LBO Interview Questions and Answers
1. A strategic acquirer usually prefers to pay for another company with 100% cash - if thats
the case why would a PE firm want to use debt in an LBO? - ANS-Different scenario
because:
1. The PE firm does not hold the company for the long term - sells it after a few
years so its not concerned with cost of debt over cash and more concerned with
using leverage to boost its returns
2. In an LBO the company is responsible for repaying the debt so the company
assumes much of the risk. In a strategic acquisition the buyer "owns" the debt so
it is more risky for them
2. Can the PE firm earn a solid return if it buys a company for $1 billion and sells it for $1
billion 5 years? - ANS-Yes because they use debt to buy it in the beginning. if they
raise $500 million of Debt and only pay with $500M of cash then get back $1 billion
in cash at the end thats a 15% IRR.
3. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-First the
Liabilities & Equity side is adjusted- new debt is added and the Shareholder's
Equity is "wiped out" and replaced by however much Investor equity the PE firm is
contributing.
On the assets side, Cash is adjusted for any cash used to finance the transaction
and for transaction fees and then Goodwill & Other Intangibles are used as a
"plug" to make the Balance Sheet balance.
There will also be all the usual effects that you see in transactions: Asset
Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing fees and so on.
4. Do you need to project all 3 statement sin an LBO model? Are there any shortcuts? -
ANS-Yes there are shortcuts and you don't necessarily need to project all 3
statements.
For example, you do not need to create a full balance sheet. You do need some
form of Income Statement to track how the debt balances change and some type
of Cash Flow Statement to show how much cash is available to repay debt.
A full blown BS is not strictly required because you can make an assumption for
the overall change in operating assets and liabilities rather than projecting each
one separately.
5. Don't you need to factor in interest payments and debt principal repayments somewhere
in the IRR calculations? - ANS-you ignore them because the company uses its own
cash flow to pay interest and pay off debt principal. Since the PE firm itself is not
paying for these neither one affects its IRR.
, 6. Give me an example of a "real-life" LBO - ANS-the most common example is taking
out a mortgage when you buy a house that you then rent out to other people.
Down Payment: Investor Equity in an LBO
Mortgage: Debt in an LBO
Mortgage Interest Payments: Debt Interest in an LBO
Mortgage Repayments: Debt Principal Repayments in an LBO
Rental Income from Tenants: Cash Flow to Pay Interest and Repay Debt in an LBO
Selling the House: Selling the company or taking it public
7. How can you estimate the IRR in an LBO? Are there any rules of thumb? - ANS-If a firm
doubles its money in 5 years, thats a 15% IRR.
If they triple their money in 5 years thats a 25% IRR.
If they double their money in 3 years thats a 26% IRR.
IF they triple their money in 3 years thats a 44% IRR.
8. How could a private equity firm boost its return in an LBO? - ANS-1. Reduce purchase
price
2. Increase the Exit Multiple and Exit Price
3. Increase leverage
4. increase company's growth rate
5. increase margins
These are all theoretical
9. How could you determine how much debt can be raised in an LBO and how many
tranches there would be? - ANS-Look at recent, similar LBOs and assess the debt
terms and tranches used in each transactions.
Look at companies in a similar size range and industry, see how much debt
outstanding they have and base your own numbers on those.
10. How do dividends issued to the PE firm affect the IRR? - ANS-Any dividends issued,
either in the normal course of business or as part of a dividend recap increase IRR
because they result in the PE firm receiving more cash back.
Usually dividends make less of an impact than the 3 key variables in an LBO:
purchase price, exit price and leverage
11. How do transaction and financing fees factor into the LBO model? - ANS-You pay for all
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)
12. How do you calculate the internal rate of return (IRR) in an LBO model and what does it
mean? - ANS-You calculate the IRR by making the amount of Investor Equity that a
1. A strategic acquirer usually prefers to pay for another company with 100% cash - if thats
the case why would a PE firm want to use debt in an LBO? - ANS-Different scenario
because:
1. The PE firm does not hold the company for the long term - sells it after a few
years so its not concerned with cost of debt over cash and more concerned with
using leverage to boost its returns
2. In an LBO the company is responsible for repaying the debt so the company
assumes much of the risk. In a strategic acquisition the buyer "owns" the debt so
it is more risky for them
2. Can the PE firm earn a solid return if it buys a company for $1 billion and sells it for $1
billion 5 years? - ANS-Yes because they use debt to buy it in the beginning. if they
raise $500 million of Debt and only pay with $500M of cash then get back $1 billion
in cash at the end thats a 15% IRR.
3. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-First the
Liabilities & Equity side is adjusted- new debt is added and the Shareholder's
Equity is "wiped out" and replaced by however much Investor equity the PE firm is
contributing.
On the assets side, Cash is adjusted for any cash used to finance the transaction
and for transaction fees and then Goodwill & Other Intangibles are used as a
"plug" to make the Balance Sheet balance.
There will also be all the usual effects that you see in transactions: Asset
Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing fees and so on.
4. Do you need to project all 3 statement sin an LBO model? Are there any shortcuts? -
ANS-Yes there are shortcuts and you don't necessarily need to project all 3
statements.
For example, you do not need to create a full balance sheet. You do need some
form of Income Statement to track how the debt balances change and some type
of Cash Flow Statement to show how much cash is available to repay debt.
A full blown BS is not strictly required because you can make an assumption for
the overall change in operating assets and liabilities rather than projecting each
one separately.
5. Don't you need to factor in interest payments and debt principal repayments somewhere
in the IRR calculations? - ANS-you ignore them because the company uses its own
cash flow to pay interest and pay off debt principal. Since the PE firm itself is not
paying for these neither one affects its IRR.
, 6. Give me an example of a "real-life" LBO - ANS-the most common example is taking
out a mortgage when you buy a house that you then rent out to other people.
Down Payment: Investor Equity in an LBO
Mortgage: Debt in an LBO
Mortgage Interest Payments: Debt Interest in an LBO
Mortgage Repayments: Debt Principal Repayments in an LBO
Rental Income from Tenants: Cash Flow to Pay Interest and Repay Debt in an LBO
Selling the House: Selling the company or taking it public
7. How can you estimate the IRR in an LBO? Are there any rules of thumb? - ANS-If a firm
doubles its money in 5 years, thats a 15% IRR.
If they triple their money in 5 years thats a 25% IRR.
If they double their money in 3 years thats a 26% IRR.
IF they triple their money in 3 years thats a 44% IRR.
8. How could a private equity firm boost its return in an LBO? - ANS-1. Reduce purchase
price
2. Increase the Exit Multiple and Exit Price
3. Increase leverage
4. increase company's growth rate
5. increase margins
These are all theoretical
9. How could you determine how much debt can be raised in an LBO and how many
tranches there would be? - ANS-Look at recent, similar LBOs and assess the debt
terms and tranches used in each transactions.
Look at companies in a similar size range and industry, see how much debt
outstanding they have and base your own numbers on those.
10. How do dividends issued to the PE firm affect the IRR? - ANS-Any dividends issued,
either in the normal course of business or as part of a dividend recap increase IRR
because they result in the PE firm receiving more cash back.
Usually dividends make less of an impact than the 3 key variables in an LBO:
purchase price, exit price and leverage
11. How do transaction and financing fees factor into the LBO model? - ANS-You pay for all
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)
12. How do you calculate the internal rate of return (IRR) in an LBO model and what does it
mean? - ANS-You calculate the IRR by making the amount of Investor Equity that a
