IB - Basic LBO Model Questions &
Answers
1. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-Liabilities
& Equities side: The new debt is added on and the Shareholders' Equity is
replaced by however much equity the private equity firm is contributing.
Assets side: Cash is adjusted for any cash used to finance the transaction, and
then Goodwill & Other Intangibles are used as a "plug" to make the Balance Sheet
balance.
Depending on the transaction, there could be other effects as well - such as
capitalized financing fees added to the Assets side.
2. Do you need to project all 3 statements in an LBO model? Are there any shortcuts? -
ANS-You do not need to create a full Balance Sheet - bankers sometimes skip this
if they are in a rush.
You need an Income Statement to track how the Debt balances change
You need a Cash Flow Statement to show how much cash is available to repay
debt.
A full-blown Balance Sheet is not required, you can make assumptions on the Net
Change in Working Capital rather than looking at each item individually.
3. Give an example of a "real-life" LBO. - ANS-Taking out a mortgage when you buy a
house.
The Down Payment is the Investor Equity in an LBO
The Mortgage is the Debt in an LBO
The Mortgage Interest Payments are Debt Interest in an LBO
The Mortgage Repayments are Debt Principal Repayments in an LBO
Selling the House is Selling the Company or Taking It Public
4. How could a private equity firm boost its return in an LBO? - ANS-1. Lower the
Purchase Price
2. Raise the Exit Multiple
3. Increase the Leverage (debt) used.
4. Increase the company's growth rate (organically or via acquisitions).
, 5. Increase margins by reducing expenses (cutting employees, consolidating
buildings, etc.).
Note that these are all "theoretical" and refer to the model rather than reality - in
practice it's hard to actually implement these.
5. How do you pick purchase multiples and exit multiples in an LBO model? - ANS-Look at
what comparable companies are trading at, and what multiples similar LBO
transactions have had.
As always, you also show a range of purchase and exit multiples using sensitivity
tables.
Sometimes you set purchase and exit multiples based on a specific IRR target that
you're trying to achieve - but this is just for valuation purposes if you're using an
LBO model to value the company.
6. How do you use an LBO model to value a company, and why do we sometimes say that
it sets the "floor valuation" for the company? - ANS-Valuing a company by setting a
targeted IRR (for example, 25%) and back-solving in Excel to determine what
purchase price achieves that IRR.
This is called a "floor valuation" because PE firms almost always pay less for a
company than strategic acquirers would.
7. How would a dividend recap impact the 3 financial statements in an LBO? -
ANS-Income Statement: No change
Cash Flow Statement: No changes to Cash Flow from Operations or Investing.
Under Financing, additional Debt raised would cancel out the Cash paid out to the
investors, so Net Change in Cash would not change.
Balance Sheet: Increase in Debt balances with a decrease in Shareholders' Equity.
8. How would you determine how much debt can be raised in an LBO and how many
tranches there would be? - ANS-Look at Comparable LBOs and see the terms of the
debt and how many tranches each of them used.
Look at companies in a similar size range and industry and use those criteria to
determine the debt your company can raise.
9. Incurrence vs Maintenance Covenants - ANS-Incurrence Covenants:
Company cannot take on more than $2 billion of total debt.
Proceeds from any asset sales must be earmarked to repay debt.
Company cannot make acquisitions of over $200 million in size.
Company cannot spend more than $100 million on CapEx each year.
Maintenance Covenants:
Total Debt / EBITDA cannot exceed 3.0 x
Senior Debt / EBITDA cannot exceed 2.0 x
Answers
1. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-Liabilities
& Equities side: The new debt is added on and the Shareholders' Equity is
replaced by however much equity the private equity firm is contributing.
Assets side: Cash is adjusted for any cash used to finance the transaction, and
then Goodwill & Other Intangibles are used as a "plug" to make the Balance Sheet
balance.
Depending on the transaction, there could be other effects as well - such as
capitalized financing fees added to the Assets side.
2. Do you need to project all 3 statements in an LBO model? Are there any shortcuts? -
ANS-You do not need to create a full Balance Sheet - bankers sometimes skip this
if they are in a rush.
You need an Income Statement to track how the Debt balances change
You need a Cash Flow Statement to show how much cash is available to repay
debt.
A full-blown Balance Sheet is not required, you can make assumptions on the Net
Change in Working Capital rather than looking at each item individually.
3. Give an example of a "real-life" LBO. - ANS-Taking out a mortgage when you buy a
house.
The Down Payment is the Investor Equity in an LBO
The Mortgage is the Debt in an LBO
The Mortgage Interest Payments are Debt Interest in an LBO
The Mortgage Repayments are Debt Principal Repayments in an LBO
Selling the House is Selling the Company or Taking It Public
4. How could a private equity firm boost its return in an LBO? - ANS-1. Lower the
Purchase Price
2. Raise the Exit Multiple
3. Increase the Leverage (debt) used.
4. Increase the company's growth rate (organically or via acquisitions).
, 5. Increase margins by reducing expenses (cutting employees, consolidating
buildings, etc.).
Note that these are all "theoretical" and refer to the model rather than reality - in
practice it's hard to actually implement these.
5. How do you pick purchase multiples and exit multiples in an LBO model? - ANS-Look at
what comparable companies are trading at, and what multiples similar LBO
transactions have had.
As always, you also show a range of purchase and exit multiples using sensitivity
tables.
Sometimes you set purchase and exit multiples based on a specific IRR target that
you're trying to achieve - but this is just for valuation purposes if you're using an
LBO model to value the company.
6. How do you use an LBO model to value a company, and why do we sometimes say that
it sets the "floor valuation" for the company? - ANS-Valuing a company by setting a
targeted IRR (for example, 25%) and back-solving in Excel to determine what
purchase price achieves that IRR.
This is called a "floor valuation" because PE firms almost always pay less for a
company than strategic acquirers would.
7. How would a dividend recap impact the 3 financial statements in an LBO? -
ANS-Income Statement: No change
Cash Flow Statement: No changes to Cash Flow from Operations or Investing.
Under Financing, additional Debt raised would cancel out the Cash paid out to the
investors, so Net Change in Cash would not change.
Balance Sheet: Increase in Debt balances with a decrease in Shareholders' Equity.
8. How would you determine how much debt can be raised in an LBO and how many
tranches there would be? - ANS-Look at Comparable LBOs and see the terms of the
debt and how many tranches each of them used.
Look at companies in a similar size range and industry and use those criteria to
determine the debt your company can raise.
9. Incurrence vs Maintenance Covenants - ANS-Incurrence Covenants:
Company cannot take on more than $2 billion of total debt.
Proceeds from any asset sales must be earmarked to repay debt.
Company cannot make acquisitions of over $200 million in size.
Company cannot spend more than $100 million on CapEx each year.
Maintenance Covenants:
Total Debt / EBITDA cannot exceed 3.0 x
Senior Debt / EBITDA cannot exceed 2.0 x
