revenue Component - Strong, Committed Management Team - Diversified Revenue Streams with Minimal Cyclicality - Low Capex Requirements & Working Capital Needs - Currently Undervalued by Market (i.e. Low-Purchase Multiple)
List some of the red flags you would look out for when assessing a potential investment opportunity?
1) Industry Cyclicality The ideal candidate for an LBO should generate predictable cash flows. Therefore, highly cyclical revenue and demand fluctuations based on the prevailing economic conditions (or other external factors) make an investment less attractive from a risk standpoint. 2) Customer Concentration As a general rule of thumb, no single customer should account for more than ~5-10% of total revenue as the risk of losing that key customer due to unforeseen circumstances or the customer's refusal to continue doing business with them (i.e. decides to not renew their contract) presents a significant risk. 3) Customer/Employee Churn While the circumstances will be specific to the case, high rates of customer and employee churn are generally perceived as a negative sign as high customer churn creates the need for constant new customer acquisitions while low employee retention signals issues in the companies' organizational structure.
Which credit ratios would you look at when assessing the financial health of a borrower?
1) Leverage Ratios Leverage ratios compare the amount of debt held by a company to a specific cash flow metric, most often EBITDA. The leverage ratio parameters will be highly dependent on the industry and the lending environment; however, the total leverage ratio in an LBO ranges between 4.0x to 6.0x with the senior debt ratio typically around 3.0x 2) Interest Coverage Ratios Interest coverage ratios examine a companies' ability to cover their interest payments using their cash flows. As a general rule of thumb: the higher the interest coverage ratio, the better (ideally >2.0x)
How do private equity firms exit their investment?
1) Sale to a Strategic Buyer The sale to a strategic buyer tends to be the most convenient while fetching higher valuations as strategics are willing to pay a premium for the potential synergies. 2) Secondary Buyout (aka Sponsor-to-Sponsor Deal) Another option is the sale to another financial buyer - but this is a less than ideal exit as financial buyers cannot pay a premium for synergies. 3) Initial Public Offering (IPO) The third method for a private equity firm to monetize its profits is for the portfolio company to undergo an IPO and sell its shares in the public market - however, this is an option exclusive to firms of larger-size (i.e. mega-funds) or club-deals.
What industry trends will you look at when you are looking for a potential investment?
1. Market position & competitive advantage (high entry barriers, strong customer relationships & high switching cost) 2. Stable & recurring cash flows (w/out continuous and stable cash flow, no PE firm would buy) 3. Multiple drivers to trigger growth (more drivers, better-diversified growth strategies, and better execution) 4. Strong Management (good management team = strategic guidance)
What is a dividend recapitalization?
A dividend recapitalization is when a private equity firm raises additional debt with the sole purpose of issuing themselves (i.e. the equity shareholders) a dividend. This is done by the firm to monetize profits from an investment before a complete exit and has the benefit of increasing the IRR to the fund due to the earlier receival of proceeds. Completing a dividend recap is often considered to be a risky action that should only be undertaken when an LBO is proceeding better than originally anticipated and the acquired company has the financial stability to take on the additional leverage raised.
What is an add-on acquisition and how does it create value?
An add-on acquisition is when a portfolio company of a private equity firm (called the "platform") acquires a smaller company. The strategic rationale for bolt-on acquisitions is that the add-on will complement the platform companies' existing product/service offerings - thus, enabling the company to realize synergies, as well as enter new end markets. One of the reasons that add-ons are a common strategy employed in private equity is because the acquisition target will more often than not be valued at a lower multiple than the acquirer (and thus be an accretive transaction). For example, if a company valued at 15.0x EBITDA purchases a smaller company for 7.5x EBITDA, the earnings of the add-on target will automatically be priced at 15.0x post-closing in theory. Once the transaction has successfully closed, the cash flows of the newly acquired company will immediately be valued at the multiple of the platform company - instantly creating value for the combined entity. Another positive consequence provided by the roll-up strategy is that it allows platform companies to better compete with strategic buyers in sale processes.
Why do Capital Expenditures (CapEx) increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc., do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings?
CapEx refers to an amount of cash spent by a firm to acquire or build new assets, upgrade and improve existing assets. These expenditures help increase the value of fixed assets and are reflected in the balance sheet. CapEx differ from OPEX (operating expenditures such as salaries and other operating expenses that keep the business operating) in the period of time the money is spent. While OPEX are expenses in only one-accounting period, CapEx is longer and can be up to 50 years for specific assets such as buildings and plants. CapEx will be deducted over the course of useful-life years as depreciation expenses.
If an acquirer writes-up the value of the intangible assets of the target, how is goodwill impacted?
During an 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. Therefore, a higher write-up of intangible assets means less goodwill will be created on the date of the transaction. Note: 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.
How does the treatment of financing fees differ from transaction fees in an LBO model?
Financing fees are related to raising debt or the issuance of equity and can be capitalized and be amortized over the tenor of the debt (~5-7 years). On the other hand, transaction fees refer to the M&A advisory fees paid to investment banks or business brokers, as well as the legal fees paid to lawyers. Transaction fees cannot be amortized and are classified as one-time expenses that are deducted from a companies' retained earnings.
How would you value a company with negative historical cash flow?
Given that negative profitability will make most multiples analyses meaningless, a DCF valuation approach is appropriate here.
A private equity firm has tripled its initial investment in five years, estimate the IRR?
If the initial investment tripled in five years, the IRR would be 24.6%. Since it is very unlikely for you to be handed a calculator to solve this calculation, it is highly recommended that you memorize the most common IRR approximations as shown in the table below:
In the context of an LBO, what does the "tax shield" refer to?
In an LBO, the "tax shield" refers to the reduction in taxable income from the highly levered capital structure. As interest payments on debt are tax-deductible, the tax savings provides an additional incentive for private equity firms to maximize the amount of leverage they can obtain for their transactions.
Two companies are identical in earnings, growth prospects, leverage, returns on capital, and risk. Company A is trading at a 15 P/E multiple, while the other - Company B trades at 10 P/E. which would you prefer as an investment?
In most cases, people choose to invest in undervalued companies over overvalued companies. In this case, two firms have homogenous earnings, growth prospects, leverage, returns on capital ad risk. You should choose Company B because its P/E multiple is lower than that of company A, it means the company B is undervalued in the market. You can have more handsome returns in future compared with holding a portion of company A.
What is rollover equity and why is it viewed as a positive sign?
In some cases, the existing management team may roll over some or all of its equity into the newly acquired company and may even contribute additional capital alongside the financial sponsor. Rollover equity is an additional source of funds and it reduces the amount of leverage necessary and the equity contribution from the financial sponsor to complete the deal. Generally, if a management team is willing to roll over some equity into the new entity, it implies the team is doing so under the belief that the risk they are undertaking is worth the potential upside in it for them. It is overall beneficial for all parties involved in the deal for the management team to have "skin in the game" and altogether have closely aligned incentives.
How is it possible for a company to show positive net income but go bankrupt?
It involves the deterioration of working capital ( increasing accounts receivable - a company cannot collect money from its customers, decreasing accounts payable - the company cannot negotiate with its suppliers to reprieve on its payment). Although the company's revenue is up and the income statement posts a positive net income, it can cause negative cash flow which reflects the situation of the company - on the brink of bankruptcy.
What is PIK interest and what are its typical features?
PIK Interest ("Payment in Kind") is a 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.
What are the levers for a private equity investor to increase the IRR on an investment?
Positive IRR Levers - 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")
What is the typical capital structure prevalent in LBO transactions?
The capital structure in an LBO tends to be cyclical and fluctuates depending on the financing environment, but there has been a structural shift from Debt to Equity ratios of 80/20 in the 1980s to around 60/40 in more recent years. The different tranches of debt include leveraged loans (revolver, term loans), senior notes, subordinated notes, high-yield bonds, and mezzanine financing. The vast majority of the debt raised will be senior, secured loans by banks and institutional investors before riskier types of debt are used. In terms of equity, the contribution from the financial sponsor represents the largest source of LBO equity. In some cases, the existing management team will roll over a portion of their equity to participate in the potential upside alongside the sponsor. Also, because most LBOs retain the existing management team, sponsors will usually reserve anywhere between 3% to 20% of the total equity as an incentive for the management team to meet financial targets.
What is the appropriate discount rate to use in an unlevered DCF analysis?
The discount rate in an unlevered DCF is the weighted average cost of capital to all providers of capital (both debt and equity). Since the free cash flows in an unlevered DCF analysis are cash flow before taking debt into account (as if it had no debt - so no interest expense, and no tax benefit from that interest expense), the cost of the cash flows relate to both the lenders and the equity providers of capital. The cost of debt is the yield on debt with equivalent risk, while the cost of equity is more difficult to estimate. Cost of equity is typically estimated using the capital asset pricing model (CAPM), which links the expected return of equity to its sensitivity to the overall market.
If you had to choose two variables to sensitize in an LBO model, which ones would you pick?
The entry and exit multiples would have the most significant impact on the returns in an LBO. The ideal scenario for a financial sponsor is to purchase the target at a lower multiple and then exit at a higher multiple, as this results in the most profitable returns. While the revenue growth, profit margins, and other operational improvements will all have an impact on the returns, it is to a much lesser degree than the purchase and exit assumptions.
Walk me through the mechanics of building an LBO model.
The first step to building an LBO model is to calculate the implied entry valuation based on the entry multiple and LTM EBITDA of the target company. Next, the "Sources and Uses" section will lay out the proposed transaction structure. The "Uses" side will calculate the total amount of capital required to make the acquisition, whereas the "Sources" side will detail how the deal will be funded. Most importantly, the key question being answered is: What is the size of the equity check the financial sponsor must contribute? Once the Sources & Uses table has been completed, the free cash flow of the company will be projected based on the operational assumptions (e.g. revenue growth rate, margins, interest rates on debt, tax rate). The FCFs generated is central to an LBO as it determines the amount of cash available for debt amortization and the interest expense due each year. Lastly, the exit assumptions of the investment are made (i.e. exit multiple, date of exit) and the total proceeds received by the private equity firm are used to calculate the IRR and cash-on-cash return, with a variety of sensitivity tables attached below.
What would the ideal type of products/services being sold be for a potential LBO target?
The ideal product/service is essential to the end market being served. In other words, discontinuance should be detrimental to the customers' business continuity, result in severe monetary consequences, or damage their reputation. For example, the decision for a data center to terminate their contract with their security solutions provider (e.g. video surveillance, access control) could impair the data center's relationships with its existing customers in the case of a security breach and loss of confidential customer data. Moreover, the decision to switch to another provider should come with high costs that make customers reluctant to move to a competitor. Said another way, the switching costs should outweigh the benefits of moving to a lower-cost provider. Also, products/services that require maintenance and having a recurring revenue component are more valuable given the greater predictability in revenue. In most cases, customers prefer to receive maintenance and other types of related services from the original provider they purchased the product from. Ultimately, there are various avenues that you can go down when answering this question and it would be best to tailor your response based on the specific types of portfolio companies the firm owns and their investment strategy.
What types of industries attract the most LBO deal flow?
The industries that tend to attract higher amounts of interest from private equity investors are those that are mature, growing at a moderate rate, and non-cyclical. The companies found in these types of industries are more likely to generate predictable revenue with less disruption risks from technological advancements or new entrants due to having high barriers to entry. The ideal industry should exhibit stable growth in the upcoming years and have positive tailwinds that present growth opportunities. Typically, industries expected to contract or prone to disruption are avoided. Some PE firms do specialize in high growth sectors (e.g. Vista Equity Partners, Thoma Bravo), but drift more so onto the side of growth equity than traditional buyouts. Furthermore, if the investment strategy of the firm is based around roll-up acquisitions - the PE firm will look for fragmented industries where the consolidation strategy (i.e. "buy-and-build") would be more viable since there are more potential add-on targets in the market.
If an LBO target had no existing debt on its closing balance sheet, would this increase the returns to the financial buyer?
Upon the completion of an 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.
Is it possible for a company to show positive cash flows but be in grave trouble?
Yes. One example involves working capital. A company sells off its inventory and delays payments to suppliers, it creates positive cash flow. However, the companies may be in serious trouble.
When measuring returns, why it is necessary to look at both the IRR and cash-on-cash return?
[Over shorter time frames, the cash-on-cash multiple is more important than IRR - however, over longer time frames, it is better to achieve a higher IRR.] The cash-on-cash multiple cannot be a standalone metric as it does not consider the time value of money, unlike the IRR calculation. For instance, a 3.0x multiple may be impressive if achieved in five years. But whether it took five years or thirty years to receive those proceeds, the cash-on-cash multiple remains the same. On the other hand, IRR is an imperfect standalone measure because it is highly sensitive to timing. For example, receiving a dividend right after the acquisition immediately increases the IRR and could be misleading for near-term time frames. Nonetheless, these two metrics are interlinked and both are widely used amongst investors to accurately assess returns.
Net Debt/EBITDA
measures financial leverage and the ability for a company to pay off its debt. gives an indication as to how long a company would need to operate at its current level to pay off all its debt.
High Yield/ Subordinated Debt (Junk Bonds)
high yield, and unsecured debt. Less restrictive limitations or covenants than there are in bank debts. In liquidation, high yield is paid before equity holders but after the bank debt. Pay higher returns.
Interest Coverage Ratio (EBIT/Interest)
is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt. 1.5 is considered the minimum acceptable ratio. below 1.5 signals default risk and refusal of lenders to lend more money to the company
Fixed Charge Coverage Ratio (EBITDA - Capex - Taxes) / (Interest + Principle)
is a measure of a company's ability to meet fixed-charge obligations such as interest expenses and lease expenses. 2 or above indicates a more financially healthy and less risky company. Less than 1 indicates that the company is struggling to meet its regularly scheduled payments
Mezzanine Debt
is a small middle layer in the LBO capital structure that is a hybrid of debt and equity and is junior or subordinate to other debt financing options. It is often financed by hedge funds and private equity investors and comes with a higher interest rate than bank debt and high-yield debt.
Senior Debt
is money owed by a company that has first claims on a companies cash flows. It is more secure than any other debt and has lower interest rates (cheaper) typically 50-80% of an LBO's capital structure
