LBO Model - Advanced Questions and
Answers
1. 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.
2. How would an asset write-up or write-down affect an LBO model? / Walk me through
how you adjust the Balance Sheet in an LBO model. - ANS-All of this is very similar to
what you would see in a merger model - you calculate Goodwill, Other Intangibles,
and the rest of the write-ups in the same way, and then the Balance Sheet
adjustments (e.g. subtracting cash, adding in capitalized financing fees, writing up
assets, wiping out goodwill, adjusting the deferred tax assets / liabilities, adding in
new debt, etc.) are almost the same.
The key differences:
• In an LBO model you assume that the existing Shareholders' Equity is wiped out
and replaced by the equity the private equity firm contributes to buy the company;
you may also add in Preferred Stock, Management Rollover, or Rollover from
Option Holders to this number as well depending on what you're
assuming for transaction financing.
• In an LBO model you'll usually be adding a lot more tranches of debt vs. what
you would see in a merger model.
• In an LBO model you're not combining two companies' Balance Sheets.
3. How would you adjust the Income Statement in an LBO model? - ANS-The most
common adjustments:
, • Cost Savings - Often you assume the PE firm cuts costs by laying off employees,
which could affect COGS, Operating Expenses, or both.
• New Depreciation Expense - This comes from any PP&E write-ups in the
transaction.
• New Amortization Expense - This includes both the amortization from written- up
intangibles and from capitalized financing fees.
• Interest Expense on LBO Debt - You need to include both cash and PIK interest
here.
• Sponsor Management Fees - Sometimes PE firms charge a "management fee" to
a company to account for the time and effort they spend managing it.
• Common Stock Dividend - Although private companies don't pay dividends to
shareholders, they could pay out a dividend recap to the PE investors.
• Preferred Stock Dividend - If Preferred Stock is used as a form of financing in the
transaction, you need to account for Preferred Stock Dividends on the Income
Statement.
Cost Savings and new Depreciation / Amortization hit the Operating Income line;
Interest Expense and Sponsor Management Fees hit Pre-Tax Income; and you
need to subtract the dividend items from your Net Income number.
4. In an LBO model, is it possible for debt investors to get a higher return than the PE firm?
What does it tell us about the company we're modeling? - ANS-Yes, and it happens
more commonly than you'd think. Remember, high-yield debt investors often get
interest rates of 10-15% or more - which effectively guarantees an IRR in that
range for them.
So no matter what happens to the company or the market, that debt gets repaid
and the debt investors get the interest payments.
But let's say that the median EBITDA multiples contract, or that the company fails
to grow or actually shrinks - in these cases the PE firm could easily get an IRR
below what the debt investors get.
5. Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as
an asset purchase. Can you also use Section 338(h)(10) election? - ANS-In most
cases, no - because one of the requirements for Section 338(h)(10) is that the
buyer must be a C corporation. Most private equity firms are organized as LLCs or
Limited Partnerships, and when they acquire companies in an LBO, they create an
LLC shell company that "acquires" the company on paper.
6. Most of the time, increased leverage means an increased IRR. Explain how increasing
the leverage could reduce the IRR. - ANS-This scenario is admittedly rare, but it
could happen if the increase leverage increases interest payments or debt
repayments to very high levels, preventing the company from using its cash flow
for other purposes.
Answers
1. 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.
2. How would an asset write-up or write-down affect an LBO model? / Walk me through
how you adjust the Balance Sheet in an LBO model. - ANS-All of this is very similar to
what you would see in a merger model - you calculate Goodwill, Other Intangibles,
and the rest of the write-ups in the same way, and then the Balance Sheet
adjustments (e.g. subtracting cash, adding in capitalized financing fees, writing up
assets, wiping out goodwill, adjusting the deferred tax assets / liabilities, adding in
new debt, etc.) are almost the same.
The key differences:
• In an LBO model you assume that the existing Shareholders' Equity is wiped out
and replaced by the equity the private equity firm contributes to buy the company;
you may also add in Preferred Stock, Management Rollover, or Rollover from
Option Holders to this number as well depending on what you're
assuming for transaction financing.
• In an LBO model you'll usually be adding a lot more tranches of debt vs. what
you would see in a merger model.
• In an LBO model you're not combining two companies' Balance Sheets.
3. How would you adjust the Income Statement in an LBO model? - ANS-The most
common adjustments:
, • Cost Savings - Often you assume the PE firm cuts costs by laying off employees,
which could affect COGS, Operating Expenses, or both.
• New Depreciation Expense - This comes from any PP&E write-ups in the
transaction.
• New Amortization Expense - This includes both the amortization from written- up
intangibles and from capitalized financing fees.
• Interest Expense on LBO Debt - You need to include both cash and PIK interest
here.
• Sponsor Management Fees - Sometimes PE firms charge a "management fee" to
a company to account for the time and effort they spend managing it.
• Common Stock Dividend - Although private companies don't pay dividends to
shareholders, they could pay out a dividend recap to the PE investors.
• Preferred Stock Dividend - If Preferred Stock is used as a form of financing in the
transaction, you need to account for Preferred Stock Dividends on the Income
Statement.
Cost Savings and new Depreciation / Amortization hit the Operating Income line;
Interest Expense and Sponsor Management Fees hit Pre-Tax Income; and you
need to subtract the dividend items from your Net Income number.
4. In an LBO model, is it possible for debt investors to get a higher return than the PE firm?
What does it tell us about the company we're modeling? - ANS-Yes, and it happens
more commonly than you'd think. Remember, high-yield debt investors often get
interest rates of 10-15% or more - which effectively guarantees an IRR in that
range for them.
So no matter what happens to the company or the market, that debt gets repaid
and the debt investors get the interest payments.
But let's say that the median EBITDA multiples contract, or that the company fails
to grow or actually shrinks - in these cases the PE firm could easily get an IRR
below what the debt investors get.
5. Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as
an asset purchase. Can you also use Section 338(h)(10) election? - ANS-In most
cases, no - because one of the requirements for Section 338(h)(10) is that the
buyer must be a C corporation. Most private equity firms are organized as LLCs or
Limited Partnerships, and when they acquire companies in an LBO, they create an
LLC shell company that "acquires" the company on paper.
6. Most of the time, increased leverage means an increased IRR. Explain how increasing
the leverage could reduce the IRR. - ANS-This scenario is admittedly rare, but it
could happen if the increase leverage increases interest payments or debt
repayments to very high levels, preventing the company from using its cash flow
for other purposes.
