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LBO MODELING EXAM FROM WALL STREET PREP
QUESTIONS AND ANSWERS
“Walk me through a basic LBO Model. - CORRECT ANSWER In an 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 about the company's operations such as Revenue Growth or Margins, depending on how much information you have. Step 2 is to create a Source and Use section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is requried, Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also add in Goodwill and Other Intangibles on the Assets side to make everything balance. Step 4, you 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 the available Cash Flow and the required Interest Payments. Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm."
"What is a leveraged buyout? - CORRECT ANSWER In an LBO, a private equity firm will
acquirer another company using a combination of debt and equity, they'll operate the company and sell the company at the end to hopefully realize a return on the investment. The PE firm will use the cash flows generated to pay off the interest expense on Debt and often the principal payment its self. The acquired company is often used collateral for the debt and this method works because leverage amplifies returns."
"Why would you use leverage when buying a company? - CORRECT ANSWER To boost your
return. Remember, any debt you use in an LBO is not "your money" so if you're paying $5 billion for a company, it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs $3 billion of your own money and $2 billion of borrowed money"
"How to set up a basic simple LBO Model-Paper LBO - CORRECT ANSWER Step 1- Make Basic
Transaction Assumptions. At a bare minimum you need to know - The Purchase Price and how much Debt and equity are used Equity really means cash used to purchase outstanding shares
Step 2- Project cCash Flows and Debt Repayment. To project cash flows, you need information on the company's Revenue, EBITDA, Taxes and other key items such as Working Capital and CapEx. Cash flow in an LBO model is neither unlevered or levered but just Cash flow from Operations- Capex Step 3- Make exit assumptions and calculate the returns Almost always have to be repay debt. Standard is to subtract Net debt at the end to calculate proceeds to the PE Firm."
"PE firms recognize minimum IRR when? - CORRECT ANSWER PE firms will recognize
minimum IRR when Equity Proceeds are at minimum level. For that to happen the company must repay no debt and generate no additional cash. IF they generate more cash or repay debt IRR will increase obviously because greater return"
"What is residual debt? - CORRECT ANSWER Residual debt= Debt started with- debt repaid.
It's just the outstanding debt."
"What is the formula for Exit Proceeds? - CORRECT ANSWER Exit Proceeds=
- Dividends paid/ FCF in excess of debt payments. Can just lump FCF in excess of debt payments into dividends" "How do you use an LBO model to value a company, and why does it set the "floor valuation" for
the company? - CORRECT 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 for 5 years. AT a 50% Debt/Equity split, that translate into a Purchase Enterprise Value of $656.
"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? - CORRECT
ANSWER 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." "Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause
controversy? - CORRECT ANSWER "If existing management uses its excess cash to
repurchase existing shares within the company prior to the LBO take over, they are reducing the cash for equity that the Sponsor firm will have to put up. It also means that the existing ownership will have a larger stake if their is a stock rollover. Pre LBO shareholders will find this to be a poor usage of funds Excess Cash might act as a funding source in an LBO if a company uses its Cash to repurchase its shares, reducing the number of shares that a PE firm has to purchase. It's not that the PE firm "gets" the company's Excess Cash before the deal takes place - it's that the company uses its Cash to reduce the purchase price for the PE firm. Pre-deal shareholders often object to such moves, saying that the company should have issued a Special Dividend to them or used the cash in a more productive way. Using Excess Cash to fund a deal also increases the ownership stakes of existing investors that choose to roll over their shares
- since Excess Cash reduces the Investor Equity the PE firm needs to contribute." "How do you project free cash flow and cash flow available for Debt Repayment in an LBO model? - CORRECT ANSWER You start with Net Income and add back D&A, factor in the change in working capital and subtract Capex aka (FCF CFO- Capex) Cash flow available for Debt Repaymnet is the same thing except you add in beginning cash balance and mandatory debt repayments"
"How is the "FCF" in an LBO model different from the FCF in a DCF? - CORRECT ANSWER
First, the purpose is quite different since FCF in an LBO model determines a company's ability to repay DEBT, not the implied value of a company.
Secondly, we're using discretionary cash flow aka FCF in a DCF and unlevered free cash flow in a DCF." "Why might a company's FCF in an LBO model differ from its Cash Flow available for Debt
Repayment? - CORRECT ANSWER It might differ because FCF doesn't include beginning cash
balance or mandatory debt repayment. How"
"What does the "tax shield" in an LBO mean? - CORRECT ANSWER All it means is that the
Interest on Debt reduces a company's taxes because the interest is tax deductible. That said, its taxes are still higher than if the debt didn't exist" "How can you determine how much Debt a PE firm might use in an LBO and how many tranches
there would be? - CORRECT ANSWER 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. Then you would test these assumptions by checking out the debt/EBITDA and EBITDA interest ratios." "Can you describe the different types of Debt a PE firm might use in an LBO and why it might use
them? - CORRECT ANSWER Broadly speaking, Debt is split into Secured Debt and Unsecured
Debt also known as bank debt and high-yield debt, or senior debt and junior debt Secure Debt consists of Term Loans and revolvers, is backed by collateral, floating interest rates and uses maintenance covenants such as DEBT/EBITDA and EBITDA/Interest Early repayment is generally allowed. High yield debt is fixed interest payments that are high and tends to be longer term, covenants usually include restrictions on the usage of cash. They're not collateralized either" "Why do the less risky, lower-yielding forms of Debt amortize? Shouldn't amortization be a
feature of riskier Debt to reduce the risk? - CORRECT ANSWER 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 risky debt" "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? - CORRECT
ANSWER Term loans are less expensive than subordinated notes (high yield loans) since
For example if I invested $100 in the beginning and got back $200 after 5 years, what interest rate would turn that $100 into $200? Answer is 15. You calculate the IRR by making the investor equity that a PE firm contributes negative, and then using positives for dividends to the PE firm and the Net proceeds to the PE firm at the end Money Received/Exit Proceeds= Exit Price- residual debt + dividends IRR= (Exit Proceeds/Investor Equity)^ (1/#n)- Aka MOM multiple raised to (1/n)-1"
"How quickly can you approximate the IRR in an LBO? Are there are any rules of thumb? -
CORRECT ANSWER Yes. If you double your money, you can divide by 100% by the # of years
and multiply by ~75% to account for the compounding and that gives you the approximate IRR: Example: Double in 3 yr-100/3 * .75= 25% Double in 5 yr- 100/5 *.75= 15% If you triple your money, divide 200% by the # of years and multiple by ~65% Triple in 3- 200/3 *.65= 45% Triple in 5- 200/5 * 65= 25%"
"Three ways to exit an LBO? - CORRECT ANSWER 1. Sell to another sponsor/strategic
acquirer
- IPO
- Pay dividends to yourself"
"What is formula for exit proceeds? - CORRECT ANSWER Exit Equity Proceeds-Residual debt
- dividends paid This is the numerator on the money on money multiple" "Can you explain the legal structure behind a leveraged buyout and how it benefits the private
equity firm? - CORRECT ANSWER In a leveraged buyout, the PE firm forms a "holding
company," which it owns and then this "holding company" acquires the real company. Banks and other lenders will provide this debt to the holding company so its held at the holding company level.
This structure is important because it means the P/E firm is not on the hook for the debt it uses in the deal. It's up for the target company to repay it. They boring other peoples money and no even directly"
"What assumptions impact a leveraged buyout the most? - CORRECT ANSWER The purchase
and exit assumptions, usually based on EBITDA multiples, will 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. More leverage will make the deal perform better if it does well, and will make the deal perform worse if it does now"
"How do you select the purchase multiples and exit multiples in an LBO model? - CORRECT
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 the ROIC by the end. ROIC-Return on invested capital. You can always use a range of purchase and exit multiples to analyze the transaction via sensitivity tables."
"An ideal candidate for an LBO? - CORRECT ANSWER - Stable cash flows always most
impotant
- Product or expansion growth opportunity
- Unused debt, so opportunity for further debt
- Low Capex necessity
- Strong and Stable mgmt"
"How is a leveraged buyout different from a normal M&A deal? - CORRECT 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 multiples as the key metrics.
Unsecured debt consists of senior notes, subordinated notes and Mezzaine and is not backed by collateral and has high fixed interest rates, and incurrence covenants."
"Why might a PE firm choose subordinated notes instead of term loans? - CORRECT ANSWER
They likely wouldn't? Unless they have already maxed out their term loans and still require additional debt, or if they doubt their ability to stay within maintenance covenants" "Why do the less risky, lower-yielding forms of Debt amortize? Shouldn't amortization be a
feature of riskier Debt to reduce the risk? - CORRECT ANSWER 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. Early payback is allowed so this ultimately reduces the credit risk and the potential returns. 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 $ 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."
"Assuming Debt v Refinancing Debt - CORRECT ANSWER Assuming debt means you either
take the debt as is or alter the terms of existing debt ever so slightly..ASSUMING WILL NOT ALTER PURCHASE PRICE Assuming debt shows up under both source and usage schedule (at least in an LBO model) Refinancing debt means paying off the debt entirely with cash or with new debt (or a combo of both) to replace the existing terms. Refinancing debt shows up in the uses side of the S&U" "How is purchase price allocation different in LBO Models? Does it matter more or less than in
M&A deals? - CORRECT ANSWER It's the same process as in M&A deals, but it tends to
matter far less because leveraged buyouts are based on cash flow, Debt repayment and the IRR from acquiring and then selling a company. Many of the new items that get created in the PPA process, such as D&A on Asset Write-ups, affect the company's EPS, but barely make an impact on its cash flows, which is why many LBO models leave out this schedule."
"What's the true Purchase Price in an Leveraged Buyout? - CORRECT ANSWER 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 and debt, equity rollovers and other transaction fees, the true purchase price may be different. Which is why you create a source and use schedule. For example, if existing debt is "assumed" (kept in place or replaced with new debt that's the same), it wont affect the purchase price..but if the company is refinancing or repaying the debt, then it willl increase the price. Using excess cash to fund the deal will reduce the purchase price as will equity rollovers True price is always close to Enterprise value, but wont be the same because of these issuues"
