Study Questions and Correct Answers
for LBO Modelling
Why do PE firms use leverage when buying companies? ✅Amplify returns using
leverage Less capital upfront => greater upside potential + greater risk
Walk me through a basic LBO model ✅1. Make assumptions about purchase price,
funding sources, interest rate on debt, and growth 2. S&U to back into Equity
Contribution. PPA to calculate GW and Other Intangibles created 3. Adjust target's B/S
for new debt and equity figures, allocate the purchase price, and add GW and other
Intangibles s.t. A = L + E 4. Project target's I/S, B/S, and C/S and determine how much
debt it pays based on its FCF over the holding period 5. Make assumptions about the
exit (usually exit EBITDA multiple), which is used to calculate exit EV and back into final
equity proceeds to calculate the MoM and IRR
What assumptions impact a leveraged buyout the most? ✅1. Purchase and Exit
assumptions 2. % debt used 3. revenue growth, EBITDA margins, interest rates,
principal repayments on Debt
How do you select the purchase multiples and exit multiples in an LBO model?
✅Public companies: -Assume a share-price premium and sanity check implied
purchase multiple against valuation methods Private companies: -Determine the
purchase multiple by using valuation methods (Comps & DCF) For exit multiples: -
Similar process but could go higher or lower depending on company's FCF growth and
ROC by the end
"What is an ""ideal"" candidate for an LBO?" ✅**Any deal can work at the right price**
Assuming company is relatively undervalued, an ideal candidate should also: 1. Have
stable, predictable cashflows (to repay debt) <- most important after price 2. Not have
much need for ongoing investments like capex 3. Be in a fast-growing and highly
fragmented industry 4. Have opportunities to cut costs and increase margins 5. Have a
strong management team 6. Have a solid base of assets to use as collateral 7. Have a
realistic path to an exit, with returns driven by EBITDA growth and Debt paydown rather
than multiple expansion
"How do you use an LBO model to value a company, and why does it set the ""floor
valuation"" for the company?" ✅"Use an LBO to find the PE firm's Willingness to Pay
to achieve a target IRR. In other words, this method produces a ""floor valuation"" as it
tells you the maximum amount a PE firm could pay to realize a target IRR. Other
valuation methods are not constrained in the same way."
,How is an LBO different from a DCF? Don't they both value the company based on its
cashflows? ✅"Both based on cashflows, but in a DCF you're finding the intrinsic value
of the company based on the NPV of those cashflows. In an LBO you're constraining
the ""value"" of the company based on a target return."
How is a leveraged buyout different from a normal M&A deal? ✅"LBO: -Assume
company is sold 3-5 years after => focus on MoM and IRR -Use only debt and cash
(""Investor Equity"") -Back into purchase price based on a target IRR M&A: -Many of the
times acquistion is indefinite => focus on synergies and accretion/dilution -Use debt,
cash, and stock"
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? ✅1. PE firm plans to
sell company in a few years => less concerned with expense of debt, more concerned
with using leverage to amplify returns 2. In LBO, Company is responsible for repaying
debt, so acquired company assumes most of the risk (in M&A the combined entity
assumes risk)
How could a private equity firm boost its returns in an LBO? ✅1. Multiple expansion
(lower entry, increase exit) 2. EBITDA growth (increase rev growth, ebitda margins, etc.)
3. Debt paydown and cash generation (increase debt, cut capex and working capital
requirements) Note: easiest way to boost returns is to use more debt (assuming deal
doesn't blow up)
IRR Cheat Sheet ✅2x scenarios => 100% / Yrs * 3/4 ~ IRR 3x scenarios => 200% /
Yrs * 13/20 ~ IRR In dividend recaps or IPO exits, find the avg # yrs it takes to receive
all euqity proceeds Ex: co IPO at Yr 4 and takes 3 years to recoup all proceeds => 4,5,6
=> on avg 5 yr
How do you calculate the internal rate of return (IRR) in an LBO model, and what does it
mean? ✅IRR is the effective annual compounded interest rate. For example, if you
invest $100 today and get back $200 after 5 years, what interest rate would turn make
that happen? Another way to look at it: IRR is the discount rate that makes NPV of
future cash flows = 0. You calculate by setting capital invested (capitla outflows) as
negative and all capital inflows (inc dividends and equity proceeds) as positive, then
applying the IRR function in Excel to all numbers No dividends => IRR = CAGR
How can you quickly approximate the IRR in an LBO? Are there any rules of thumb?
✅2x over 3 yrs ~ 25% 3x over 3 yrs ~ 45% 2x over 5 years ~ 15% 3x over 5 years ~
25%
A PE firm acquires a $100 million EBITDA company for a 10x purchase multiple and
funds the deal with 60% Debt. The company's EBITDA grows to $150 million by Year 5,
but the exit multiple drops to 9x. The company repays $350 million of Debt in this time
and generates no extra Cash. What's the IRR? ✅100 * 10 = 1000 EV (600d/400e) 150
,* 9 = 1350 (350d/1000e) @ YR5 MoM = 1000/400 = 2.5x over 5 yrs => [~20%] 2x over
5 yrs = 15% 3x over 5 yrs = 25%
A PE firm acquires a $200 million EBITDA company using 50% Debt, at an EBITDA
purchase multiple of 6x. The company's EBITDA grows to $300 million by Year 3, and
the exit multiple stays the same. Assuming the company pays its interest and required
Debt principal but generates no additional Cash, what is the MINIMUM IRR? ------- How
does the IRR change if the company repays ALL its Debt but nothing else changes?
✅200 * 6 = 1200 EV (600d/600e) 300 * 6 = 1800 EV (yd/1800-ye) MoM = 1800-y /
600... Min(IRR) => Min(MoM) => Max(y) => y=600 (no debt repayment; constant debt)
MoM = 1200/600 = 2x over 3 years ~ [25% IRR] --------- MoM = 1800/600 = 3x over 3
years ~ [45% IRR] --------- NOTE: Deal will be 25%<IRR<45% depending on Debt
repayment
You buy a $100 EBITDA business for a 10x EBITDA multiple, and you believe you can
sell it in 5 years for a 10x multiple. You use 5x Debt / EBITDA to fund the deal, and the
company repays 50% of that Debt over 5 years. By how much does EBITDA need to
grow over 5 years for you to realize a 20% IRR? ✅100 * 10 = 1000 EV (500d/500e) y *
10 = 10y EV (250d/10y-250e) Based on: 2x over 5yr = 15% 3x over 5yr = 25% 20%
over 5 yr => 2.5x MoM 10y- = 2.5 => y = [150]
A PE firm acquires a business for a 12x EBITDA multiple, using 5x Debt / EBITDA, and
plans to sell it in 5 years. The company's initial EBITDA is $100, and it grows to $200 by
Year 5. If there's no Debt repayment and no additional Cash generation, what exit
multiple do we need for a 25% IRR? ---------- Now assume the company repays 75% of
the initial Debt balance over 5 years. What exit multiple do we need for a 25% 5-year
IRR? ✅100 * 12 = 1200 (500d/700e) 200 * y = 200y (500d/200y - 500e) 25% IRR over
5 years => 3x 200y- = 3 => y = [13x] -------------------- MoM = 200y - 500(0.25) /
700 = 3 => y = [11.125x]
A private equity firm acquires a $200 EBITDA company for an 8x EBITDA multiple using
50% Debt. It wants to sell the company in 3 years, but it's difficult to find buyers, so the
firm decides to take the company public instead. If this company's EBITDA increases to
$240, and it repays ALL the Debt over 3 years, and the PE firm takes it public and sells
off its stake evenly in Years 3 - 5 at a 10x EBITDA multiple, what's the approximate
IRR? ------------------------------ How does the IRR change if, after going public, the
company's share price drops by approximately 10% per year in Years 4 and 5? ✅200 *
8 = 1600 (800d/800e) 240 * 10 = 2400 (0d/2400e) AVG Y = 4 MoM = 2400/800 = 3x
over 4 years ~ [35%] 3x over 2 years ~ 45% 3x over 5 years ~ 25% ---------------------------
--------- 10% drop in share price => 10% drop in EqV, 0 debt => 10% drop in EV => 10%
drop in multiple 10x -> 9x -> 8x (10% drop twice)... 9x AVG MULTIPLE 240 * 9 = 2160
(0d/2160e) MoM = 2160/800 = 2.7x over 4years ~ [30%] 2.5x over 5 years is 20% IRR
2.5x over 3 years ~ 35% IRR
What's the approximate IRR if a PE firm acquires a company using $500 of Investor
Equity, sells it for $1,000 in Equity Proceeds in Year 3, and receives a Dividend of $250
, in Year 2? ✅Assuming dividend occurred at YR 3, 1250/500 = 2.5x in 3 years =>
~35% IRR However, dividend occured in YR2 => IRR will be between higher than 35%
(and less than 45%) ~[40%]
A PE firm acquires a company with $100 in EBITDA, which grows to $150 by the end of
7 years, at which point the PE firm sells the company for a 10x EBITDA multiple. The
PE firm uses $500 of Debt initially, and the company has $300 of Net Debt remaining
upon exit. If the PE firm realizes an approximate IRR of 10% on this investment, what
was the purchase multiple? ✅100 * y = 100y EV (500d/100y-500e) 150 * 10 = 1500 EV
(300d/1200) @ Yr7 w/ 10% IRR 2x => 100%/7 * (3/4) = 3/28 ~ 10.7% 3x => 200%/7 *
(13/20) = 13/70 ~ 18.5% => MoM = 2x = y-500 => y = [11x]
Could a private equity firm earn a 20% IRR if it buys a company for a Purchase
Enterprise Value of $1 billion and sells it for an Exit Enterprise Value of $1 billion after 5
years? ✅Yes, 1000mm EV (yd/1000-ye) 1000mm EV (0d/1000e) MoM = -y
= 2.5x over 5 years => y = 600 => [(600d/400e) initially, then 100% debt repaid] 2x over
5 years ~ 15% 3x over 5 years ~ 25%
Could a private equity firm ever earn a 20%+ IRR if it buys a company using Investor
Equity of $1 billion and gets back exactly $1 billion in Equity Proceeds at the end of 5
years? ✅Mathematically, yes but this is nearly impossible. To earn 20% IRR, acquired
company would have to issue extremely high dividends and/or do multiple Dividend
Recaps during the holding period. Most companies cannot afford to pay close to 20%
dividend yield, so this scenario is exceptionally unlikely
What's the true purchase price in a leveraged buyout? ✅"1. Start with Equity Purchase
Price - cost of acquiring all the common shares 2. Depending on treatment of cash,
debt, transaction fees, and equity rollovers, price will vary (that's why you use S&U) Ex:
if debt is ""assumed"", it won't affect the purchase price. But if PE repays it with Investor
Equity (or a combination of Debt and IE), then that increases the effective price. Using
excess cash to fund the deal reduces the true price, as do equity rollovers. The true
price is often close to the EV, but it won't be the same due to these issues."
How can you determine how much debt a PE firm might use in an LBO and how many
tranches there would be? ✅- Look at recent, similar LBOs and use median
Debt/EBITDA levels as references - Can also look at highly levered public comps in the
industry For example, if median Debt/EBITDA for LBOs has been 5x with 2x Term
Loans and 3x Subordinated Notes, you might assume those same figures. Then test
these assumptions by projecting your company's leverage and coverage ratios over
time.
Can you describe the different types of Debt a PE firm might use in a leveraged buyout,
and why it might use them? ✅Broadly speaking, debt is split into Secured and
Unsecured Debt Secured Debt (eg term loans and revolvers): -backed by collateral -
tend to have lower, floating interest rates -may have amortization -maintenance
