LEVERAGE BUYOUT (WALL
STREET PREP) QUESTIONS AND
CORRECT VERIFIED NSWERS
2023/2024 GRADED A+.
,1. What is a leveraged buyout (LBO)?: In a leveraged buyout, a private equity firm(often called the
financial sponsor) acquires a company with most of the purchase price being funded through the use of
various debt instruments such as loans, bonds.The financial sponsor will secure the financing package
ahead of the closing of thetransaction and then contribute the remaining amount.
Once the sponsors gain majority control of the company, they get to work on stream-lining the business -
which usually means operational improvements, restructuring,and asset sales intending to make the
company more efficient at generating cash flow so that the large debt burden can be quickly paid down.
The investment horizon for sponsors is 5-7 years, at which point the firm hopes toexit by either:
- Selling the company to another private equity firm or strategic acquirer
- Taking the company public via an initial public offering (IPO)
FInancial sponsors usually target returns of -20-25% when considering an invest-ment.
2. Explain the basic concept of an LBO to me using a real-life example?: Onemetaphor to explain
an LBO is "house flipping" using mostly borrowed money. Imagine you found a house on the market
selling for a low price, in which you seenan opportunity to sell it later for a higher price at a profit. You
end up purchasing the house, but much of the purchase price was financed by a mortgage lender, with a
small down payment that came out of your pocket. In return for the lender financing the home, you
have a contractual obligation to repay the full loan amountplus interest.
But instead of purchasing the house to live there, the house was bought as a property investment with
the plan to put the house back on the market in five years.Therefore, each room is rented out to tenants to
generate monthly cash flow. The mortgage principal will gradually be paid off and the periodic interest
payments
,are paid down using the rental income from the tenants. Home renovations are completed with the
remaining amount and any existing property damages are fixed
- again, using the rental income.
After around five years, the house is sold for a price higher than the initial purchasedue to the
improvements made to the house and because the house is located in anarea where home values have
been increasing. The remaining mortgage balance will have to be paid in full, but you pocket a greater
percentage of the proceeds fromthe sale of the house because you consistently paid down the principal.
3. What is the intuition underlying the usage of debt in an LBO?: The typical transaction structure
in an LBO is financed using a high percentage of borrowed funds, with a relatively small equity
contribution from the financial sponsor. As the
, debt principal is paid down throughout the holding period, the sponsor will realise greater returns at
exit. Therefore, private equity firms attempt to maximise the amount of leverage while keeping the
debt level manageable to avoid bankruptcyrisk.
The logic behind why it's beneficial for sponsors to contribute minimal equity is dueto debt having a
lower cost of capital than equity. One reason the cost of debt is loweris that debt is higher on the capital
structure - as well as the interest expense beingtax-deductible, which creates a "tax shield." Thus, the
increased leverage enablesthe firm to reach its returns threshold easier.
4. What is the typical capital structure prevalent in LBO transactions?: LBO capital structures are
cyclical and fluctuate depending on the financing environment,but there has been a structural shift from
debt to equity ratios of 80/20 in the 1980sto around 60/40 in more recent years.
The different debt tranches include leveraged loans (revolver, term loans), senior notes, subordinated
notes, high-yield bonds, and mezzanine financing. The majorityof the debt raised will be senior, secured
loans by banks and institutional investorsbefore riskier types of debts are used. In terms of equity, the
contribution from
the financial sponsor represents the largest source of LBO equity. Sometimes, theexisting management
team will roll over a portion of their equity to participate in thepotential upside alongside the sponsor.
Since most LBOs retain the existing management team, sponsors will usually reserve anywhere
between 3% to 20% of the total equity to incentivise the man-agement team to meet financial
targets.
5. What are the main levers in an LBO that drive returns?: Debt Paydown (Deleveraging):
STREET PREP) QUESTIONS AND
CORRECT VERIFIED NSWERS
2023/2024 GRADED A+.
,1. What is a leveraged buyout (LBO)?: In a leveraged buyout, a private equity firm(often called the
financial sponsor) acquires a company with most of the purchase price being funded through the use of
various debt instruments such as loans, bonds.The financial sponsor will secure the financing package
ahead of the closing of thetransaction and then contribute the remaining amount.
Once the sponsors gain majority control of the company, they get to work on stream-lining the business -
which usually means operational improvements, restructuring,and asset sales intending to make the
company more efficient at generating cash flow so that the large debt burden can be quickly paid down.
The investment horizon for sponsors is 5-7 years, at which point the firm hopes toexit by either:
- Selling the company to another private equity firm or strategic acquirer
- Taking the company public via an initial public offering (IPO)
FInancial sponsors usually target returns of -20-25% when considering an invest-ment.
2. Explain the basic concept of an LBO to me using a real-life example?: Onemetaphor to explain
an LBO is "house flipping" using mostly borrowed money. Imagine you found a house on the market
selling for a low price, in which you seenan opportunity to sell it later for a higher price at a profit. You
end up purchasing the house, but much of the purchase price was financed by a mortgage lender, with a
small down payment that came out of your pocket. In return for the lender financing the home, you
have a contractual obligation to repay the full loan amountplus interest.
But instead of purchasing the house to live there, the house was bought as a property investment with
the plan to put the house back on the market in five years.Therefore, each room is rented out to tenants to
generate monthly cash flow. The mortgage principal will gradually be paid off and the periodic interest
payments
,are paid down using the rental income from the tenants. Home renovations are completed with the
remaining amount and any existing property damages are fixed
- again, using the rental income.
After around five years, the house is sold for a price higher than the initial purchasedue to the
improvements made to the house and because the house is located in anarea where home values have
been increasing. The remaining mortgage balance will have to be paid in full, but you pocket a greater
percentage of the proceeds fromthe sale of the house because you consistently paid down the principal.
3. What is the intuition underlying the usage of debt in an LBO?: The typical transaction structure
in an LBO is financed using a high percentage of borrowed funds, with a relatively small equity
contribution from the financial sponsor. As the
, debt principal is paid down throughout the holding period, the sponsor will realise greater returns at
exit. Therefore, private equity firms attempt to maximise the amount of leverage while keeping the
debt level manageable to avoid bankruptcyrisk.
The logic behind why it's beneficial for sponsors to contribute minimal equity is dueto debt having a
lower cost of capital than equity. One reason the cost of debt is loweris that debt is higher on the capital
structure - as well as the interest expense beingtax-deductible, which creates a "tax shield." Thus, the
increased leverage enablesthe firm to reach its returns threshold easier.
4. What is the typical capital structure prevalent in LBO transactions?: LBO capital structures are
cyclical and fluctuate depending on the financing environment,but there has been a structural shift from
debt to equity ratios of 80/20 in the 1980sto around 60/40 in more recent years.
The different debt tranches include leveraged loans (revolver, term loans), senior notes, subordinated
notes, high-yield bonds, and mezzanine financing. The majorityof the debt raised will be senior, secured
loans by banks and institutional investorsbefore riskier types of debts are used. In terms of equity, the
contribution from
the financial sponsor represents the largest source of LBO equity. Sometimes, theexisting management
team will roll over a portion of their equity to participate in thepotential upside alongside the sponsor.
Since most LBOs retain the existing management team, sponsors will usually reserve anywhere
between 3% to 20% of the total equity to incentivise the man-agement team to meet financial
targets.
5. What are the main levers in an LBO that drive returns?: Debt Paydown (Deleveraging):
