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LBO EXAM WITH COMPLETE QUESTIONS AND ANSWERS
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LBO EXAM WITH COMPLETE QUESTIONS ANDANSWERS
What is a leveraged buyout, and why does it work? - ANSWER In LBO, a PE
firm acquires a company using a combination of Debt and Equity, operates it for
several years, and then sells the company at the end of the period to realize a
return on its investment.
During ownership, the PE firm uses the company's cash flows to pay for the
interest expense on the Debt and to repay Debt principal. It works because
leverage amplifies returns: If the deal performs well, the PE firm will realize higher
returns than if it had bought the company with 100% Equity. But leverage also
presents risks because it means the returns will be even worse if the deal does
not perform well.
MP: waterfall of cash falls on rocks (interest on debt + debt principal)
Why do PE firms use leverage when buying companies? - ANSWER To amplify
their returns. Leverage does NOT "increase returns": Using leverage - borrowing
money from others - to fund a deal simplify makes positive returns even more
positive and negative returns even more negative. All PE firms aim for positive
returns above a certain IRR, and using leverage makes it easier to get there... if
the deal goes well. A secondary benefit is that the PE firm has more capital
available to buy other companies since it won't use up all its funds on acquiring
one company.
Walk me through a basic LBO model. - ANSWER 1. Assumptions for the
Purchase Price, Debt and Equity, Interest Rate on Debt, and other variables such
as the company's revenue growth and margins.
- Assume
2. Sources & Uses schedule to show exactly how much how much in Investor
Equity the PE firm contributes; you also create a Purchase Price Allocation
Schedule to calculate the Goodwill.
- SourPatch kids
3. Adjust the company's Balance Sheet for the new Debt and Equity figures,
allocate the purchase price, and add Goodwill & Other Intangibles to the Assets
side to make everything balance.
,- Adjust your taste and
4. Project the company's Income Statement, Balance Sheet, and Cash Flow
Statement, and determine how much Debt it repays each year based on its Free
Cash Flow.
- Project a funny face before
5. Assumptions about the exit, usually assuming an EBITDA Exit Multiple, and you
calculate the IRR and Money-on-Money multiple based on the proceeds the PE
firm earns at the end."
- Assuming normalcy
Can you explain the legal structure behind a leveraged buyout and how it benefits
the private equity firm? - ANSWER In a leveraged buyout, the PE firm forms a
"holding company," which it owns, and then this "holding company" acquires the
real company. The banks and other lenders that provide the Debt lend to this
Holding Company so that the Debt is at the "HoldCo" level.
Managers and executives at the acquired company that retain ownership after the
deal closes also have shares in this Holding Company. This structure is important
because it means that the private equity firm is NOT "on the hook" for the Debt it
uses in the deal: It's up to the Target Company to repay it. Not only does the PE
firm borrow other peoples' money to do the deal, but it doesn't even borrow the
money directly - the company borrows the money so the PE firm can do the deal.
What assumptions impact a leveraged buyout the most? - ANSWER PE =
Purchase and Exit assumptions
The Purchase and Exit assumptions, usually based on EBITDA multiples, make
the biggest impact on a leveraged buyout. A lower Purchase Multiple results in
higher returns, and a higher Exit Multiple results in higher returns. After that, the
% Debt Used makes the biggest impact. If the deal performs well, more leverage
will make it perform even better, and vice versa if it does not perform well.
Revenue growth, EBITDA margins, interest rates and principal repayments on
Debt all make an impact as well, but less so than the other assumptions.
How do you select the purchase multiples and exit multiples in an LBO model? -
ANSWER For public companies, typically you assume a share-price premium
and check the implied purchase multiple against the valuation methodologies to
make sure it's reasonable. For example, you might assume a 30% premium to the
company's share price of $10.00, which implies an EV / EBITDA multiple of 10x.
For private companies, you determine the purchase multiple by looking at
,comparable companies, precedent transactions, and the DCF analysis. The exit
multiple is typically similar to the purchase multiple but could go higher or lower
depending on the company's FCF growth and ROIC by the end. You always use a
range of purchase and exit multiples to analyze the transaction via sensitivity
tables.
What is an "ideal" candidate for an LBO? - ANSWER Almost any deal can work
at the right price. Assuming the price is right - i.e., the company is relatively
undervalued compared with its peers - an ideal LBO candidate should also:
• Have stable and predictable cash flows (so it can repay Debt);
• Not have much need for ongoing investments such as CapEx;
• Be in a fast-growing and highly fragmented industry (so the company can make
add-on acquisitions);
• Have opportunities to cut costs and increase margins;
• Have a strong management team;
• Have a solid base of assets to use as collateral for Debt;
• Have a realistic path to an exit, with returns driven by EBITDA growth and Debt
paydown rather than multiple expansion.
The first point about stable cash flows is the most important one after price.
How do you use an LBO model to value a company, and why does it set the "floor
valuation" for the company? - ANSWER You use it to value a company by
setting a targeted IRR, such as 25%, and then using Goal Seek in Excel to
determine the purchase price that the PE firm could pay to achieve that IRR. For
example, if the exit multiple is 11x, which translates into $1,000 in Equity
Proceeds for the PE firm, Goal Seek in Excel might tell you that the firm could pay
$328 in Investor Equity to achieve a 25% IRR over 5 years. At a 50% Debt / Equity
split, that translates into a Purchase Enterprise Value of $656. This method
produces a "floor valuation" because it tells you the maximum amount a PE firm
could pay to realize a certain IRR. Other methodologies are not constrained in the
same way.
Wait a minute, how is an LBO valuation different from a DCF valuation? Don't they
both value the company based on its cash flows? - ANSWER They are both
based on cash flows, but in a DCF you're saying, "What could this company be
worth, based on the Present Value of its cash flows?" But in an LBO, you're
saying, "What could we pay for this company if we want to achieve an IRR of, say,
25%, in 5 years?" Both methodologies are similar, but with the LBO valuation,
, you're constraining the values based on the returns you're targeting.
How is a leveraged buyout different from a normal M&A deal? - ANSWER In an
LBO, you assume the company is sold after 3-5 years (and sometimes a bit more
than that). As a result, you focus on the IRR and MoM multiple as the key metrics.
Also, PE firms can use only Debt and Equity (Equity means "Cash" in this context)
to fund deals, whereas normal companies in M&A deals can use Cash, Debt, and
Stock. Synergies and EPS accretion/dilution matter a lot in M&A deals, but not at
all in LBOs. You determine the Purchase Price in similar ways, but in an LBO,
you'll often "back into" the Purchase Price based on the price required to achieve
a targeted IRR.
A strategic acquirer usually prefers to pay for another company with 100% Cash -
if that's the case, why would a PE firm want to use Debt in an LBO? - ANSWER
It's a different scenario in an LBO because:
1) The PE firm plans to sell the company in a few years - so it's less concerned
with the expense of Debt and more concerned with using leverage to amplify its
returns by reducing the capital it contributes upfront.
2) In an LBO, the company is responsible for repaying the Debt, so the acquired
company assumes most of the risk. In a standard M&A deal, the Buyer or
"Combined Entity" carry the Debt, so there's far more risk for the acquirer.
How could a private equity firm boost its returns in an LBO? - ANSWER The
main returns drivers are Multiple Expansion, EBITDA Growth, and Debt Paydown
and Cash Generation, so a PE firm could improve its returns by improving any of
those.
In practice, this means:
• Multiple Expansion - Reduce the Purchase Multiple and/or increase the Exit
Multiple.
• EBITDA Growth - Increase the company's revenue growth rate or boost its
margins by cutting expenses.
• Debt Paydown and Cash Generation - Increase the Leverage (Debt) used in the
deal, or improve the company's cash flow by cutting CapEx and Working Capital
requirements.
Since the PE firm has the most control over the last factor, the easiest way to
boost returns is to use more Debt (assuming the deal doesn't blow up and destroy
the universe).
How do you calculate the internal rate of return (IRR) in an LBO model, and what
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