Technical Prep: BIWS + Red Book (COMBINED)

Walk me through the mechanics of building an LBO model.

1. Entry Valuation based on ltm EBITDA and entry multiple. or, price per share for a public

2. Sources and Uses table including fees, equity that needs to be bought out, and debt that needs refinancing. Then, the amount of sources needed to meet this obligations will be determined

3. FCF Build: forecast operations over the 5-7 year expected holding period and a complete 3-stmt model so that LBO debt assumptions properly impact IS and CFS. Must build an accurate debt schedule

4. Exit valuation and returns based on the exit multiple, calculate IRR and MOIC

5. Sensitivity Analysis: one common one is to back into the implied pre-LBO equity value based on explicit sponsor hurdle rates and operating assumptions.

What is the purpose of the “Sources & Uses” section of an LBO model?

This shows how much capital the sponsor needs in order to make the deal possible and where they will get it from. It is critical to determining financing needs and how those will impact the statements going forward.

How would you measure the credit health of a pre-LBO target company?

Look at leverage and interest coverage ratios both pre-LBO and then what you think they will be post LBO to determine if the company can support the leverage.

• Ratios depend bust post LBO ranges between 5x-7x, with senior debt ratio around 3x

• Rule of thumb is that a higher interest coverage ratio is better, and you want at least 2x post-LBO first year

Why is LBO analysis used as a floor valuation when analyzing company value using several valuation methodologies?

It is used as a floor because it determines the MAXIMUM a sponsor would pay to achieve a specific IRR. Meaning, the return they expect is already embedded, so it isn’t about intrinsic or implied value, just what they would have to pay to get the return they seek.

These hurdle rates are usually higher than the cost of equity capital on the same business without those LBO-specific risks. Thus, the present value (or valuation) implied, given those higher hurdle rates, will be lower than the valuation of the company when analyzed through the traditional DCF and comps approaches.

When analyzing the viability of undertaking an LBO, how do private equity firms estimate the company's value in the exit year?

They estimate the value based on a final year financial metric, usually EBITDA, and tend to apply a similar multiple to where they entered so that the investment case doesn’t hinge too much on expansion.

This assumption will be sensitized to show IRRs across a spectrum.

If you had to choose two variables to sensitize in an LBO model, which ones would you pick?

Exit multiple and entry multiple since they have the greatest impact on returns.

Other possible variables include:

• revenue growth

• leverage multiple at purchase

• EBITDA margin

What are the capex and net working capital requirement considerations for a private equity firm looking at a potential investment?

Ideally low CapEx and low NWC requirements so that as much cash can go towards paying down principal as possible. You would prefer most of the CapEx to be maintenance. If a mature company has high numbers for both of these metrics, then the cost structure is probably just very unfavorable.

Higher CapEx could be a positive if it is an element of maintaining the business’ moat, though.

If management decides to rollover equity, how would you calculate their new ownership stake and proceeds received at exit?

Rollover equity would be included as a Source of capital on the Sources and Uses table. So, the new stake would be equal to the Rollover Equity Amount/(Rollover Equity Amount + New Equity).

At exit, the amount of proceeds received by multiplying the exit equity value by the implied ownership by the management team that rolled over their equity.

Alternatively, this could be based on a percentage of the excess value creation over the initial equity investment or structured with a liquidation preference in which management doesn't receive any proceeds unless a returns threshold is met.

What are the two most common return metrics used by private equity firms?

IRR and MoM

If you're given the multiple of money (MoM) of an investment and the number of years the investment was held, what is the formula to calculate the internal rate of return (IRR)?

IRR = MoM^(1/t) - 1

What levers have a positive/negative impact on the IRR of an investment?

Higher IRR:

• payouts throughout

• Lower entry, higher exit multiple

• more debt paid down

• more leverage (less initial equity)

• EBITDA growth

• Shorter holding periods

Lower IRR

• opposite of the above

When measuring returns, why is it necessary to look at both the IRR and MoM?

The MoM cannot be a standalone metric as it doesn't 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 the multiple remains the same, whether it took five years or thirty years to receive those proceeds.

IRR is an imperfect standalone measure because it's highly sensitive to timing. For example, a private equity firm issuing itself a dividend soon after the acquisition increases the IRR, but the MoM may have been sub-par (making the IRR misleading in this case).

Tell me how you would calculate IRR in Excel

Record initial investment as a negative amount. Project out cash flows over the time period, record exit value, use XIRR function.

What is the difference between gross IRR and net IRR in private equity?

Gross IRR is the return on the equity as a whole. Net IRR is the return to LPs after accounting for management and performance fees in the 2/20 structure.

Tell me about the J-curve in private equity returns.

For the first few years of a fund, returns are low because there is dry powder, investments are getting closed

Early in the fund lifespan, the J-curve begins with a steep, negative slope as the initial investments represent capital outflows and the annual management fee paid to the PE firm. But gradually, as the fund exits its portfolio companies after each holding period, the downward trajectory will reverse course and ascend upward.

If a business that underwent an LBO has been operating as intended, why does the private equity firm not hold on to the investment for a longer duration (e.g., 10+ years)?

Their investments are time-bound by the fund structure that they operate. They need to return capital to LPs before they can raise the next fund.

Also, longer holding periods decrease IRR, and that looks worse on marketing materials that help those future fundraisings.

In the situation when a private equity firm has the option to exit within a 1 to 2-year time frame, why might the firm be reluctant to proceed with the sale?

They may be reluctant to proceed because this creates reinvestment risk for LPs and GPs since a new investment needs to be sourced in the fund.

Also, transaction fees could weigh on the return anyways.

How would you calculate the levered free cash flow yield for private equity investment, and when would it be used?

Although used far less often than the IRR and MoM, the levered free cash flow yield (FCFY) can be a useful metric for assessing a private equity investment's performance. 1. The first step to calculating the levered FCFY is to calculate the levered free cash flow. Recall, this investment is from a private equity firm's perspective, so we must deduct interest payments and mandatory debt pay down. Levered FCF = EBITDA –Taxes –Interest –Capex –Increase in NWC −Mandatory Debt Amortization 2. Now that we have the levered FCF, the only remaining calculation is to divide the levered FCF by the initial equity investment amount. Levered Free Cash Flow Yield (FCFY) = Levered Free Cash Flow Initial Equity Investment There is no set levered FCFY that PE firms target since it'll vary not only by industry but by other factors such as the financing mix, total ownership percentage, and required amortization by debt. However, the higher the levered FCFY, the better since this implies the company is generating cash that can be used to reinvest into the business or payout a special dividend. If a private equity firm wanted to see how its investment was performing, then the levered FCF yield is one metric they could use. So rather than the percentage amount, what matters more is the year-over-year growth (YoY). If the levered free cash flow becomes a larger proportion than the firm's initial equity contribution, it's a positive sign as that would signify downside protection above all else.

If we had not deducted interest and the mandatory debt amortization in calculating the levered free cash flow, what metric would we be measuring?

We would be measuring unlevered free cash flow, which is the cash flow available to all investors, not just the equity holders.

it can tell us how much FCF remains to reinvest into the business and pay a dividend to equity holders, as well as the amount that can be used to paydown debt.

How does the accounting treatment of financing fees differ from transaction fees in an LBO?

Financing fees are amortized over the life of the bond while transaction fees are a one-time expense.

If an acquirer writes-up the value of the intangible assets of a target, how are goodwill and amortization impacted?

Goodwill decreases because assets make up more of the purchase price.

Publicly traded companies cannot amortize goodwill under US GAAP – however, private companies can opt to amortize goodwill for tax reporting purposes. This question is specifically regarding the purchase accounting on the closing date of the transaction.

What does a cash sweep refer to in LBO modeling?

A cash sweep refers to a percentage allocation of free cash flows to paying off debt at different tranches based on cash flows left over after making mandatory principal repayments. Any revolver balance must be paid off first.

In most cases, this optionality to repay debt early comes with a prepayment penalty fee since the lender receives reduced interest payments.

What is the purpose of the minimum cash balance in an LBO model?

The minimum cash balance reflects the need for a business to have working capital in order to run its day-to-day operations.

The debt schedule will contain logical functions that ensure the cash balance never dips below this specified amount. The minimum cash balance will increase the amount of funding required since this cash on the company’s balance sheet cannot help fund the transaction.

What is a leveraged buyout (LBO)?

An LBO is an acquisition made by a financial sponsor that creates a holding company to take on a bunch of debt to acquire a target company with as little equity as reasonably possible.

Once they take ownership, they look to lean-out the business’ operations to squeeze any value out of it through cost cutting, restructurings, or divesting assets. This creates incremental cash flows that can help pay down their debt.

The goal is to amplify their returns on a 5-7 year horizon and then sell the business with more equity to either another company/PE firm or take the company public through an IPO.

Explain the basic concept of an LBO to me using a real-life example.

One metaphor to explain an LBO is "house flipping," using mostly borrowed money. Imagine you found a house on the market selling for a low price, in which you see an opportunity to sell it later for a higher price at a profit. You end up purchasing the house, but much of the purchase price was financed by a mortgage lender, with a small down payment that came out of your pocket. In return for the lender financing the home, you have a contractual obligation to repay the full loan amount plus interest.

But instead of purchasing the house to live there, the house was bought as a property investment with the plan to put the house back on the market in five years. Therefore, each room is rented out to tenants to generate monthly cash flow. The mortgage principal will gradually be paid off and the periodic interest payments are paid down using the rental income from the tenants. Home renovations are completed with the remaining amount and any existing property damages are fixed – again, using the rental income.

After around five years, the house is sold for a price higher than the initial purchase due to the improvements made to the house and because the house is located in an area where home values have been increasing. The remaining mortgage balance will have to be paid in full, but you pocket a greater percentage of the proceeds from the sale of the house because you consistently paid down the principal.

What is the intuition underlying the usage of debt in an LBO?

Debt amplifies returns. By using debt in a deal, you can put up less of your own capital. So, if the deal goes well, you can capture a greater return than you could have if you used your own funds for the entire initial investment.

Additionally, it is cheaper to use debt than equity because of the position in the capital structure and the tax shield. So, using more debt than equity helps the company itself actually reach return thresholds easier.

What is the typical capital structure prevalent in LBO transactions?

Back in the day, it was common to see D/E in the 80/20 area, but today you are more likely to see closer to 60/40, though it depends heavily on the financing environment.

The different debt tranches include leveraged loans (revolver, term loans), senior notes, subordinated notes, high-yield bonds, and mezzanine financing. The 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. Sometimes, the existing management team will rollover a portion of their equity to participate in the potential upside alongside the sponsor, which usually makes up 3-20%$ of the equity component.

What are the main levers in an LBO that drive returns?

• FCF generation/EBITDA growth

  • comes from operational improvements, new growth strategies, accretive add-ons

  • Increases value at the same multiple, or can increase intermittent payouts to investors

• Multiple expansion

  • can come from better sentiment, growth prospects, scale, etc

• Debt paydown

  • Value of PE firm’s equity grows

What attributes make a business an ideal LBO candidate?

• Stable, preferably high cash flows

  • recurring revenue from long-term contracts, high value products and services

• Fragmented market, but a wide moat

• clean balance sheet

• Low risk of technological disruption

• High margins/favorable unit economics

  • sign of moat, low CapEx, low working capital requirements

• Strong, committed management team

  • proven track record, they have to executte the strategic plan

• Low multiple entry price (undervalued hopefully due to external factors or easily fixable problems.)

• Good value-add opportunities

  • selling non-core assets, cutting costs, better S&M

What types of industries attract more deal flow from financial buyers?

• Non-cyclical and low growth

  • more stability

  • Target’s need to turn to inorganic growth anyways

• Subscription/contractual based

  • recurring, stable revenue

  • B2B SaaS

• High R&D requirements

  • Incumbents want to acquire new tech, not go through the cumbersome process of innovating it

• Potential synergies

  • What industries or business types can combine to realize revenue or cost synergies

• Structural industry trends

  • can ride the wave, don’t have to pour a ton of money into being the groundbreaker

What would be the ideal type of products/services of a potential LBO target?

• Mission-critical: it is essential to the ultimate consumer and cannot be removed or easily replaced

• Recurring/Contract Based: enterprise software fits this mold and creates predictable revenue

• High switching costs: hard for end consumers to move away from the products

• High tech: better moat, more pricing power, less competition. This makes cash flows more stable and less risky.

  • Look for companies with high R&D, patents/IP, and industry reputation

• Locational competition: these fragmented businesses (like Chris, but also lawncare and stuff) have less competition and function largely on customer relationships

What is the relationship between debt and purchase price?

A higher purchase price means that the buyer will likely need to take on more debt in order to finance the deal, but this also means that firms can buy companies at a price they never would be able to with their cash alone.

Also, by not using all their cash, they can seek out additional investment opportunities to create other return streams and diversify

What is the relationship between debt and purchase price?

The debt-to-equity mix in private equity deals has hovered around 60% debt/40% equity as M&A activity stabilized since the 2008 financial crisis. However, leverage varies significantly across industries, besides being specific to the target company's fundamental qualities. Debt/EBITDA has hovered in the 5.0x to 7.0x range and is pressured upward as overall valuations increase. When LBOs emerged as a type of M&A transaction in the 1980s, debt represented as much as 90% of the capital structure. But this has come down because of the risks inherent to high debt burdens.

Ultimately, it is going to be based on the cost of debt and whether the cash flows of the target can reasonably meet those obligations.

Why might a private equity firm not raise leverage to the maximum leverage, even if it had the option to do so?

Inherently, leverage comes with risks.

• More default risk from incremental debt load

• Negative perception from the company’s perspective, they’d rather be viewed as a value-add partner

• In the case of a bankruptcy, there is large reputational risk and fund risk for the PE sponsor

• Planned dividend recap, especially if the firm has a view that rates will go down, so they want the optionality to lever up more in the future

What determines a company's debt capacity?

In most cases, a leveraged finance group at an investment bank and the capital markets team will guide a private equity firm looking to raise debt financing.

1. Industry risk like growth rate, barriers to entry, cyclicality, tech disruption and regulatory risks

2. Narrow in on the company’s position within said industry

3. Look at historical performance to create a forecast model that focuses largely on downside scenarios and predictable cash flows that would indicate capacity for debt

4. Based on scenario analysis from the forecast model, the company's appropriate debt capacity will be determined. This leverage multiple (Total Debt/EBITDA) represents the maximum leverage multiple the debt can be raised up to with a sufficient "cushion" that enables it to meet all of its debt obligations even if it were to underperform. This ratio will vary based on the industry and lending environment

In the context of an LBO, what is the “tax shield”?

The tax shield refers to the fact that the interest expense on all of the debt that the firm is taking out is tax deductible, so it isn’t actually as expensive as the headline rate would suggest when looking at financing.

Since senior debt is cheaper, why don't financial sponsors fund the entire debt portion of the capital structure with senior debt?

They cannot. Once the company reaches a certain amount of leverage, creditors will begin to demand incremental compensation for the incremental risk they are taking, which means you need to pay them a higher interest rate. Senior debt also imposes the strictest covenants, which could act to dissuade a debtor.

Also, part of the reason that senior debt gets to have a lower interest rate is because the creditors sit higher in the capital stack, insulated from losses by lower tranches. If there were no lower tranches, then there is nothing insulating them, and so they would demand a higher rate.

How do financial sponsors exit their investments?

They have three main ways of realizing value from one of their investments:

1. Sell to another sponsor or acquirer

   1. cleanest way, wipe their hands of risk, creates a one-time taxable event

2. IPO

   1. have to hold the stake for longer, which can hurt IRR and also introduces public market risk from the stock price moving on them

3. Dividend recap

   1. issue more debt during the holding period and use it to pay a special dividend to the equity holders, which can help boost IRR

What is the one caveat of an IPO exit?

The PE firm itself cannot just sell all its shares right away in the IPO. So, they have additional stock market risk and IRR risk from a longer holding period in a public company.

**there are lockups and also the sentiment around big insider sales like that

What is a secondary buyout?

A secondary buyout is when a PE firm LBOs a target that was already under the ownership of another PE firm. They may believe that they have additional value to add, but most evidence shows that secondary buyouts have a lower return profile than traditional buyouts because much of the streamlining will already have been done.

What is a dividend recapitalization?

When a sponsor borrows more debt onto a firm so that they can use the cash to pay out a special dividend. This can boost IRR incrementally since the investors get to receive payouts sooner. The cash they receive on their position also helps them de-risk.

How might operating a highly levered company differ from operating a company with minimal or no debt?

When operating a highly levered company, you cannot make mistakes. You have to be much more conservative and calculated with your decisions, because one misstep could get you behind debt payments and maturities that can swallow you. Also, you have limited capacity for reinvestment since you want to put as much cash flow as possible towards the debt.

How can a private equity firm increase the probability of achieving multiple expansion during the sale process?

Building a higher quality business via entering new markets through geographic expansion, product development, or strategic add-ons could help a PE firm fetch higher exit valuations – and increase the odds of exiting at a higher multiple than entry. Also, exit multiples can expand due to improvements in market conditions, investor sentiment in the relevant sector, and transaction dynamics (e.g., selling to a strategic).

Why is multiple expansion viewed as a less than ideal lever for value creation?

Because it is much more external, and you would rather bet on your own merits to deliver value rather than speculate on what the market as a whole is going to do or think.

The deal environment in the future is unpredictable, as well.

Can you name a scenario when multiple contraction is common?

For large-sized companies undergoing LBOs, it's normal to see minor multiple contractions. The reason is that as the company grows larger, the number of potential bidders that could afford to purchase the company grows smaller (i.e., a reduced pool of prospective buyers with sufficient capital). Since there's less competition, this usually leads to a lower purchase price.

This company could undergo an IPO, but this would depend on the situation, and a minor contraction in the exit multiple would not impair returns to the fund, especially since the expanded size of the company implies there was revenue and EBITDA growth, as well as debt paydown.

What are some risks you would look out for when assessing potential investment opportunities?

• Industry cyclicality reduces stability

• Customer concentration

• Customer/Employee churn

  • requires constant new acquisitions

• Temporarily inflated valuations

  • Don’t buy at the top of an industry

• Past institutional ownership

  • Less incremental value-add opportunities

• Retiring key management

  • introduces replacement risk

If you had to pick, would you rather invest in a company that sells B2C or B2B?

B2B. Typically these revenue are contracted, recurring, larger, relationship-driven, and necessary no matter what the economic conditions are. Also, higher switching costs usually, and they are less sensitive to price changes.

Imagine that you're performing diligence on the CIM of a potential LBO investment. Which questions would you attempt to answer?

Is there a strong management team in place and do they intend to stay on during the LBO?

What value does the company's products/services provide to their customers?

Which factors make the company’s revenue recurring? Are there any long-term customer contracts?

Where does the team see new opportunities for growth or operational improvements?

What has been driving recent revenue growth (e.g., pricing increases, volume growth, upselling)?

How is the threat of competition? Does this company have a defensible "moat" to protect its profits?

What specific levers does the private equity firm have to pull for value creation? Is the industry that the company operates within cyclical?

How concentrated are the company's revenue and end markets served?

Is there a viable exit strategy? Will there be enough buyer interest when the firm looks to exit?

What is a management buyout (MBO)?

An MBO is an LBO where prior management retains a significant amount of the post-LBO equity. Maybe due to recent underperformance or investor scrutiny, the management team believes they can better drive operational improvements, plus there’s no scrutiny of public filings.

They will roll over existing equity and put in new cash, while other financial sponsors or investors may also be in on the deal. The debt portion is akin to the debt of an LBO.

What is rollover equity and why do private equity firms perceive it as a positive sign?

Rollover equity is when the existing ownership retains their equity in the business through the process of an LBO. This is generally viewed as a positive sign because it shows that the management team is committed, optimistic, and incentivized to help create value. Also, it reduces the amount of equity or leverage that the PE firm has to contribute to fund the deal.

When might a PE firm prefer to use term loans rather than subordinated notes in an LBO?

A PE firm might prefer to use term loans if they are okay taking stricter covenants in exchange for a lower interest rate. Typically, this would be a trade-off they would be willing to make because it gives the sponsor more cash flow to pay down debt with, which is especially relevant because term loans are typically structured with the ability to make optional early repayments.

In addition, if the company is expecting to be active in terms of M&A activity (e.g., add-ons, divestitures), the restrictive incurrence covenants associated with subordinated notes should be considered.

Would a private equity firm prefer high growth or stability in revenue?

Generally, they would prefer stability. While high growth revenue can be a great thing, it also typically comes with higher risk, and a PE firm needs to manage its downside so that it can still make debt repayments.

Stability provides them that cushion and relative guarantee that allows them to make strategic decisions.

Why might a higher average selling price (ASP) or average order value (AOV) not always be better?

It may not always be better because it could coincide with lower volume propping up their revenues. A more concentrated customer base presents risks if a competitor came in to try to take them away with some sort of differentiated offer since only a few leaving can be very costly. Higher ticket items can also make it hard to expand to additional customers.

Can a highly capital-intensive industry be appealing to PE investors?

Asset-light industries can often be attractive because they require less capital to be deployed to generate sales growth. However, a highly capital-intensive industry could create a high barrier to entry that deters entrants, confers stability, and increases the collective pricing power over customers.

Since a capital-intensive industry implies higher amounts of PP&E, this can become beneficial when raising debt financing. As a result of having more fixed assets that can be pledged as collateral, the company can receive better lending terms as the borrowing base has increased.

When might customer concentration be considered being at a manageable level?

An exception to the customer concentration risk will be if there are irrevocable contracts in place (i.e., long term customer agreements). This contractual obligation between the company and the customer being served makes the concentration risk more tolerable but could still lead to a discount on the purchase price.

Explain the strategic rationale behind add-on acquisitions and how it creates value

Add-on acquisitions create the opportunity for synergies to be realized, which can provide an inorganic way to quickly boost cash flows that can be used to repay debt principal.

Another side benefit of the roll-up strategy is that it allows platform companies to compete with strategic buyers in auction-based sale processes since synergies can be realized.

How can value be created during a consolidation play?

• Increased pricing power: customers pay more for stronger brands and complementary product/service offerings

• More bargaining power: larger customers have more power over suppliers, allowing them to extend payables and make bulk, discounted purchases

• Lower CAC: Improved software, more infra integrations, etc lead to increased scale and higher efficiency

• Improved cost structure: Benefit from economies of scale and cost savings (things like combining divisions or offices and reducing overhead expenses.)

What does “multiple arbitrage” in a roll-up acquisition scenario imply?

Multiple arbitrage is achieved when a firm acquirers a firm trading at a lower multiple, making it accretive. So, once their cash flows are integrated with the acquirer, they will automatically trade at the acquirer’s multiple without having to make any actual improvements to the business.

A private equity firm has tripled its initial investment in five years, estimate the IRR?

~25%

Common IRR Aproximations

2.0x Initial Investment in 3 Years  ~25% IRR

2.0x Initial Investment in 5 Years  ~15% IRR

2.5x Initial Investment in 3 Years  ~35% IRR

2.5x Initial Investment in 5 Years  ~20% IRR

3.0x Initial Investment in 3 Years  ~45% IRR

3.0x Initial Investment in 5 Years  ~25% IRR

How many years would it take to double a $100,000 investment at a 9% annual return?

Using the rule of 72, it would take roughly 8 years.

**Rule of 115 can estimate time to triple an investment

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

Most private deals are done on a cash-free, debt-free basis already, so pre-LBO capital structure doesn’t matter much at the end of the day since equity going in and cash flows during the holding period (dividends, fees, exit proceeds) are what drive returns.

**If mgmt. is inexperienced running a company with debt that might impact the risk a bit due to the lower margin of error.

Where do financial sponsors typically get their capital?

It depends on where in the capital structure the capital sits.

For term loans, they may look to banks or insurance companies for sourcing.

For subordinated debt, they may look to private credit firms or pensions.

For mezzanine debt, they may look to hedge funds or opportunistic credit investors.

For equity, they will be putting a lot of this up themselves, but additional equity may come from management or other partners on the deal.

Other sources of capital include sovereign wealth funds, endowments, and HNW individuals.

In the private markets, what does "dry powder" mean?

Dry powder is cash sitting on the sidelines that can be used opportunistically to make new investments when they become attractive.

If dry powder is high, it means that it is hard to find opportunities, which means that bidding processes will be competitive.

What is proprietary deal sourcing and how does it compare to intermediated deals?

• Proprietary deal: initiated through cold outreach or existing relationships. Negotiations are friendlier. PE firm usually wants to establish a relationship so that when an opportunity comes. Grueling, long process. Most target companies are already doing pretty good so why would they want to sell

• Intermediated deals: led by an investment bank with a large list of potential buyers. Increased competition leads to higher prices and the investment bank is incentivized to get the higher selling price too.

From a limited partner's perspective, what are the advantages/disadvantages of the private equity asset class?

Advantages:

• Steadier, often higher returns

• Less exposed to equity markets

• Low reinvestment risk

• Managers are more active in their portcos

Disadvantages

• Illiquid

• Less transparent

• If it goes bad, it goes really bad

Explain the “2 and 20” compensation structure in private equity.

PE firm charges LPs a 2% management fee on their AUM and then takes 20% of returns above a specific hurdle rate, usually.

What is a distribution waterfall schedule in private equity?

The schedule shows how disbursements will be paid based on claim priority.

Classic Structure:

1. Initial LP investment returned in full, as well as returns up to the hurdle rate

2. 20% of returns above that go to GPs due to catch-up clause

3. Remaining proceeds split 80-20 between LPs and GPs

In the distribution waterfall in private equity, what is the catch-up clause?

It states that once the LPs have received a specified return (usually their initial investment plus a hurdle rate), the GPs receive the majority (or all) of the profits until the return proportion outlined in the agreement is met so that the GPs' return will “catch-up” to the original agreed-upon split since the LPs were paid first.

What is a clawback provision?

A fund can start well in terms of investment returns (i.e., the first couple of exits), which benefits both the GPs and LPs, but then later, the back-end of the remaining portfolio companies could be less profitable, and this clause gives LPs the right to reclaim some of their capital back from the profits that the GPs took.

What is the difference between a recapitalization and an LBO?

• Recap vs. LBO: A recap restructures the existing balance sheet (changes the debt/equity mix) with ownership intact; an LBO is an acquisition/change of control funded mostly with debt.

• Dividend recap mechanism: Company raises new debt (Cash ↑, Debt ↑), then pays proceeds out as a special dividend (Cash ↓, Retained Earnings ↓). Cash nets out → net effect is Debt ↑, Equity ↓.

• Why book equity goes negative: By A = L + E, if the dividend (or buyback) exceeds total book equity, retained earnings becomes an accumulated deficit large enough to push total shareholders' equity below zero. Buybacks do the same via treasury stock (contra-equity) — e.g., MCD, SBUX, HP.

What is a recapitalization in the context of PE?

A recapitalization changes a company's capital structure — usually by piling on new debt to fund a big payout to shareholders — without being treated as a true acquisition, because the same legal entity survives and existing owners keep a continuing stake. There's still an offer price since a buyer is paying (often above book value) to take control or buy people out; what's different is only the accounting. Because it's not a purchase, assets stay at their old carrying values and no goodwill is created. So unlike a real acquisition — where the premium over book gets absorbed by writing up assets and booking goodwill — here the debt piles on but the asset side can't be inflated to match. Equity gets squeezed and often goes negative.

Why do some portfolio companies pay sponsor consulting fees?

Many private equity firms, particularly those with in-house consultants, a team of operating partners, or have a separate division specifically offering consulting services, will arrange these types of advisory fees in their investment agreement.

So the PE firm will actually be helping fix the operations, and the fee helps boost their IRR.

What is the impact of the 2017 tax reform on the private equity industry?

1. The most significant change was that corporate tax rates were reduced from 35% to 21%. There were also reductions to S Corporations/LLCs, but the impact is a bit murkier and minor. 2. Companies face limits on how much interest expense can be deducted for tax purposes. While the formula is a little more complicated, companies can roughly deduct interest up to 30% of their EBITDA. This offsets the lower tax rate benefits for highly levered companies. 3. Companies can now accelerate depreciation for tax purposes even more than they could before, which lowers upfront tax bills. This lowers taxes further for capital intensive businesses. 4. Companies can no longer carryback NOLs, but they can carryforward indefinitely instead of just 20 years. Also, companies can use NOLs to offset only 80% of current period income (before tax reform, NOLs could offset 100% of current period income)

For private equity funds, the limited partnership is called a “blind pool.” What does this mean?

This means that investors pool their money in not knowing exactly what it will be invested into and having essentially no choice over.

In private equity, what is a capital call?

A capital call is when a PE firm has commitments from LPs, finds an investment opportunity, and then calls for the cash to actually be sent in from the LPs to take advantage of the opportunity.

This is also called a drawdown, and it allows them LP to use short-term, low-risk investments so that its cash is not just sitting idly by.

A penalty fee or immediate call of all capital might occur if the LP doesn’t meet their capital call obligation usually within a period of 7-12 days

Walk me through a simple M&A model.

• Determine price to pay

• Determine sources, costs, and uses of funding

• Combine balance sheets

  • The major adjustment to the combined balance sheet involves calculating the incremental goodwill created in the transaction, which involves making assumptions regarding asset write-ups and deferred taxes created (or eliminated).

  • Factor in the consequences of the borrowing and paydown

• Project pro-forma IS to get pro-forma EPS

What are two ways to determine the accretive/dilutive impact to EPS?

Bottom-up: When the post-transaction EPS calculation is done as a bottom -up analysis, this involves starting from the buyer ’s and seller’s standalone EPS and adjusting to reflect the incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write-ups.

Top-down: Alternatively, the accretion/dilution analysis can be done top-down, whereby the two income statements are combined, starting with revenue and then moving down to expenses while making the deal-related adjustments.

What does accretion/dilution analysis tell you about the attractiveness of a transaction?

It truthfully doesn’t tell you very much. Many of the benefits of a transaction will only be truly realized after synergies and integration costs have been factored in, and earnings per share is not what a company’s value is based off, it’s cash flows.

That said, the short-term market reaction around an acquisition does look at EPS, so the stock price in the short-term will very likely be impacted. The fear is that the buyer’s apply the same P/E multiple to the lower EPS.

What does it mean when a transaction is done on a “cash-free, debt-free” basis?

This is a very common structure that assumes the seller distributes all excess cash and pays off all debt outstanding before the transaction is completed, excess cash being what is left over after debt is paid down and minimum requirements are met.

Since there is no debt or cash to factor in, the buyer is just paying the seller’s EV because their funds that they pay the seller go towards that debt paydown.

Is it better to finance a deal via debt or stock?

Buyer: When the buyer’s P/E ratio is significantly higher than the target’s, a stock transaction will be accretive, which is an important consideration for buyers and may tilt the decision towards stock. When considering debt, the buyer ’s access to debt financing and the cost of debt will influence the buyer’s willingness to finance a transaction with debt. The buyer will also analyze the deal’s impact on its capital structure, credit rating implications, and credit statistics.

Seller: Most sellers will prefer cash (i.e., debt financing) over a stock sale unless tax deferment is a priority for the seller. A stock sale is usually most palatable to the seller in a transaction that more closely resembles a merger of equals and when the buyer is a public company, where its stock is viewed as a relatively stable form of consideration.

What does purchase consideration refer to in M&A?

The purchase consideration in an M&A deal represents the acquirer's proposed payment method to the target’s shareholders. The purchase consideration can be categorized as cash, stock, or a combination.

• An acquisition paid all-cash has an immediate tax consequence, as a taxable event has been triggered.

• In contrast, if the purchase method made was all-equity (i.e., exchange of shares in the newly merged company), this would not trigger any taxes.

Shareholders’ perception of the post-M&A company and its future can also impact their decision:

• If they have negative views of the company’s future, they would not want to own shares in that company – even if it means they must pay taxes for that year associated with the deal.

• But if they believe the new company will perform well and the share price will appreciate, the shareholders will be inclined to accept stock as compensation to take part in the potential upside.

What is an exchange ratio and what are the two main types?

An exchange ratio is a fixed ratio of a buyer’s shares to a seller’s shares made in a stock deal.

Two types:

• Fixed: the seller’s shareholder’s are guaranteed a fixed amount of shares for each share. This means their ownership percentage is constant once the agreement is signed and executed, but based on how the share price moves post-closing, they have no protections

• Floating: the seller’s shareholders receive a specific dollar value’s worth of shares. This means that their downside is protected if the stock price moves, but the post-close ownership percentage could change.

shares are exchanged at closing.

When might an acquirer prefer to pay for a target company using stock over cash?

If their shares yield more than their cash (super high P/E over the amount they could make in a money market), or they may want cash on hand for opportunities and risks that could arise in the near future.

Paying with stock also means you don’t have to use debt as the alternative if you are low on cash.

For the seller, a stock deal makes it possible to share in the future growth of the business and enables the seller to defer the payment of tax on gain associated with the sale.

Why might some shareholders prefer cash compensation rather than stock?

If the shareholder doesn’t believe in the merger or the potential of the combined company, then they won’t want the chance in participating in downside of the shares.

Also, the seller might need cash to pay down debt balances.

Would you expect an all-cash or all-stock deal to result in a higher valuation?

In all likelihood an all-stock deal would result in a lower valuation because the new owners get to participate in potential upside. The guarantee of the cash payment would feed into any premium, while providing the upside optionality allows them to buy for less.

In all-stock deals, how can you determine whether an acquisition will be accretive or dilutive?

You can use the P/E trick.

If the buyer’s P/E is greater than the target, it is accretive because you are getting higher yield shares for less

If the buyer’s P/E is less than the target, it is dilutive because you are getting lower yield shares for a higher cost.

Assume that a company is trading at a forward P/E of 20x and acquires a company trading at a forward P/E of 13x. If the deal is 100% stock-for-stock and a 20% premium was paid, will the deal be accretive in year 1?

Yes, because the company is using its stock with a 5% yield to acquire shares at a ~6% yield.

How do you calculate the offer value in an M&A deal?

The offer price per share refers to the purchase price to acquire the seller's equity on a per-share basis.

Thus, the calculation of offer value involves multiplying the fully diluted shares outstanding (including options and convertible securities) times the offer price per share.

Offer Value = Fully Diluted Shares Outstanding × Offer Price Per Share

Why is a “normalized” share price used when calculating the offer value?

Shares can fluctuate a good deal on any given day, so you don’t want one day of volatility to create a large difference in the purchase price. So, especially when that day may include news of the merger or acquisition and the share price could already reflect investor sentiment about the future of the deal.

How do you calculate the control premium in an M&A model?

Control premium % = ((Offer price per share/normalize current price per share) - 1) X 100

How do you calculate the transaction value?

Transaction value in the M&A context refers to the target’s implied enterprise value given the offer value

Transaction Value = Target Offer Value + Net Debt

What are the most common balance sheet adjustments in an M&A model?

• Write down seller’s CSE to 0

• Re-value assets and liabilities with write-ups and write-downs

  • create any corresponding DTLs

• Write down any deferred taxes

• Goodwill

• Create new acquirer debt, cash, or equity

What are the most common income statement adjustments in an M&A model?

• You combine revenue and expense line items

• Interest expense, foregone interest on cash

• Pro-forma EPS

• Incremental D&A

• Transaction, financing and integration related costs

• Tax adjustments to acquirer’s tax rate

What does a goodwill impairment tell you about a deal?

It tells you that the acquirer paid more for the deal than the company is worth now and is not getting the value they believed that they would.

Which balance sheet items are often adjusted to fair market value in a transaction?

PP&E and Intangibles because they are typically held far below fair value on the books of a company

Who determines the value of fair market write-ups in a transaction?

Independent appraisers, accountants, and other valuation firms can help determine the write-up amounts.

What is the purpose of a fairness opinion in the M&A context?

A fairness opinion is a document provided by a seller’s investment banker to the seller’s board of directors attesting to fairness of the transaction from a 3rd party perspective and give an unbiased evaluation

Would an acquirer prefer $100 in revenue synergies or $100 in cost synergies?

They would prefer $100 in cost synergies because it is closer to cash flow and net income. $1 of revenue gets eaten away by costs, while $1 of costs can flow straight through