M&I Guide LBO Model Questions and
Answer
1. How do you calculate the internal rate of return (IRR) in an LBO model, and what does it
mean? - ANS--The IRR in an LBO is "the effective annual compounded interest
rate": For example, if you invest $100 in the beginning and get back $200 after 5
years, what interest rate would turn that $100 into $200 by the end?
-You calculate the IRR by making the Investor Equity (Cash) that a PE firm
contributes a negative, and then using positives for Dividends to the PE firm and
the Net Proceeds to the PE firm at the end.
-Then, you apply the IRR function in Excel to all the numbers, making sure that
you've entered "0" for any periods where there's no cash received or spent.
-If there are no Dividends or other distributions in between purchase and exit:
IRR = (Exit Proceeds / Investor Equity) ^ (1 / # Years) - 1
2. What is a leveraged buyout, and why does it work? - ANS--In a leveraged buyout
(LBO), a private equity firm acquires a company using a combination of Debt and
Equity, operates it for several years, and then sells the company at the end of the
period to realize a return on its investment.
-During the period of ownership, the PE firm uses the company's cash flows to
pay for the interest expense on the Debt and to repay Debt principal.
-It works because leverage amplifies returns: If the deal performs well, the PE firm
will realize higher returns than if it had bought the company with 100% Equity. But
leverage also presents risks because it means the returns will be even worse if the
deal does not perform well.
3. 10. How does the IRR change if, after going public, the company's share price drops by
approximately 10% per year in Years 4 and 5? - ANS--A 10% share price decline each
year means that the EBITDA multiple falls to 9x and then 8x.
-The "average" EBITDA multiple at which the PE firm sells its stake is 9x rather
than 10x.
-Therefore, the Proceeds to the PE Firm decline from $2,400 to $2,160, since
$2,400 - $240 = $2,160.
-The multiple is $2,160 / $800 = 2.7x.
, -A 2.5x multiple over 5 years is a 20% IRR, while a 2.5x multiple over 3 years is a
~35% IRR, so we'd expect an IRR in between those. But it will be closer to 35%
since 2.7x is above 2.5x.
-We could approximate this IRR as 30%; in real life, it is exactly 30%.
4. 10. How is a leveraged buyout different from a normal M&A deal? - ANS--In an LBO,
you assume the company is sold after 3-5 years (and sometimes a bit more than
that). As a result, you focus on the IRR and MoM multiple as the key metrics.
-Also, PE firms can use only Debt and Equity (Equity means "Cash" in this
context) to fund deals, whereas normal companies in M&A deals can use Cash,
Debt, and Stock.
-Synergies and EPS accretion/dilution matter a lot in M&A deals, but not at all in
LBOs.
-You determine the Purchase Price in similar ways, but in an LBO, you'll often
"back into" the Purchase Price based on the price required to achieve a targeted
IRR.
5. 11. A strategic acquirer usually prefers to pay for another company with 100% Cash - if
that's the case, why would a PE firm want to use Debt in an LBO? - ANS--It's a different
scenario in an LBO because:
1) The PE firm plans to sell the company in a few years - so it's less concerned
with the expense of Debt and more concerned with using leverage to amplify its
returns by reducing the capital it contributes upfront.
2) In an LBO, the company is responsible for repaying the Debt, so the acquired
company assumes most of the risk. In a standard M&A deal, the Buyer or
"Combined Entity" carry the Debt, so there's far more risk for the acquirer
6. 11. What's the approximate IRR if a PE firm acquires a company using $500 of Investor
Equity, sells it for $1,000 in Equity Proceeds in Year 3, and receives a Dividend of $250
in Year 2? - ANS--Doubling our money in 3 years normally corresponds to a ~25%
IRR.
-But the Dividend turns this into $1,250 / $500 = 2.5x, which is halfway between
doubling and tripling our money.
-You'd think, based on "3x in 3 years = ~45% IRR" that the IRR would be around
35% here.
-But the Dividends arrived in Year 2 instead of Year 3, so it's higher than that. We
would approximate it as "Between 35% and 40%" - in real life, it is 39%.
Answer
1. How do you calculate the internal rate of return (IRR) in an LBO model, and what does it
mean? - ANS--The IRR in an LBO is "the effective annual compounded interest
rate": For example, if you invest $100 in the beginning and get back $200 after 5
years, what interest rate would turn that $100 into $200 by the end?
-You calculate the IRR by making the Investor Equity (Cash) that a PE firm
contributes a negative, and then using positives for Dividends to the PE firm and
the Net Proceeds to the PE firm at the end.
-Then, you apply the IRR function in Excel to all the numbers, making sure that
you've entered "0" for any periods where there's no cash received or spent.
-If there are no Dividends or other distributions in between purchase and exit:
IRR = (Exit Proceeds / Investor Equity) ^ (1 / # Years) - 1
2. What is a leveraged buyout, and why does it work? - ANS--In a leveraged buyout
(LBO), a private equity firm acquires a company using a combination of Debt and
Equity, operates it for several years, and then sells the company at the end of the
period to realize a return on its investment.
-During the period of ownership, the PE firm uses the company's cash flows to
pay for the interest expense on the Debt and to repay Debt principal.
-It works because leverage amplifies returns: If the deal performs well, the PE firm
will realize higher returns than if it had bought the company with 100% Equity. But
leverage also presents risks because it means the returns will be even worse if the
deal does not perform well.
3. 10. How does the IRR change if, after going public, the company's share price drops by
approximately 10% per year in Years 4 and 5? - ANS--A 10% share price decline each
year means that the EBITDA multiple falls to 9x and then 8x.
-The "average" EBITDA multiple at which the PE firm sells its stake is 9x rather
than 10x.
-Therefore, the Proceeds to the PE Firm decline from $2,400 to $2,160, since
$2,400 - $240 = $2,160.
-The multiple is $2,160 / $800 = 2.7x.
, -A 2.5x multiple over 5 years is a 20% IRR, while a 2.5x multiple over 3 years is a
~35% IRR, so we'd expect an IRR in between those. But it will be closer to 35%
since 2.7x is above 2.5x.
-We could approximate this IRR as 30%; in real life, it is exactly 30%.
4. 10. How is a leveraged buyout different from a normal M&A deal? - ANS--In an LBO,
you assume the company is sold after 3-5 years (and sometimes a bit more than
that). As a result, you focus on the IRR and MoM multiple as the key metrics.
-Also, PE firms can use only Debt and Equity (Equity means "Cash" in this
context) to fund deals, whereas normal companies in M&A deals can use Cash,
Debt, and Stock.
-Synergies and EPS accretion/dilution matter a lot in M&A deals, but not at all in
LBOs.
-You determine the Purchase Price in similar ways, but in an LBO, you'll often
"back into" the Purchase Price based on the price required to achieve a targeted
IRR.
5. 11. A strategic acquirer usually prefers to pay for another company with 100% Cash - if
that's the case, why would a PE firm want to use Debt in an LBO? - ANS--It's a different
scenario in an LBO because:
1) The PE firm plans to sell the company in a few years - so it's less concerned
with the expense of Debt and more concerned with using leverage to amplify its
returns by reducing the capital it contributes upfront.
2) In an LBO, the company is responsible for repaying the Debt, so the acquired
company assumes most of the risk. In a standard M&A deal, the Buyer or
"Combined Entity" carry the Debt, so there's far more risk for the acquirer
6. 11. What's the approximate IRR if a PE firm acquires a company using $500 of Investor
Equity, sells it for $1,000 in Equity Proceeds in Year 3, and receives a Dividend of $250
in Year 2? - ANS--Doubling our money in 3 years normally corresponds to a ~25%
IRR.
-But the Dividend turns this into $1,250 / $500 = 2.5x, which is halfway between
doubling and tripling our money.
-You'd think, based on "3x in 3 years = ~45% IRR" that the IRR would be around
35% here.
-But the Dividends arrived in Year 2 instead of Year 3, so it's higher than that. We
would approximate it as "Between 35% and 40%" - in real life, it is 39%.
