7 - Leveraged Buyouts and LBO models
Questions and Answers
"
A PE firm acquires a $100 million EBITDA company for a 10x purchase multiple and
funds the deal with 60% Debt. The company's EBITDA grows to $150 million by Year 5,
but the exit multiple drops to 9x. The company repays $250 million of Debt in this time
and generates no extra Cash. What's the IRR? - ANS-Initially, the PE firm uses 40%
Equity, which means $100 million * 10x * 40% = $400 million. The Exit Enterprise Value
= $150 million * 9x = $1,350 million (Mental Math: $150 million * 10x = $1.5 billion, and
subtract $150 million). The initial Debt amount was $600 million, and the company repaid
$250 million, so $350 million of Debt remains upon exit. The Equity Proceeds to the PE
firm are $1,350 million - $350 million = $1 billion. $1 billion / $400 million = 2.5x, which is
in between 2x and 3x over 5 years; since 2x over 5 years is 15% and 3x is 25%, this IRR
is approximately 20%.
"
1. Can you explain the legal structure behind a leveraged buyout and how it benefits the
private equity firm? - ANS-In a leveraged buyout, the PE firm forms a "holding
company," which it owns, and then this "holding company" acquires the real
company. The banks and other lenders that provide the Debt lend to this Holding
Company so that the Debt is at the "HoldCo" level. This structure is important
because it means that the private equity firm is NOT "on the hook" for the Debt it
uses in the deal: It's up to the Target Company to repay it.
"
2. How can you quickly approximate the IRR in an LBO? Are there any rules of thumb? -
ANS-"Double Your Money in 3 Years = ~25% IRR
Double Your Money in 5 Years = ~15% IRR
Triple Your Money in 3 Years = ~45% IRR
Triple Your Money in 5 Years = ~25% IRR
"
3. How is a leveraged buyout different from a normal M&A deal? - ANS-An LBO, you
assume the company is sold after a certain amount of years, 3-7 years. 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.
EPS accretion/dilution matter a lot in M&A deals, but not at all in LBOs
"
4. How is the "Free Cash Flow" in an LBO model different from the FCF in a DCF? -
ANS-First, the purpose is quite different since FCF in an LBO model determines a
company's ability to repay Debt, not the implied value of the entire company.
Second, FCF in an LBO model starts with Net Income, not NOPAT, and so it
, includes the Net Interest Expense. But it's also not Levered FCF since it does not
include Debt principal repayments.
"
5. Shortcuts to remember for doubling your return and tripling your return - ANS-Take
100%, divide by the # of Years, and multiply by ~75% to approximate the IRR in
"Double Your Money" scenarios. Take 200%, divide by the # of Years, and multiply
by ~65% to approximate the IRR in "Triple Your Money" scenarios.
"
6. Walk me through a basic LBO model? - ANS-"In an LBO model, in Step 1, you make
assumptions for the Purchase Price, the % Debt and Equity, Interest Rate on Debt,
and other variables such as the company's revenue growth and margins.
In Step 2, you create a Sources & Uses schedule to show exactly how much how
much in Investor Equity the PE firm contributes; you also create a Purchase Price
Allocation Schedule to calculate the Goodwill.
In Step 3, you adjust the company's Balance Sheet for the new Debt and Equity
figures, allocate the purchase price, and add Goodwill & Other Intangibles to the
Assets side to make everything balance.
In Step 4, you project the company's Income Statement, Balance Sheet, and Cash
Flow Statement, and determine how much Debt it repays each year based on its
Free Cash Flow.
Finally, in Step 5, you make assumptions about the exit, usually assuming an
EBITDA Exit Multiple, and you calculate the IRR and Money-on-Money multiple
based on the proceeds the PE firm earns at the end.
"
7. What does "assuming" or "refinancing" Debt mean, and how do these two options affect
an LBO model? - ANS-"The terms of most Debt state that in a "change of control"
scenario, the Debt must be repaid. In LBO scenarios, PE firms must repay it with
either Investor Equity (their cash) or new Debt. In practice, most PE firms usually
choose to "replace" a company's existing Debt with new Debt in the same
amount; using Investor Equity would reduce their returns.
"Assuming" Debt means that the PE firm keeps the existing Debt in place, or that
it replaces it with new, identical Debt. "Refinancing" Debt means that the PE firm
repays it using Investor Equity or some combination of Investor Equity and New
Debt; in these cases, more Investor Equity (and, possibly, additional Debt) is
required for the deal.
"Debt Assumed" shows up under both Sources and Uses in the S&U schedule.
"Debt Refinanced" shows up only on the Uses side of the S&U schedule.
"
8. What IRR and MoM multiple do PE firms typically target? - ANS-Most private equity
firms aim for an IRR of at least 20%, about twice what public equity markets in
developed countries have returned historically. The targeted multiple depends on
the time frame of each investment, but a 20% IRR over 5 years equates to a 2.5x
multiple. Most firms also target different numbers for Base, Upside, and Downside
cases, and aim to avoid losing money no matter what happens.
Questions and Answers
"
A PE firm acquires a $100 million EBITDA company for a 10x purchase multiple and
funds the deal with 60% Debt. The company's EBITDA grows to $150 million by Year 5,
but the exit multiple drops to 9x. The company repays $250 million of Debt in this time
and generates no extra Cash. What's the IRR? - ANS-Initially, the PE firm uses 40%
Equity, which means $100 million * 10x * 40% = $400 million. The Exit Enterprise Value
= $150 million * 9x = $1,350 million (Mental Math: $150 million * 10x = $1.5 billion, and
subtract $150 million). The initial Debt amount was $600 million, and the company repaid
$250 million, so $350 million of Debt remains upon exit. The Equity Proceeds to the PE
firm are $1,350 million - $350 million = $1 billion. $1 billion / $400 million = 2.5x, which is
in between 2x and 3x over 5 years; since 2x over 5 years is 15% and 3x is 25%, this IRR
is approximately 20%.
"
1. Can you explain the legal structure behind a leveraged buyout and how it benefits the
private equity firm? - ANS-In a leveraged buyout, the PE firm forms a "holding
company," which it owns, and then this "holding company" acquires the real
company. The banks and other lenders that provide the Debt lend to this Holding
Company so that the Debt is at the "HoldCo" level. This structure is important
because it means that the private equity firm is NOT "on the hook" for the Debt it
uses in the deal: It's up to the Target Company to repay it.
"
2. How can you quickly approximate the IRR in an LBO? Are there any rules of thumb? -
ANS-"Double Your Money in 3 Years = ~25% IRR
Double Your Money in 5 Years = ~15% IRR
Triple Your Money in 3 Years = ~45% IRR
Triple Your Money in 5 Years = ~25% IRR
"
3. How is a leveraged buyout different from a normal M&A deal? - ANS-An LBO, you
assume the company is sold after a certain amount of years, 3-7 years. 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.
EPS accretion/dilution matter a lot in M&A deals, but not at all in LBOs
"
4. How is the "Free Cash Flow" in an LBO model different from the FCF in a DCF? -
ANS-First, the purpose is quite different since FCF in an LBO model determines a
company's ability to repay Debt, not the implied value of the entire company.
Second, FCF in an LBO model starts with Net Income, not NOPAT, and so it
, includes the Net Interest Expense. But it's also not Levered FCF since it does not
include Debt principal repayments.
"
5. Shortcuts to remember for doubling your return and tripling your return - ANS-Take
100%, divide by the # of Years, and multiply by ~75% to approximate the IRR in
"Double Your Money" scenarios. Take 200%, divide by the # of Years, and multiply
by ~65% to approximate the IRR in "Triple Your Money" scenarios.
"
6. Walk me through a basic LBO model? - ANS-"In an LBO model, in Step 1, you make
assumptions for the Purchase Price, the % Debt and Equity, Interest Rate on Debt,
and other variables such as the company's revenue growth and margins.
In Step 2, you create a Sources & Uses schedule to show exactly how much how
much in Investor Equity the PE firm contributes; you also create a Purchase Price
Allocation Schedule to calculate the Goodwill.
In Step 3, you adjust the company's Balance Sheet for the new Debt and Equity
figures, allocate the purchase price, and add Goodwill & Other Intangibles to the
Assets side to make everything balance.
In Step 4, you project the company's Income Statement, Balance Sheet, and Cash
Flow Statement, and determine how much Debt it repays each year based on its
Free Cash Flow.
Finally, in Step 5, you make assumptions about the exit, usually assuming an
EBITDA Exit Multiple, and you calculate the IRR and Money-on-Money multiple
based on the proceeds the PE firm earns at the end.
"
7. What does "assuming" or "refinancing" Debt mean, and how do these two options affect
an LBO model? - ANS-"The terms of most Debt state that in a "change of control"
scenario, the Debt must be repaid. In LBO scenarios, PE firms must repay it with
either Investor Equity (their cash) or new Debt. In practice, most PE firms usually
choose to "replace" a company's existing Debt with new Debt in the same
amount; using Investor Equity would reduce their returns.
"Assuming" Debt means that the PE firm keeps the existing Debt in place, or that
it replaces it with new, identical Debt. "Refinancing" Debt means that the PE firm
repays it using Investor Equity or some combination of Investor Equity and New
Debt; in these cases, more Investor Equity (and, possibly, additional Debt) is
required for the deal.
"Debt Assumed" shows up under both Sources and Uses in the S&U schedule.
"Debt Refinanced" shows up only on the Uses side of the S&U schedule.
"
8. What IRR and MoM multiple do PE firms typically target? - ANS-Most private equity
firms aim for an IRR of at least 20%, about twice what public equity markets in
developed countries have returned historically. The targeted multiple depends on
the time frame of each investment, but a 20% IRR over 5 years equates to a 2.5x
multiple. Most firms also target different numbers for Base, Upside, and Downside
cases, and aim to avoid losing money no matter what happens.
