7.7 Leveraged Buyouts and LBO Models -
More Advanced LBO Features
1. When might a PE firm use a leveraged dividend recap in a leveraged buyout? - ANSA PE
firm might do this if the company pays off a significant amount of Debt midway through the
holding period or becomes able to support more Debt at that point (e.g., its EBITDA increases
significantly and it can support another 1-2x of Debt).
If a deal performs well, a dividend recap will boost the IRR because it allows the PE firm to earn
proceeds from the deal earlier on; the MoM multiple won't change by as much.
2. Walk me through how the Balance Sheet and IRR in an LBO change with a $100 leveraged
dividend recap and $2 in financing fees. - ANSOn the Assets side of the Balance Sheet, you
deduct the $2 in financing fees from Cash, so the Assets side is down by $2.
On the L&E side, you record $100 - $2 = $98 for the new Debt because you deduct financing
fees directly from the book value of the Debt.
You also deduct $100 from Retained Earnings to reflect the Dividends issued to the PE firm, so
the L&E side is down by $2 and both sides balance.
In the IRR calculation, you reflect this $100 in Dividends to the PE firm, which boosts the IRR.
3. How would you model a "waterfall returns" structure where different Equity investors in an
LBO receive different percentages of the returns based on the overall IRR?
For example, let's say that Investor Group A receives 10% of the returns up to a 15% IRR
(Investor Group B receives 90%), but then receives 15% of the returns (with Investor Group B
receiving 85%) beyond a 15% IRR. How does that work? - ANSThe exact Excel formulas get
tricky, but here is the basic idea:
• First, you check to see what the IRR is for the Equity Proceeds generated in the deal. For
example, let's say the deal generates $500 million in Equity Proceeds; you do the calculations
and find that $500 million equates to an 18% IRR for this period.
• Next, you determine the Equity Proceeds that represent a 15% IRR. Here, you run the
numbers and find that $450 million equates to a 15% IRR.
• You allocate 10% of this $450 million, or $45 million, to Investor Group A, and 90%, or $405
million, to Investor Group B.
, • Then, you allocate 15% of the remaining $50 million ($500 million minus $450 million) to
Investor Group A and 85% to Investor Group B.
4. Why might a private equity firm create a management option pool in an LBO, and how does it
affect the model? - ANSThe PE firm does this to incentivize the management team to perform
while giving up relatively little in exchange.
If a deal performs well and the Exit Equity Value exceeds the initial Investor Equity, a small
percentage of the Equity Proceeds will go to management, barely reducing the IRR for the PE
firm while greatly increasing the IRR for the management team.
If the deal does not perform well, and the Exit Equity Value is below the initial Investor Equity,
nothing is paid out to management and the PE firm loses nothing.
5. Walk me through the impact of a 10% option pool in an LBO if the initial Investor Equity is
$500 and the Exit Equity Value is $1,000. - ANSThe options are in-the-money because the Exit
Equity Value exceeds the initial Investor Equity.
The Cash Payment to the PE firm for the exercise of these options is 10% * $500 = $50.
Proceeds to Management are: (10% / (100% + 10%)) * ($1,000 + $50) = ~9% * $1,050 = ~$95.
The PE firm receives: Exit Equity Value of $1,000 + $50 in Cash - $95 in Proceeds to
Management, which equals $955.
As a result, its IRR and MoM multiple will decline slightly, but the difference is very small.
6. How do add-on acquisitions affect the IRR and financial statements in an LBO? - ANSWith
add-on acquisitions, you assume that the PE firm uses additional Debt and Equity to acquire
other companies and combines them with the original company.
You'll see additional Debt and Equity on the Combined Balance Sheet and the acquired
companies' revenue, expense, and cash flow contributions on the statements.
The IRR could increase or decrease depending on the numbers; higher-yielding add-on
acquisitions (e.g., the EBITDA / Purchase Enterprise Value is high and above the original
company's) tend to increase IRR, while lower-yielding ones tend to decrease it.
But it depends on the funding method as well: It's easier to make add-on acquisitions work,
mathematically, with 100% Debt funding because the PE firm won't have to use additional
Investor Equity.
More Advanced LBO Features
1. When might a PE firm use a leveraged dividend recap in a leveraged buyout? - ANSA PE
firm might do this if the company pays off a significant amount of Debt midway through the
holding period or becomes able to support more Debt at that point (e.g., its EBITDA increases
significantly and it can support another 1-2x of Debt).
If a deal performs well, a dividend recap will boost the IRR because it allows the PE firm to earn
proceeds from the deal earlier on; the MoM multiple won't change by as much.
2. Walk me through how the Balance Sheet and IRR in an LBO change with a $100 leveraged
dividend recap and $2 in financing fees. - ANSOn the Assets side of the Balance Sheet, you
deduct the $2 in financing fees from Cash, so the Assets side is down by $2.
On the L&E side, you record $100 - $2 = $98 for the new Debt because you deduct financing
fees directly from the book value of the Debt.
You also deduct $100 from Retained Earnings to reflect the Dividends issued to the PE firm, so
the L&E side is down by $2 and both sides balance.
In the IRR calculation, you reflect this $100 in Dividends to the PE firm, which boosts the IRR.
3. How would you model a "waterfall returns" structure where different Equity investors in an
LBO receive different percentages of the returns based on the overall IRR?
For example, let's say that Investor Group A receives 10% of the returns up to a 15% IRR
(Investor Group B receives 90%), but then receives 15% of the returns (with Investor Group B
receiving 85%) beyond a 15% IRR. How does that work? - ANSThe exact Excel formulas get
tricky, but here is the basic idea:
• First, you check to see what the IRR is for the Equity Proceeds generated in the deal. For
example, let's say the deal generates $500 million in Equity Proceeds; you do the calculations
and find that $500 million equates to an 18% IRR for this period.
• Next, you determine the Equity Proceeds that represent a 15% IRR. Here, you run the
numbers and find that $450 million equates to a 15% IRR.
• You allocate 10% of this $450 million, or $45 million, to Investor Group A, and 90%, or $405
million, to Investor Group B.
, • Then, you allocate 15% of the remaining $50 million ($500 million minus $450 million) to
Investor Group A and 85% to Investor Group B.
4. Why might a private equity firm create a management option pool in an LBO, and how does it
affect the model? - ANSThe PE firm does this to incentivize the management team to perform
while giving up relatively little in exchange.
If a deal performs well and the Exit Equity Value exceeds the initial Investor Equity, a small
percentage of the Equity Proceeds will go to management, barely reducing the IRR for the PE
firm while greatly increasing the IRR for the management team.
If the deal does not perform well, and the Exit Equity Value is below the initial Investor Equity,
nothing is paid out to management and the PE firm loses nothing.
5. Walk me through the impact of a 10% option pool in an LBO if the initial Investor Equity is
$500 and the Exit Equity Value is $1,000. - ANSThe options are in-the-money because the Exit
Equity Value exceeds the initial Investor Equity.
The Cash Payment to the PE firm for the exercise of these options is 10% * $500 = $50.
Proceeds to Management are: (10% / (100% + 10%)) * ($1,000 + $50) = ~9% * $1,050 = ~$95.
The PE firm receives: Exit Equity Value of $1,000 + $50 in Cash - $95 in Proceeds to
Management, which equals $955.
As a result, its IRR and MoM multiple will decline slightly, but the difference is very small.
6. How do add-on acquisitions affect the IRR and financial statements in an LBO? - ANSWith
add-on acquisitions, you assume that the PE firm uses additional Debt and Equity to acquire
other companies and combines them with the original company.
You'll see additional Debt and Equity on the Combined Balance Sheet and the acquired
companies' revenue, expense, and cash flow contributions on the statements.
The IRR could increase or decrease depending on the numbers; higher-yielding add-on
acquisitions (e.g., the EBITDA / Purchase Enterprise Value is high and above the original
company's) tend to increase IRR, while lower-yielding ones tend to decrease it.
But it depends on the funding method as well: It's easier to make add-on acquisitions work,
mathematically, with 100% Debt funding because the PE firm won't have to use additional
Investor Equity.
