Leveraged Buyout Analysis (LBO) + Questions

Basic LBO Walkthrough:

  1. Make transaction assumptions on the purchase price
  2. Make a Sources and Uses table 
  3. Project out a company's financial statements to free cash flows after debt paydown
  4. Make assumptions about the exit and calculate the returns (MoM and IRR)
Purchase Price Assumptions:
  • Public company: the purchase price is mostly based on a premium to its current share price
    • Calculate its purchase equity value and then adjust for cash and debt to reach purchase enterprise value
  • Private company: assume entry EV/EBITDA multiple to reach purchase enterprise value directly
Sources and Uses of Funds:
  • Sources:
    • All forms of debt: revolver, term loans, senior notes, subordinated notes, mezzanine, preferred stock, and other debt products
    • Management Rollover
    • Excess cash
    • Sponsor Equity
  • Uses:
    • Equity purchase price of the company
    • Advisory, legal, and financing fees
    • Refinanced debt: if the debt is refinanced, the PE firm repays it using new debt and equity
After creating a Sources and Uses table, the PE firm can see all the sources of financing and back into how much their initial equity in the investment must be

Free Cash Flow Build and Debt Schedule:

LBO is all about cash flow, so we need to project the company's cash flow over the holding period
  1. Project the company's income statement (revenues and expenses) over the holding period (the PE firm may assume reduced cost margins by making "operational improvements")
  2. Calculate all the way down to net income for each year in the projection period
  3. Get to Free Cash Flow Available for Debt Repayments by (+) D&A, (-) increases in NWC, and (-) Capex
  4. Project out the company's debt repayment over the holding period and subtract out any Mandatory Debt Repayments to get your Levered Free Cash Flow, which is the cash flow available to the PE firm after paying out all its obligations
Exit Strategies:
  • M&A: sell the company to another company or a different PE firm after 7 years
  • IPO: take the company public and sell off stake gradually over time. PE firms can't sell 100% of their ownerships in IPO and must wait several years to sell off their stock after the company goes public
PE firms prefer M&A:
  • This produces the highest IRR
  • The firm sells its entire stake all at once and doesn't have to wait for years to sell its shares
  • The PE firm removes all legal risk
  • M&A exit is fast and PE firm will never deal with the company again; while IPO and dividend recap 
However, while M&A is ideal, PE firm might not always want to execute it:
  • If the company is too big to be sold
  • If the IPO market is quite hot
  • If there are no interested buyers, at least at the price the PE firm wants
Dividend Recap:
  • Typically occurs in the middle of a PE firm's investment in a company when that company has been performing well and paying down debt, reducing leverage. The owners of the business (normally the PE firm) will go back to market looking to issue new debt both to repay the existing debt and to fund a distribution to shareholders
Exit Assumptions and Returns:

2 metrics: MoM (money on money multiple) and IRR (internal rate of return)
MoM = PE firm's ending equity / PE firm's beginning equity
IRR = depends on MoM and time of investment holding period
- Usually done on Excel or a calculator, but in the case of a paper LBO, there are shortcuts (Rule of 72)

Ways to increase IRR:
  1. Earlier exit time/shorter holding period: IRR considers annualized returns, so IRR is going to be much higher if you spread it over a short amount of time
  2. Lower purchase price/lower entry multiples
  3. Higher exit multiples
  4. Higher Leverage, less sponsor equity (provided the deal already has a positive IRR)
  5. Improve operations (improve EBITDA and cash flows)
  6. Improve the company's cost structure (reduce Capex, etc)
Returns Attribution Analysis:
  1. Multiple Expansion: has the biggest impact on returns. Buy at lower multiples and sell at higher multiples
  2. Higher Leverage: use of leverage to reduce the entry price
  3. EBITDA growth: organic growth to increase revenue and/or improve operating efficiency or margins
Even though multiple expansion has the biggest impact on returns, they cannot be relied on as it is unpredictable. Thus, we want to bet on EBITDA growth in our projections and have it as our main driver behind LBO returns. 

Debt Repayment:
  • Excess cash
    • Can use the company's levered free cash flow to pay down more debt in addition to the mandatory debt repayments
  • The Revolver
    • If company doesn't have enough cash flow to pay mandatory debt repayments, company would have to set up a Revolver with lenders that allows it to draw down extra cash to meet these required repayments
PIK Interest:
  • PIK interest allows interest to accrue to the loan principle instead of being paid out in cash
  • In simple terms: interest on debt that you don't pay out in cash this year but instead add to the very end and repay at maturity. i.e, interest expense is paid for with more debt, not cash
LBO Valuation:
  • We know that the LBO is known as a "floor valuation" because it usually produces the lowest valuation as it has the 20% target IRR baked into the entry value (the discount rate used in an LBO is higher than used in DCF)
  • LBO is like asking, "what would we pay for this company if we want to achieve a 20% IRR?"
  • LBO is backsolving: PE firm starts with desired IRR, makes assumptions, and projects out the financial statements. At the end, the PE firm backs into maximum amount of initial equity they have to give in order to attain their desired returns


Interview Questions:

Walk me through a basic LBO
  • In an LBO, the PE firm uses a mixture of debt and equity to purchase a company, operate it for a few years, and sell it through an M&A or IPO
  • First, we make transaction assumptions on the purchase price of the company
  • Next, we make a sources and uses table to determine the different tranches of debt and how much sponsor equity the PE firm contributes
  • Then we project out the company's financial statements and build a cash flow table
  • Create a debt repayment schedule
  • Make exit assumptions and calculate the returns (IRR and MoM)
How do you use LBO to value a company?
  • Using an IRR of 20% and backsolving on Excel to determine the purchase price
Why are LBOs "floor valuations?"
  • PE firms will almost always pay as little as possible for a company compared to a strategic buyer
What is an ideal LBO candidate?
  • Steady and predictable cash flows: this is important because we need cash to pay down debt
  • Good management team in case we want them to roll over
  • Industry leader
  • Not in a cyclical industry
  • Has assets that can be used as collateral for debt
What assumptions impact LBO the most?
  • Purchase and exit assumptions, usually based on EBITDA multiples
  • Lower purchase multiple results in higher returns, and higher exit multiple results in higher returns
  • After that, the % debt used makes the biggest impact. If deal performs well (already has positive IRR), more leverage makes it perform even better
How do you select the purchase multiples and exit multiples in an LBO model?
  • Public companies: purchase price is usually a premium of the share price
  • Private companies: determine purchase multiple by looking at comps, precedents, or DCF
  • Exit multiple is typically similar to purchase multiple but could go higher or lower depending on market outlook, company FCF growth, etc.
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 possible but nearly impossible in reality
  • This is a 1x MoM multiple
  • For the PE firm to earn 20% IRR, the acquired company would have to issue extremely high dividends or do multiple dividend recaps during the holding period
  • Most companies cannot pay anything close to a 20% dividend yield, so this scenario is exceptionally unlikely

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