Leveraged Buyouts and LBO Models -
The Purchase Price, Debt, and Sources
& Uses Schedule Q&A
1. What's the true purchase price in a leveraged buyout? ✅Just as in a merger model,
you always start with the Equity Purchase Price - the cost of acquiring all the company's
common shares.
Then, depending on the treatment of Cash, Debt, Transaction Fees, and Equity
Rollovers, the "true price" may be different, which is why you create a Sources & Uses
schedule.
For example, if existing Debt is "assumed" (kept in placed or replaced with new Debt
that's the same), it won't affect the purchase price. But if the PE firm repays the existing
Debt with its Investor Equity or a combination of Debt and Investor Equity, 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 Purchase Enterprise Value, but it won't be the same
because of these issues.
2. How can you determine how much Debt a PE firm might use in an LBO and how
many tranches there would be? ✅You look at recent, similar LBOs and use the median
Debt / EBITDA levels from them as references; you could also look at highly leveraged
public companies in the industry and check their Debt / EBITDA levels.
For example, if the median Debt / EBITDA for LBOs has been 5x, with 2x Term Loans
and 3x Subordinated Notes, you might assume those same figures.
Then, you would test these assumptions by projecting the company's leverage (Debt /
EBITDA) and coverage (EBITDA / Interest) ratios over time.
If they hold up reasonably well - e.g., the company's coverage ratio always stays above
2x - then you might stick with the original numbers. If not, you have to try different
assumptions.
3. 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
Debt and Unsecured Debt, which some people also label "Bank Debt" and "High-Yield
Debt" or "Senior Debt" and "Junior Debt."
, Secured Debt consists of Term Loans and Revolvers, is backed by collateral, tends to
have lower, floating interest rates, may have amortization, and uses maintenance
covenants such as restrictions on the company's EBITDA, Debt / EBITDA, and EBITDA
/ Interest.
Early repayment of principal is allowed, maturity periods tend to be shorter (~5 years up
to 10 years), and the investors tend to be conservative banks.
Unsecured Debt consists of Senior Notes, Subordinated Notes, and Mezzanine, and is
not backed by collateral; interest rates tend to be higher and fixed rather than floating,
there is no amortization, and it uses incurrence covenants (e.g., The company can't sell
Assets above a certain dollar amount).
Early repayment is not allowed, maturity periods tend to be longer (8-10 years, and
sometimes much longer or even indefinite), and the investors tend to be hedge funds,
merchant banks, and mezzanine funds.
4. Why do the less risky, lower-yielding forms of Debt amortize? Shouldn't amortization
be a feature of riskier Debt to reduce the risk? ✅Amortization reduces credit risk but
also reduces the potential returns. Since risk and potential returns are correlated,
amortization should be a feature of less risky Debt.
If $100 million of 10% interest bonds stay outstanding for 10 years, and the company
repays them, in full, after 10 years, the investors earn a 10% IRR on those bonds.
But if there's amortization or optional repayment, that balance will decline to less than
$100 million by the end, so the investors earn less than a 10% IRR. But the investors
also take on less risk because more capital is returned earlier on.
5. Why might a PE firm choose to use Term Loans rather than Subordinated Notes in
an LBO, if it has the choice between two capital structures with similar levels of
leverage? ✅Term Loans are less expensive than Subordinated Notes since interest
rates are lower, and they give the company more flexibility with its cash flows since
optional repayments are allowed in most cases.
Also, since Term Loans have maintenance covenants, they might be better if the
company is planning to divest assets, make acquisitions, or spend a huge amount on
CapEx, any of which might be forbidden with incurrence covenants found in
Subordinated Notes.
6. Why might a PE firm do the opposite and use Subordinated Notes instead? ✅On
the surface, this doesn't make much sense because Subordinated Notes are more
expensive than Term Loans.
