LBO - Basic M&I Questions

Walk me through a basic LBO model.

Step 1 is making assumptions about the purchase price, debt/equity ratio, interest rate on debt, and other variables. You might also assume something on the company’s operations (e.g. revenue growth or margins) based on how much information you have. 

Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much investor equity is required. 

Step 3 is to adjust the company’s Balance Sheet for the new debt and equity figures, and also add in Goodwill & Other Intangibles on the assets side to make everything balance 

Step 4 is to project out the company’s Income Statement, Balance Sheet, and Cash Flow Statement, and determine how much debt is paid off each year, based on available cash flow and the required interest payments. 

Step 5 is to make assumptions about the exit after several years, usually assuming an EBITDA exit multiple, and calculate the return based on how much equity is returned to the firm.

Why would you use leverage when buying a company?

To increase your returns. Any debt used in an LBO is not “your money”.

What variables impact an LBO model the most?

Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used has a big impact, as well as operational characteristics such as revenue growth and EBITDA margins.

How do you pick purchase multiples and exit multiples in an LBO?

Look at what comparable companies are trading at and what multiples similar LBO transactions have had. Show a range of purchase and exit multiples using sensitivity tables. 

Sometimes you set purchase and exit multiples based on a specific IRR target - but this is just for valuation purposes.

What is an “ideal” candidate for an LBO?

Ideal candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as CapEx, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt.

6. How do you use an LBO model to value a company, and why do we sometimes say

that it sets the “floor valuation” for the company?

You use it to value a company by setting a targeted IRR (e.g. 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR. 

This is called a “floor valuation” because PE firms almost always pay less for a company than strategic acquirers would.

Give an example of a “real-life” LBO

The most common example is taking out a mortgage when you buy a house. 

Down payment: investor equity (cash) in an LBO 

Mortgage: Debt in an LBO 

Mortgage interest payments: Debt interest in an LBO 

Mortgage repayments: debt principle repayments in an LBO 

Selling the house: selling the company/taking it public in an LBO 

Can you explain how the Balance Sheet is adjusted in an LBO model?

First, the Liabilities and Equities side is adjusted - the new debt is added on, and the Shareholders’ Equity is “wiped out” and replaced by however much equity the PE firm is contributing. 

On the Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Other Intangibles are used as a “plug” to make the Balance Sheet balance.

Why are Goodwill & Other Intangibles created in an LBO?

Both of these represent the premium paid to the “fair market value” of a company. In an LBO, they act as a “plug” and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.

We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that’s the case, why would a PE firm want to use debt in an LBO?

1) The PE firm doesn’t intend to hold the company for the long term - it usually sells it after a few years, so it’s less concerned with the “expense” of cash vs debt and more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront 

2) In an LBO, the debt is “owned” by the company, so they assume much of the risk.

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

Yes, there are shortcuts and you don’t necessarily need to project all 3 statements. 

For example, you don’t need a full Balance Sheet. You do need some form of Income Statement to track how the Debt balances change and some type of Cash Flow Statement to show how much cash is available to repay debt. 

A full-blown Balance Sheet isn’t required because you can just make assumptions on the Net Change in Working Capital rather than looking at each item individually.

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

1. Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios? 

This is dependent on the company, industry, and the leverage/coverage ratios for comparable LBO transactions. 

You would need to look at “debt comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used.

1. What is the difference between bank debt and high-yield debt? 

High-yield debt tends to have higher interest rates than bank debt (hence the name). 

High-yield debt has incurrence covenants while bank debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something while maintenance covenants require you to maintain a minimum financial performance (e.g. 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. 

Usually in a sizable LBO, the PE firm uses both types of debt.

1. Why might you use bank debt rather than a high-yield debt in an LBO? 

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

Why would a PE firm prefer high-yield debt instead?

If the PE firm intends to refinance the company 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 the high-yield option if they don’t have plans for major expansion or selling off the company’s assets. 

Why would a PE firm buy a company in a “risky” industry, such as technology?

There are some mature, cash flow-stable companies in almost every industry, even technology. Some PE firms specialize in specific goals such as:

1) Industry consolidation - buying competitors in a similar market and combining them to increase efficiency and win more customers

2) Turnarounds - taking struggling companies and making them function properly again

3) Divestitures - selling off divisions of a company or taking a division and turning it into a strong stand-alone entity

How could a PE firm boost its return in an LBO?

1) Lower the purchase price

2) Raise the exit multiple/exit price

3) Increase the leverage (debt) used

4) Increase the company’s growth rate (organically or via acquisitions) 

5) Increase margins by reducing expenses (e.g. cutting employees, consolidating buildings, etc.)

What is meant by the “tax shield” in an LBO?

This means the interest a firm pays on debt is tax-deductible - so they save money on taxes and therefore increase their cash flow as a result of having debt from the LBO. 

Note, however, that their cash flow is still lower than what it would be without the debt - saving on taxes helps, but the added interest expenses still reduces Net Income over what it would be for a debt-free company.

What is a dividend recapitalization (“dividend recap”)?

In a dividend recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it.

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

Primarily to boost returns. More leverage means a higher return to the firm. 

With a dividend recap, the PE firm is “recovering” some of its equity investment in the company - as we saw earlier, the lower the equity investment, the better, since it’s easier to earn a higher return on a smaller amount of capital.

How would a dividend recap impact the 3 financial statements in an LBO?

No changes to the Income Statement. On the Balance Sheet, Debt would go up and Shareholders’ Equity would go down and they would cancel each other out so that everything remained balanced. 

On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash wouldn’t change.