1. How could you determine how much debt can be raised in an LBO and how many tranches there would be? Usually you would look at recent, similar LBOs and assess the debt terms and tranches that were used in each transaction. You could also look at companies in a similar size range and industry, see...
LBO Advanced Questions and 100%
Correct Answers
1. How could you determine how much debt can be raised in an LBO and how many
tranches there would be? ✅Usually you would look at recent, similar LBOs and assess
the debt terms and tranches that were used in each transaction.
You could also look at companies in a similar size range and industry, see how much
debt outstanding they have, and base your own numbers on those.
2. 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
completely dependent on the company, the industry, and the leverage and coverage
ratios for comparable LBO transactions.
To figure out the numbers, you would look at "Debt Comps" showing the types,
tranches, and terms of debt that similarly sized companies in the industry have used
recently.
There are some general rules: for example, you would never lever a company at 50x
EBITDA, and even during bubbles leverage rarely exceeds 10x EBITDA.
For interest coverage ratios (e.g. EBITDA / Interest), you want a number where the
company can pay for its interest without much trouble, but also not so high that the
company could clearly afford to take on more debt.
For example, a 20x coverage ratio would be far too high because the company could
easily pay 2-3x more in interest. But a 2x coverage ratio would be too low because a
small decrease in EBITDA might result in disaster at that level.
3. What is the difference between Bank Debt and High-Yield Debt? ✅This is a
simplification, but broadly speaking there are 2 "types" of Debt: "Bank Debt" and "High-
Yield Debt."
There are many differences, but here are a few of the most important ones:
• High-Yield Debt tends to have higher interest rates than Bank Debt (hence the name
"high-yield") since it's riskier for investors.
• High-Yield Debt interest rates are usually fixed, whereas Bank Debt interest rates are
"floating" - they change based on LIBOR (or the prevailing interest rates in the
economy).
• High-Yield Debt has incurrence covenants while Bank Debt has maintenance
covenants. The main difference is that incurrence covenants prevent you from doing
something (such as selling an asset, buying a factory, etc.) while maintenance
, covenants require you to maintain a minimum financial performance (for example, the
Total 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 (bullet maturity) and early
principal repayments are not allowed.
5. Why might you use Bank Debt rather than High-Yield Debt in an LBO? ✅If the PE
firm is concerned about the company meeting interest payments and wants a lower-cost
option, they might use Bank Debt.
They might also use Bank Debt if they are planning on a major expansion or Capital
Expenditures and don't want to be restricted by incurrence covenants.
6. Why would a PE firm prefer High-Yield Debt instead? ✅If the PE firm intends to
refinance the debt 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 High-Yield Debt if they don't have plans for a major expansion
effort or acquisitions, or if they don't plan to sell off the company's assets.
7. How does refinancing vs. assuming existing debt work in an LBO model? ✅If the PE
firm assumes debt when acquiring a company, that debt remains on the Balance Sheet
and must be paid off (both interest and principal) over time. And it has no net effect on
the funds required to acquire the company. In this case, the existing debt shows up in
both the Sources and Uses columns.
If the PE firm refinances debt, it pays it off, usually replacing it with new debt that it
raises to acquire the company. Refinancing debt means that additional funds are
required, so the effective purchase price goes up. In this case, the existing debt shows
up only in the Uses column
8. How do transaction and financing fees factor into the LBO model? ✅You pay for all
of these fees upfront in cash (legal, advisory, and financing fees paid on the debt), but
the accounting treatment is different:
• Legal & Advisory Fees: These come out of Cash and Retained Earnings immediately
as the transaction closes.
• Financing Fees: These are amortized over time (for as long as the Debt remains
outstanding), very similar to how CapEx and PP&E work: you pay for them upfront in
cash, create a new Asset on the Balance Sheet, and then reduce that Asset over time
as the fees are recognized on the Income Statement.
1. Can you explain how the Balance Sheet is adjusted in an LBO model? ✅First, the
Liabilities & Equity side is adjusted - the new debt is added, and the Shareholders'
Equity is "wiped out" and replaced by however much Investor Equity the private equity
firm is contributing (i.e. how much cash it's paying for the company).
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