Private Equity

Leveraged Buyout Model

An analysis that projects the returns of a potential investmetn; typical LBO puts leverage on the company and pays down that debt with the company’s cash flow

Key LBO levers

EBITDA Growth
Raising debt and paydown
Multiple expansion

Key sections of an LBO model

Transaction Assumptions
Sources & Uses
Financial Forecast / Operating Model
3-Statement Model
Return Analysis

Enterprise Value (definition)

The total value of a company, including its equity and debt, often used in LBO valuations to assess how much a buyer might pay for it. It reflects the market's view of the company's overall worth.

Enterprise Value (formula)

The formula for calculating Enterprise Value is: EV = Market Value of Equity + Total Debt - Cash and Cash Equivalents. This measure provides a comprehensive view of a company's total value.

Equity Value (definition)

The total value of a company's equity, reflecting the market capitalization of its shares. It is an important measure used in LBOs to assess the worth of the company to equity investors.

Equity Value (formula)

The formula for calculating Equity Value is: Equity Value = Fully Diluted Shares Outstanding (FDSO) multiplied by the Purchase Price per Share. This measure indicates the total value attributable to shareholders.

FDSO (definition)

Fully diluted shares outstanding represents the total share count and true economic ownership share; Represents basic shares outstanding + Net Options + Net Warrants

Net Options

The in-the-money value of employee stock options (options that would be exercised) added to equity value, typically calculated using the treasury stock method and increasing enterprise value.

Net Warrants

Similar to net options, the in-the-money portion of warrants (longer-dated rights to buy shares) that are assumed exercised and netted against cash proceeds, increasing equity value and thus enterprise value

Restricted Stock Units

Shares granted but not yet vested that are treated as outstanding (or added on a net basis) in diluted equity value, increasing enterprise value since they represent future shareholder claims

Treasury Stock Method

Method to calculate the net amount of options to be included in FDSO

Net options = Options (#) - (Exercise proceeds / Current Share Price)

How can we decide what the premium on a share price should be?

• Historical trading levels / volume weighted price

• Trading comparables and precedent transactions

• General rule of thumb is to a 15-30% premium, but can depend significantly on market conditions and competitiveness of process

How to calucate Enterprise Value for a private company?

Enterprise Value = EBITDA x Multiple

Implied Equity Value = Enterprise Value - Debt + Cash

Equity financing pros and cons

Pros
No mandatory payments → no interest or principal, so lower risk of distress (important in downturn cases).

Flexible capital → can fund growth, turnarounds, or volatile businesses where cash flow isn’t stable.

Stronger balance sheet → lower leverage improves credit profile and borrowing capacity late

Cons

Dilution of ownership → founders/PE sponsor give up upside.

More expensive capital → equity investors require higher returns than lenders.

Loss of control → new investors may require governance rights (board seats, vetoes).

Debt financing pros and cons

Pros

• No dilution → sponsor retains ownership and upside (critical in LBOs).

• Cheaper capital → interest is lower than equity return expectations.

• Tax shield → interest is tax-deductible, boosting cash flow and returns.

Cons

• Fixed obligations → interest + principal payments increase bankruptcy risk.

• Covenants & restrictions → limits on operations, dividends, additional debt, etc.

• Refinancing risk → if markets tighten or performance dips, rolling over debt can be difficult.

Most common forms of debt

Bank debt; Notes; Bonds

Bank Debt

• Interest rate (relative direction)

• Types of bank debt

• Rate type

• Pre-payment

• Tenor

• Features

• Interest rate (relative direction) = Low

• Types of bank debt = Revolver; Term loan A & B

• Rate type = Floating (moves w/LIBOR)

• Pre-payment = Yes

• Tenor = 5-7 years

  • Features = offered by banks

Notes

• Interest rate (relative direction)

• Types of notes debt

• Rate type

• Pre-payment

• Tenor

• Features

• Interest rate (relative direction) = Higher than bank debt but lower than bonds

• Types of notes debt = Senior; Subordinated

• Rate type = Fixed

• Pre-payment = No

• Tenor = 7-10 years

• Features = Offered by credit funds & banks

Bonds

• Interest rate (relative direction)

• Types of bond debt

• Rate type

• Pre-payment

• Tenor

• Features

• Interest rate (relative direction) = Higher than bank and note debt

• Types of bond debt = Investment grade, high-yield, convertible

• Rate type = Fixed or floating

• Pre-payment = No

• Tenor = 7-10 years

  • Features = Traded on public

When calculating the debt amount in a enterprise value for a public company, what are the items that are included

Common debt; convertible debt; preferred stock; capitalized leasesC

Capitalization

• Describes when costs are recorded as assets on a balance sheet, instead of being listed as an expense on the income statement

• Acknowledges that some expenses produce benefits that extent beyond current accounting cycle and enables the company to distribute its costs over multiple periods through D&A, instead of reporting the expense right away

• Capitalized lease behave like debt (fixed payments over long-term)

What are the typical forms of equity sources

• Common equity

• Preferred stock

• Options

Common equity as a form of equity financing

• 1-sentence description: Basic ownership in a company with residual claim on profits and value after all other stakeholders are paid.

• Popularity / typical use:

  • Most common form of equity

  • Used in almost all deals (LBOs, growth equity, venture, public companies)

  • In PE, this is the sponsor’s main investment

• Capital structure position:

  • Last in line (most junior)

  • Gets paid after debt and preferred stock

• Additional features:

  • Voting rights (control)

  • Unlimited upside

  • No fixed return or dividend requirement

Preferred Stock within th econtext of equity financing

• 1-sentence description: Hybrid security that sits between debt and common equity, offering a fixed return and priority over common equity.

• Popularity / typical use:

  • Very common in structured deals

  • Used in growth equity, venture capital, minority PE deals, and recapitalizations

  • Less common in traditional control LBOs (unless structuring downside protection)

• Capital structure position:

  • Above common equity, below debt

  • Paid before common in dividends and liquidation

• Additional features:

  • Fixed dividend (cash or PIK)

  • Liquidation preference (e.g., 1.0x–2.0x return before common gets anything)

  • Can be participating or convertible into common

  • Often includes downside protection + some upside participation

Options within the context of equity financing

• 1-sentence description: Rights (not obligations) to purchase shares at a fixed price, typically granted as compensation.

• Popularity / typical use:

  • Very common in all equity-backed companies

  • Used in management incentive plans (MIPs) in PE deals

  • Rarely a primary funding source—more of a compensation / alignment tool

• Capital structure position:

  • Not part of the capital structure until exercised

  • Once exercised → become common equity (most junior)

• Additional features:

  • Strike price (usually set at or above entry valuation in PE)

  • Vesting schedules (time- or performance-based)

  • Provide leveraged upside for management

  • Dilutive to existing shareholders (important for EV → equity bridge)

What are the uses of financing sources

• Purchase equity - taking out shares of existing owners so that we own the company instead

• Refinance debt - replacing or taking out existing debt structure; in an LBO the pre-acquisition capital structure does NOT impact returns, what matters is our sources and the capital structure we install

• Cash to balance sheet - any excess cash needed for operations will be sent to balance sheets, typically want to minimize amount of cash needed

• Original Issue Discount - debt is often issued below par to make it more attractive to investor (generally 1-2%); able to amortize OID interest

• Fees - fees related to debt or equity financing which can be capitlized / amortized to reduece future tax

• Expenses - fees spent on advisors, M&A, lawyer, etc. which CANNOT be amortized

Unlevered Free cash flow

Cash flow generated by the business before debt payments, representing cash available to all capital providers (debt + equity).

EBITDA
Less cash taxes
Less Capex
Less increase in NWC

Why do we subtract the increase in NWC?

Because an increase in NWC means cash is tied up in the business, so it’s not actually “free” cash.

Simple example:

• You make a sale → revenue goes up

• But the customer hasn’t paid yet → Accounts Receivable increases

• So you haven’t received the cash yet

Levered free cash flow

Levered free cash flow is the cash remaining after operating costs, taxes, reinvestment, and all debt payments, representing what’s available to equity holders only

EBITDA
Less cash taxes

Less CAPEX

Less increase in NWC

Unlevered Free Cash Flow

Less interest and debt paydown

Levered Free Cash Flow

Net working capital

Current assets - current liabilities

Additional NWC represents a use of cash; in a counter-intuitive way, every time we make a sale we need to inject more cash into the business; if AR increases then its “cash being used”

Purchase accounting

describes the accounting adjustments that must be made in the event of a merger or acquisition; need to adjust the assets pro-forma post-purchase to ensure the balance sheet still balances in the face of a premium

In purchase accounting, what are the key revised accounts and what are the wiped accounts

Key revised accounts

• Cash

• Capitalized financing fees

• Goodwill

• Intangible assets

• New debt instruments

• Deferred tax liability

• Shareholder equity

Wiped accounts

• Existing debt

• Existing equity

Purchase accounting revision: Cash

Logic: All available cash will be used in the transaction

Pro Forma Calc: Cash to balance sheet

Purchase account revision: Goodwill

Logic: Any excess purchase price of equity plugged by goodwill

Pro Forma Calc: Purchase price - book value of equity + Existing good will - write up of intangibles + Deferred Tax Liability

Purchase account revision: Intangible assets

Logic: Some acquired assets (patent trademarks) will be re-valued or increased

Pro Forma Calc: % of step-up of equity

Purchase account revision: New debt instruments

Logic: debt arranged by investor to acquire company; wipe old debt account

Pro Forma Calc: $ model assumption or mutiple of EBITDA

Purchase account revision: Capitlized financing fees

Logic: Debt fees paid to bank can be amortized over the life of the debt

Pro Forma Calc: Det raised x Fee %

Purchase account revision: Deferred tax liability

Logic: We must pay taxes based on the intangible asset write-up

Pro Forma Calc: Tax rate % x Intangible asset write-up

Purchase account revision: Shareholder Equity

Logic: Equity invested into company; wipe old equity account

Pro Forma Calc: $ Model assumption or FDSO * Share Price

Purchase account revision: Capitalized Financing Fees

Logic: Fees associated with issuing debt. WE amortize them beacuse debt has a finite life

Pro Forma Calc: $ debt amount x Financing fees %

Purchase account revision: Transaction expenses

Logic: One-time expenses paid to transaction advisors in cash. Cannot be amortized

Pro Forma Calc: $ Assumption or % of Enterprise Value

Step up of equity (formula); additionally, what is book value of equity

Purchase Price - (Book Value of Equity) + Existing Goodwill

Book value of equity = Fair vale of Assets - Fair Value of Liabilities

What are the two accounting adjustments to the step-up of eqity to get to goodwill

1. Make an assumption for how much of that step=up applies to other intagnbles assets (patentts, trademarkets, copyrights, i.e. non-goodwill intangble assets); this write-up WILL be amortized over time

2. Create a deferred tax liability because the itnagnble asset write-up is taxabl

Reasoning:
Amortization expense increase leads to lower GAAP taxes. Must create deferred tax liability to offset tax discrepancy

What is the total step-up of eqiuty (formula)

It is the difference between the acquisition value and book value
Step up of equity = Purchase equity value - book value of equity + existing goodwill

WHy are intangible assets written up to begin with?

Intagnible assets are re-assessed as part of the acquisiton process. They are tyrpically written up, as book values tend to lag market values

Why do we subtract the write-up of intangble assets to get to goodwill?

Recall that goodwill is a plug. If our intangble assets are assessed as higher, then we need less goodwill

WHy is a deferred tax liability created from goodwill purchase accounting

The deferred tax liability is created because of the difference between GAAP and IRS (Cash) taxes. This DTL simply represents the difference between GAAP and cash taxes

The writeup of intagnles from an aquision is NOT recognized by the IRS. It is only recorgnized under GAAP. So we owe the IRS more taxes in the future

Do we add back the DTL in the caluation to pr forma goodwill? WHy or why not?

Yes, we do. The DTL is a liailty Goodwill is the plug and itis an asset. THe DTL increases the gap on the liabilities side, so goodwill needs to be larger to blance the books

Why would a writeup of intangles result in less taxes?

A higher intanglble asset results in more amortization expense. MOre expenses reslt in less taxes. Therefore, a write-up of intangble assets under GAAP results in lower GAAP taxes

What is the impact to cash flow from these accounting changes?

There is NO impact to cash flow. The increased amortization expense reduces teh GAAP taxes, but there is an equial offestting amount in the “Unwind of Deferred Tax LIability” in the cash flow statement. The net impact to cash flow is zero

What is the waterfall logic of the debt schedule

Typcally Revolver → Term Loan A → Term Loan B → Bonds / notesW

What is the debt schedule line logic?

Beginning balance
Plus: PIK interest
Plus: Recap debt / additional allocation
Less: Mandatory repayment
Less: Voluntary Repayment
Ending balance

Interest expense = avg. between beginning & ending balance

What is a revolver?

The company’s revolving line of credit and is drawn down when the company needs more cash than it is generating

Typically comes with a <1% commitment fee (Annual fee paid to bank) t

What are the revolver inputs?

Maximum capacity
Interest rate

Interest rate floor

Optional borrowing

Define the following revolver inputs
Maximum capacity
Interest rate

Interest rate floor

Optional borrowing

Maximum capacity = the maximum amount a revolver can be drawn, any borrowing cannot exceed this amount
Interest rate = often calculated as LIBOR + a rate in basis points

Interest rate floor = the minimum amount that will be added to the rate (i.e., if LIBOR is below the floor, you must add the rate to the floor)

Optional borrowing = if cash flow is negative, then you will borrow cash from the revolver here. If cash flow is positive, you will pay down any revolver balance

Excel formulas for
Interest rate
Optional Borrowing
Available capacity

Interest rate = Rate / 10,000 + MAX (LIBOR, Rate Floor)

Optional Borrowing = MIN(Available Capacity, -MIN(Cash Available for Paydown, Beginning Balance of Revolver))

Available capacity = Maximum Capacity - beginning Balance

What is PIK interest?

Non-cash itnerst, meaning the comapny compensates the lener in the form of additional debt; Features inlclude
- Typically carry higher interst rate bc it is higher risk to investor
- Popular with compankes who cannot afford cash payouts
- Compounts annually
- Still considered taxable income to the investor

Preferred stock definition

A higher laim on assets than common stock and often received cash or PIK dividences. Preferred stock typically does not have voting rights; it is a way to incentivize and attract different invesstors. Companies can also prevent common equity idlution by gving protection istead

Two types
Participating preferred
Convertible preferred

WHat is particpatin gpreferred stock

Receive preferred amount AND have a claim to common equity. In negotiations, can lead to a higher company valuation because they give up less ownership

WHat is a convertible preferred stock?

Reciev higher of preferred amount OR common equity; convert into common equity shares when “in the money”Wh

what is a dividend recap and tyipcal impact on IRR and MoM? hwere does recap Debt sit in waterfall

PE firms will sometimes raise additional debt during the forecast in order to issue a dividend to themselves

This increases the ttoal amount of debt and interest paid, but accelerates when cash is received; will reduce shareholder equity

An accretive Dividend REcap typically increases IRR and dcresases MoM (bc additional interest has to be paid)

Recap debt is often ghiher in priroty than bank debt / senior notes; there may also be fees (which would be amortized)