4. LBO (PE Questions) and Answers
1. After reading a company's CIM, you decide to meet with the CEO. What are the top 3
questions you would ask him/her? - ANS-You'd focus on questions that are not
answered in the CIM, so the best questions depend heavily on the company, its
industry, and how much information is disclosed in the CIM.
2. Can you walk me through how you might make an investment decision based on the
output from an LBO model? - ANS-1) Determine investment criteria (IRR and MoM
multiple)
2) Build projections and look at LBO model output for Base Case. If numbers
work, build projections for Downside Case
3) Back up decision with qualitative criteria.
3. Explain what happens on the financial statements when a 10-year Subordinated Note
with a par value of $1,000 is issued for $950. Assume no principal repayments. -
ANS-This is an OID.
Initially record the Subordinated Notes on the BS at $950. Amortize IOD over 10
years so there's $5 in amortization on the IS (and added back on CFS) and the
Subordinated Notes increased by $5 each year.
Company pays interest expense based on Subordinated Note's constant face
value of $1000 so OID amortization doesn't affect true cash expenses.
4. How do add-on acquisitions affect the IRR and financial statements in an LBO? -
ANS-With add-on acquisitions, you assume that the PE firm uses additional Debt
and Equity to acquire other companies and combines them with the original
company.
You'll see additional Debt and Equity on the Combined Balance Sheet and the
acquired companies' revenue, expense, and cash flow contributions on the
statements. High yielding add-ons increase IRR while low ones can decrease it.
Also depends on funding method.
5. How do Cash Flow Sweeps affect Debt repayment in an LBO? - ANS-A Cash Flow
Sweep specifies that a certain percentage of the company's excess cash flow
must be used to repay Debt in a given year.
Cash Flow Sweeps rarely make a big impact on the model, but they complicate the
optional Debt repayment formulas because you use some smaller percentage of
the company's excess cash flow, rather than everything, to repay Debt.
6. How do Subordinated Notes with Call Premiums affect a PE firm's exit strategy in a
leveraged buyout? - ANS-Call Premiums make it more expensive to repay Debt
principal early so it incentivizes PE firms to hold onto a company for a longer
period.
, 7. How does a Returns Attribution Analysis for an LBO affect your investment decision? -
ANS-This analysis makes an impact because certain returns sources are
considered more favorable than others.
If a deal is predicated on Multiple Expansion, you should be very skeptical
because Multiple Expansion is highly speculative and often fails to materialize. If a
deal depends mostly on EBITDA Growth, it's more credible because it's easier to
grow a company's business than to increase its multiple. Debt Paydown and Cash
Generation is somewhere in the middle - it indicates that the deal depends on
financial engineering more than core business growth.
8. How does a stub period affect all the calculations in an LBO model? - ANS-A "stub
period" means that the deal closes in between fiscal years.
Need to "roll forward" last Balance Sheet, project company's financial statements
for months in stub period, use XIRR.
9. How might a PE firm reduce its downside risk if a leveraged buyout does not perform
well? - ANS-Much of the risk in leveraged buyouts comes from multiple
contraction: The Exit Multiple might be lower than the Purchase Multiple.
The best way to reduce this risk is to avoid acquiring companies trading at
relatively high multiples and to focus on companies that are undervalued in some
way.
Other methods: companies with Tangible Assets to sell off, use more Debt,
acquire smaller stake, improve company operations.
10.How might you convince the management team of a company to agree to a leveraged
buyout? - ANS-The company could take its time to execute long-term plans away
from the scrutiny of quarterly earnings calls and the public markets, the
management could own a higher percentage through incentives (Equity Rollover,
options), offer a high price.
How would you model a "waterfall returns" structure where different Equity
investors in an LBO receive different percentages of the returns based on the
overall IRR?
11.For example, let's say that Investor Group A receives 10% of the returns up to a 15%
IRR (Investor Group B receives 90%), but then receives 15% of the returns (with
Investor Group B receiving 85%) beyond a 15% IRR. How does that work? - ANS-1)
Check to see what the IRR is for the Equity Proceeds generated in the deal.
2) Determine the Equity Proceeds for a 15% IRR. Allocate 10% to Group A and 90%
to Group B
3) Allocate 15% of remaining proceeds (minus what's given out in first tier) to
Group A and 85% to Group B.
1. After reading a company's CIM, you decide to meet with the CEO. What are the top 3
questions you would ask him/her? - ANS-You'd focus on questions that are not
answered in the CIM, so the best questions depend heavily on the company, its
industry, and how much information is disclosed in the CIM.
2. Can you walk me through how you might make an investment decision based on the
output from an LBO model? - ANS-1) Determine investment criteria (IRR and MoM
multiple)
2) Build projections and look at LBO model output for Base Case. If numbers
work, build projections for Downside Case
3) Back up decision with qualitative criteria.
3. Explain what happens on the financial statements when a 10-year Subordinated Note
with a par value of $1,000 is issued for $950. Assume no principal repayments. -
ANS-This is an OID.
Initially record the Subordinated Notes on the BS at $950. Amortize IOD over 10
years so there's $5 in amortization on the IS (and added back on CFS) and the
Subordinated Notes increased by $5 each year.
Company pays interest expense based on Subordinated Note's constant face
value of $1000 so OID amortization doesn't affect true cash expenses.
4. How do add-on acquisitions affect the IRR and financial statements in an LBO? -
ANS-With add-on acquisitions, you assume that the PE firm uses additional Debt
and Equity to acquire other companies and combines them with the original
company.
You'll see additional Debt and Equity on the Combined Balance Sheet and the
acquired companies' revenue, expense, and cash flow contributions on the
statements. High yielding add-ons increase IRR while low ones can decrease it.
Also depends on funding method.
5. How do Cash Flow Sweeps affect Debt repayment in an LBO? - ANS-A Cash Flow
Sweep specifies that a certain percentage of the company's excess cash flow
must be used to repay Debt in a given year.
Cash Flow Sweeps rarely make a big impact on the model, but they complicate the
optional Debt repayment formulas because you use some smaller percentage of
the company's excess cash flow, rather than everything, to repay Debt.
6. How do Subordinated Notes with Call Premiums affect a PE firm's exit strategy in a
leveraged buyout? - ANS-Call Premiums make it more expensive to repay Debt
principal early so it incentivizes PE firms to hold onto a company for a longer
period.
, 7. How does a Returns Attribution Analysis for an LBO affect your investment decision? -
ANS-This analysis makes an impact because certain returns sources are
considered more favorable than others.
If a deal is predicated on Multiple Expansion, you should be very skeptical
because Multiple Expansion is highly speculative and often fails to materialize. If a
deal depends mostly on EBITDA Growth, it's more credible because it's easier to
grow a company's business than to increase its multiple. Debt Paydown and Cash
Generation is somewhere in the middle - it indicates that the deal depends on
financial engineering more than core business growth.
8. How does a stub period affect all the calculations in an LBO model? - ANS-A "stub
period" means that the deal closes in between fiscal years.
Need to "roll forward" last Balance Sheet, project company's financial statements
for months in stub period, use XIRR.
9. How might a PE firm reduce its downside risk if a leveraged buyout does not perform
well? - ANS-Much of the risk in leveraged buyouts comes from multiple
contraction: The Exit Multiple might be lower than the Purchase Multiple.
The best way to reduce this risk is to avoid acquiring companies trading at
relatively high multiples and to focus on companies that are undervalued in some
way.
Other methods: companies with Tangible Assets to sell off, use more Debt,
acquire smaller stake, improve company operations.
10.How might you convince the management team of a company to agree to a leveraged
buyout? - ANS-The company could take its time to execute long-term plans away
from the scrutiny of quarterly earnings calls and the public markets, the
management could own a higher percentage through incentives (Equity Rollover,
options), offer a high price.
How would you model a "waterfall returns" structure where different Equity
investors in an LBO receive different percentages of the returns based on the
overall IRR?
11.For example, let's say that Investor Group A receives 10% of the returns up to a 15%
IRR (Investor Group B receives 90%), but then receives 15% of the returns (with
Investor Group B receiving 85%) beyond a 15% IRR. How does that work? - ANS-1)
Check to see what the IRR is for the Equity Proceeds generated in the deal.
2) Determine the Equity Proceeds for a 15% IRR. Allocate 10% to Group A and 90%
to Group B
3) Allocate 15% of remaining proceeds (minus what's given out in first tier) to
Group A and 85% to Group B.
