LBO Model Guide Questions and Answers
1. 3 major components of basic model assumptions - ANS-1. assume a purchase price
and the amount of debt and equity you will be using
2. figure out debt terms, including interest rate and annual repayment
3. create a Sources and Uses schedule that tracks where your funds are coming
from, and where they're going to
2. 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-1. The PE firm does
not hold the company for the long term - so it is less concerned with the higher
expense on debt over cash and more concerned over using leverage to boost its
returns by paying less cash upfront
2. In an LBO, the company is responsible for repaying the debt, so the company
assumes the debt/risk; whereas in a strategic acquisition, the buyer "owns" the
debt so it is more risky
3. Amortization structures: straight line vs. bullet vs. minimal - ANS-Straight line - debt is
paid off in equal installments each year
Bullet - debt is paid off in full at the end of its maturity period
Minimal - low % of principal each year, usually in the 1-5% range
4. Bank debt generally has ___ interest rates bc it is less risky and secured by collateral -
ANS-lower
5. Bank debt has maintenance covenants, which are... - ANS-e.g. total debt/EBITDA
must always be below 4x, or EBITDA/interest expense must always be above 2x
financial requirements that the borrower must meet
6. Basic explanation of what a PE firm does - ANS-It buys a company using some
combination of debt and equity and then sell it in 3-5 years for a return. The firm
uses the company's cash flows to pay off interest and debt principal
7. Biggest obstacles to doing an LBO for a private company - ANS-1. company may not
want to sell
2. info is more limited
8. Can all types of debt be repaid early ? - ANS-No - bank debt can, but high yield debt
cannot
9. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-For the
acquired company --
1. new debt is added to liabilities side and the SE 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 the transaction fees and then goodwill and other intangibles are used as a
"plug" to make the BS balance
, There will also be the usual effects you see in transactions: asset write ups and
write Downs, DTLs, DTAs, capitalized financing fees etc.
10.Can you give a complete list of items that you might see in the Sources&Uses section
and explain the less common ones? - ANS-Sources Column:
Debt and pref stock
Investor equity
Debt assumed
Noncontrolling interests assumed
Mgmt rollover
Uses Column:
Equity value of company
advisory and legal fees
capitalized financing
debt assumed
non controlling interests assumed
debt refinanced
noncontrolling interests purchased
11.Can you walk me through how a debt schedule works in an LBO model when you have
multiple tranches of debt? for example, what happens when you have existing debt, a
revolver, term loans, and senior notes? - ANS-First, you must make all mandatory
debt repayments on each tranche of debt before anything else. So there is no real
order there. The order only applies when you have extra cash flow beyond what is
needed to meet these mandatory debt repayments:
- revolver: borrow additional funds here and add them to the BS is you do not
have enough cash to make mandatory debt repayments; use any extra cash flow
each year to repay the revolver first
- existing debt: this coms first, before the new debt raised in the LBO, when
setting aside extra cash flow to make optional repayments
- term loans: payments on these come after paying off revolver and existing debt
- senior notes: these come last in the hierarchy, and typically optional repayments
is limited or not allowed at all
12.Changes that decrease IRR - ANS-higher purchase price, higher equity, lower
revenue growth, lower EBITDA margins, higher CapEx, higher interest rates
13.Changes that increase IRR - ANS-lower purchase price, less equity, lower interest
rates, higher EBITDA margins, higher revenue growth, lower CapEx
14.Do you need to project all 3 statements in an LBO model? Are there any shortcuts? -
ANS-Yes, there are shortcuts and you do not necessarily need to project all 3
statements.
for example, you do not need to create a full BS. You do need some form of IS,
something to track how the Debt balances change and some type of cash flow
statement to show much cash is available to repay debt
, but a full blown BS is not strictly required bc you can make an assumption for the
overall change in operating assets and liabilities rather than projecting each one
separately
15.Does reducing the amount of cash you pay upfront increase or decrease your returns?
Why? - ANS-Increase; money today is worth more than money tomorrow
16.Explain how a Revolver is used in an LBO model. - ANS-You use a Revolver when the
cash required for your Mandatory Debt Repayments exceeds the cash flow you
have available to repay them.
The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment -
Cash Flow Available to Repay Debt).
The Revolver starts off "undrawn," meaning that you don't actually borrow money
and don't accrue a balance unless you need it - similar to how credit cards work.
You add any required Revolver Borrowing to your running total for cash flow
available for debt repayment before you calculate Mandatory and Optional Debt
Repayments.
Within the debt repayments themselves, you assume that any Revolver Borrowing
from previous years is paid off first with excess cash flow before you pay off any
Term Loans.
17.Factors that go into decisions about an LBO - ANS-Leverage ratio and how it stacks
up against similar companies
Interest coverage ratio and how it stacks up
does company have any major expansion plans or acquisitions that would limit
the amount of debt it could take on
what are lenders comfortable with? will it be more difficult to get investors on
board w/ certain debt structures
18.Floating versus fixed interest rates - ANS-Floating interest rates are tied to LIBOR
- often expressed as L+100, which means that the rate is whatever LIBOR is plus
100 base points (1%)
Fixed interest rates just say the same
19.Give me an example of a "real life" LBO - ANS-The most common example is taking
out a mortgage when you buy a house. We think it's better to think of it as,
"Buying a house that you rent out to other people" because that situation is more
similar to buying a company that generates cash flow.
Here's how the analogy works:
• 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
1. 3 major components of basic model assumptions - ANS-1. assume a purchase price
and the amount of debt and equity you will be using
2. figure out debt terms, including interest rate and annual repayment
3. create a Sources and Uses schedule that tracks where your funds are coming
from, and where they're going to
2. 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-1. The PE firm does
not hold the company for the long term - so it is less concerned with the higher
expense on debt over cash and more concerned over using leverage to boost its
returns by paying less cash upfront
2. In an LBO, the company is responsible for repaying the debt, so the company
assumes the debt/risk; whereas in a strategic acquisition, the buyer "owns" the
debt so it is more risky
3. Amortization structures: straight line vs. bullet vs. minimal - ANS-Straight line - debt is
paid off in equal installments each year
Bullet - debt is paid off in full at the end of its maturity period
Minimal - low % of principal each year, usually in the 1-5% range
4. Bank debt generally has ___ interest rates bc it is less risky and secured by collateral -
ANS-lower
5. Bank debt has maintenance covenants, which are... - ANS-e.g. total debt/EBITDA
must always be below 4x, or EBITDA/interest expense must always be above 2x
financial requirements that the borrower must meet
6. Basic explanation of what a PE firm does - ANS-It buys a company using some
combination of debt and equity and then sell it in 3-5 years for a return. The firm
uses the company's cash flows to pay off interest and debt principal
7. Biggest obstacles to doing an LBO for a private company - ANS-1. company may not
want to sell
2. info is more limited
8. Can all types of debt be repaid early ? - ANS-No - bank debt can, but high yield debt
cannot
9. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-For the
acquired company --
1. new debt is added to liabilities side and the SE 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 the transaction fees and then goodwill and other intangibles are used as a
"plug" to make the BS balance
, There will also be the usual effects you see in transactions: asset write ups and
write Downs, DTLs, DTAs, capitalized financing fees etc.
10.Can you give a complete list of items that you might see in the Sources&Uses section
and explain the less common ones? - ANS-Sources Column:
Debt and pref stock
Investor equity
Debt assumed
Noncontrolling interests assumed
Mgmt rollover
Uses Column:
Equity value of company
advisory and legal fees
capitalized financing
debt assumed
non controlling interests assumed
debt refinanced
noncontrolling interests purchased
11.Can you walk me through how a debt schedule works in an LBO model when you have
multiple tranches of debt? for example, what happens when you have existing debt, a
revolver, term loans, and senior notes? - ANS-First, you must make all mandatory
debt repayments on each tranche of debt before anything else. So there is no real
order there. The order only applies when you have extra cash flow beyond what is
needed to meet these mandatory debt repayments:
- revolver: borrow additional funds here and add them to the BS is you do not
have enough cash to make mandatory debt repayments; use any extra cash flow
each year to repay the revolver first
- existing debt: this coms first, before the new debt raised in the LBO, when
setting aside extra cash flow to make optional repayments
- term loans: payments on these come after paying off revolver and existing debt
- senior notes: these come last in the hierarchy, and typically optional repayments
is limited or not allowed at all
12.Changes that decrease IRR - ANS-higher purchase price, higher equity, lower
revenue growth, lower EBITDA margins, higher CapEx, higher interest rates
13.Changes that increase IRR - ANS-lower purchase price, less equity, lower interest
rates, higher EBITDA margins, higher revenue growth, lower CapEx
14.Do you need to project all 3 statements in an LBO model? Are there any shortcuts? -
ANS-Yes, there are shortcuts and you do not necessarily need to project all 3
statements.
for example, you do not need to create a full BS. You do need some form of IS,
something to track how the Debt balances change and some type of cash flow
statement to show much cash is available to repay debt
, but a full blown BS is not strictly required bc you can make an assumption for the
overall change in operating assets and liabilities rather than projecting each one
separately
15.Does reducing the amount of cash you pay upfront increase or decrease your returns?
Why? - ANS-Increase; money today is worth more than money tomorrow
16.Explain how a Revolver is used in an LBO model. - ANS-You use a Revolver when the
cash required for your Mandatory Debt Repayments exceeds the cash flow you
have available to repay them.
The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment -
Cash Flow Available to Repay Debt).
The Revolver starts off "undrawn," meaning that you don't actually borrow money
and don't accrue a balance unless you need it - similar to how credit cards work.
You add any required Revolver Borrowing to your running total for cash flow
available for debt repayment before you calculate Mandatory and Optional Debt
Repayments.
Within the debt repayments themselves, you assume that any Revolver Borrowing
from previous years is paid off first with excess cash flow before you pay off any
Term Loans.
17.Factors that go into decisions about an LBO - ANS-Leverage ratio and how it stacks
up against similar companies
Interest coverage ratio and how it stacks up
does company have any major expansion plans or acquisitions that would limit
the amount of debt it could take on
what are lenders comfortable with? will it be more difficult to get investors on
board w/ certain debt structures
18.Floating versus fixed interest rates - ANS-Floating interest rates are tied to LIBOR
- often expressed as L+100, which means that the rate is whatever LIBOR is plus
100 base points (1%)
Fixed interest rates just say the same
19.Give me an example of a "real life" LBO - ANS-The most common example is taking
out a mortgage when you buy a house. We think it's better to think of it as,
"Buying a house that you rent out to other people" because that situation is more
similar to buying a company that generates cash flow.
Here's how the analogy works:
• 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
