LBO Fundamentals Quiz: Student-Focused Questions and Answers

LBO Fundamentals Quiz: Student-Focused
Questions and Answers




Which of the following statements below are TRUE regarding why an LBO works
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conceptually?

a. By using debt, the PE firm reduces up-front cash required, thereby boosting returns
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b. Using cash flows produced by the company to pay down debt and make interest payments
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produces a better return for the PE firm than simply keeping the cash flows
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c. Since the PE firm sells the entire company in the future, it's guaranteed to at least get back
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100% of its original capital
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d. The PE firm sells the company in the future, which allows it to get back (at least some of) the
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funds that it used to acquire the company in the first place - correct answersExplanation:
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Statements A, B, and D are all true. By using little of its own cash and borrowing heavily to v v v v v v v v v v v v v v v v v v v




purchase the company, the PE fund significantly boosts its returns for the simple reason that
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money today is worth more than money tomorrow due to the interest that it could earn. In an
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LBO, the PE fund uses the cash flows of the company it acquires to pay debt principal and debt
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interest, which is a much better use of those funds than keeping the money for itself, again
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boosting returns. The other reason LBOs work in practice and earn such high returns is
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because the PE fund only operates the company for 3 to 5 years before it sells it off and regains
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its money plus profit; if the PE fund were to keep the companies it purchased indefinitely, it
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would not be possible to earn the returns that PE funds seek. C is incorrect because there's no
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"guarantee" that the PE fund will get back 100% of its original capital - if the company's v v v v v v v v v v v v v v v v v




EBITDA declines or if the exit multiple declines significantly, for example, that may not
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happen.

What's the best analogy to use when thinking of how a leveraged buyout works?
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, a. A homeowner buys a house to live in with a down payment and mortgage,
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and then sells the house in the future once the mortgage is repaid
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b. An investor buys a house to rent out to tenants, using a down payment and mortgage, then
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uses the rental income to repay the mortgage, and then sells
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the house in the future v v v v




c. A person buys a car using cash and a car loan, drives it for several years, repays the debt,
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and then sells the car v v v v




d. None of the above - correct answersExplanation: B is correct because that is exactly what
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happens in an v v




LBO - you buy a company that generates cash flows, you use the cash flows to repay debt, and
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then sell it off at the end of several years. A is incorrect because a house that you live in is not an
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income-generating asset. So it is not the best way to think of an LBO. C is incorrect because v v v v v v v v v v v v v v v v v v




unlike a house, cars always depreciate in value and you'll likely lose a lot of money after buying
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it, running it, and selling it... plus cars do not generate income, unlike rental houses.
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All of the following characteristics make for a good LBO target EXCEPT:
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a. High PP&E and/or Fixed Assets on the Balance Sheet
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b. Relatively low Capital Expenditures
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c. Non-volatile, non-cyclical, cash flow producing business
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d. Early-stage fast growth company - correct answersExplanation: The correct answer
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choice is D. Answer choice A v v v v v




represents an asset-rich company which can pledge its current assets and PP&E as collateral v v v v v v v v v v v v v




for high levels of bank debt (which is necessary for an LBO). Answer choice B refers to
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companies with negligible large cash outflows in the form of capital expenditures; that is a v v v v v v v v v v v v v v v




good sign since the company can use those cash flows to pay interest and debt principal post-
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LBO instead. Answer choice C represents companies that produce lots of cash flow and
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exhibit no volatility in those cash flows from year to year. Usually, PE firms prefer very mature
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companies and industries, sometimes even if they are in the decline phase of their lifecycle. v v v v v v v v v v v v v v v




Something very early-stage with high growth would probably produce cash flows that are too v v v v v v v v v v v v v v




volatile to make consistent and periodic interest payments and debt repayment. Usually
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early-stage hyper growth companies are not cash-flow positive businesses, and the majority v v v v v v v v v v v v




of their value is not comprised of 'hard assets' such as PP&E which can be used as collateral
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for the large sums of debt that need to be raised.
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Since an LBO valuation and a DCF are both based on Free Cash Flows and how much cash
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the company generates, they are likely to produce similar implied values.
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a. True v v