LBO Model Quiz Basic Question and
Answer
1. A mega-cap private equity fund such as KKR or Blackstone is considering buying a $4
billion public company using 50% debt and 50% equity. It has run the numbers and
found that it could realize a 20% IRR in 5 years at those levels. Furthermore, the fund
also has more than enough cash on hand to do the deal at those levels. During deal
negotiations, however, the PE firm pushes to contribute only $1.5 billion in equity rather
than $2 billion. Why would it do this?
a. All else being equal, less equity contributed will still
boost its IRR
b. A 20% IRR is too low and will not please the firm's Limited Partners
c. Because the firm needs more "dry powder" on hand and wants to save cash
in case it decides to make more investments in the near future
d. None of the above - ANS-Explanation: A 20% IRR is a good outcome, so B is not
the best answer
choice here. It really comes down to the two answers outlined in A and C: a PE
firm almost always earns more by contributing less equity, so it's in their interest
to negotiate it down even lower, if possible, assuming that the company can
support that level of debt. C is also a major motivation, and sometimes PE firms
are actually prohibited from investing over a certain amount or percentage of
equity in a single deal. Fund-raising is expensive and time-consuming, so it is in
their interest to reduce the amount of cash contributed as much as possible
before doing the deal.
2. A PE firm might prefer high-yield debt over bank debt because it's less expensive and
the company's CapEx and acquisitions would not be restricted.
a. True
b. False - ANS-Explanation: The correct answer choice is B. Between HY debt and
bank debt, the latter is a lower cost method of financing. Furthermore, HY debt
does have incurrence covenants, which would prohibit it from taking certain
actions such as spending additional funds on Capital Expenditures or on
acquisitions. In summary, for a lower cost option of financing without restrictive
incurrence covenants, a PE fund would chose bank debt rather than HY debt.
3. A PE fund buys a company (with no existing debt or cash) for $500 million, at a purchase
EBITDA multiple of 10.0x. They use 75% debt and 25% equity. At the end of the 3-year
, period, they sell the company at an exit EBITDA multiple of 12.0x. However, EBITDA has
not changed at all. Finally, the PE fund has paid off $150 million worth of debt. What is
the approximate IRR on this deal?
a. Approximately a 44% IRR
b. Approximately a 15% IRR
c. Approximately a 25% IRR
d. Approximately a 26% IRR - ANS-Explanation: The correct answer choice is A. We
can refer to the rules of thumb provided in the LBO Guide to approximate the IRR
returns. In this case, the PE sponsor tripled their money in 3 years, which
corresponds to a 44% IRR. Here is how we do the calculation: the PE sponsor
used $125M in cash to acquire the company and borrowed the remaining $375M. 3
years later the company is sold and the exit multiple expanded to 12.0x. However,
EBITDA remained the same. Since the company was initially purchased at 10.0x
EBITDA for $500M, that implies an EBITDA of $50M per year. So we take this $50M
EBITDA and multiply it by the exit multiple of 12.0x, which results in an exit price
of $600M. The net proceeds to the PE sponsor is $375M (i.e. exit price less
remaining debt outstanding), resulting in 3.0x the initial investment (i.e. $375M net
proceeds / $125M initial investment = 3.0x).
4. All of the following characteristics make for a good LBO target EXCEPT:
a. High PP&E and/or Fixed Assets on the Balance Sheet
b. Relatively low Capital Expenditures
c. Non-volatile, non-cyclical, cash flow producing business
d. Early-stage fast growth company - ANS-Explanation: The correct answer choice is
D. Answer choice A
represents an asset-rich company which can pledge its current assets and PP&E
as collateral for high levels of bank debt (which is necessary for an LBO). Answer
choice B refers to companies with negligible large cash outflows in the form of
capital expenditures; that is a good sign since the company can use those cash
flows to pay interest and debt principal post-LBO instead. Answer choice C
represents companies that produce lots of cash flow and exhibit no volatility in
those cash flows from year to year. Usually, PE firms prefer very mature
companies and industries, sometimes even if they are in the decline phase of their
lifecycle. Something very early-stage with high growth would probably produce
cash flows that are too volatile to make consistent and periodic interest payments
and debt repayment. Usually early-stage hyper growth companies are not
Answer
1. A mega-cap private equity fund such as KKR or Blackstone is considering buying a $4
billion public company using 50% debt and 50% equity. It has run the numbers and
found that it could realize a 20% IRR in 5 years at those levels. Furthermore, the fund
also has more than enough cash on hand to do the deal at those levels. During deal
negotiations, however, the PE firm pushes to contribute only $1.5 billion in equity rather
than $2 billion. Why would it do this?
a. All else being equal, less equity contributed will still
boost its IRR
b. A 20% IRR is too low and will not please the firm's Limited Partners
c. Because the firm needs more "dry powder" on hand and wants to save cash
in case it decides to make more investments in the near future
d. None of the above - ANS-Explanation: A 20% IRR is a good outcome, so B is not
the best answer
choice here. It really comes down to the two answers outlined in A and C: a PE
firm almost always earns more by contributing less equity, so it's in their interest
to negotiate it down even lower, if possible, assuming that the company can
support that level of debt. C is also a major motivation, and sometimes PE firms
are actually prohibited from investing over a certain amount or percentage of
equity in a single deal. Fund-raising is expensive and time-consuming, so it is in
their interest to reduce the amount of cash contributed as much as possible
before doing the deal.
2. A PE firm might prefer high-yield debt over bank debt because it's less expensive and
the company's CapEx and acquisitions would not be restricted.
a. True
b. False - ANS-Explanation: The correct answer choice is B. Between HY debt and
bank debt, the latter is a lower cost method of financing. Furthermore, HY debt
does have incurrence covenants, which would prohibit it from taking certain
actions such as spending additional funds on Capital Expenditures or on
acquisitions. In summary, for a lower cost option of financing without restrictive
incurrence covenants, a PE fund would chose bank debt rather than HY debt.
3. A PE fund buys a company (with no existing debt or cash) for $500 million, at a purchase
EBITDA multiple of 10.0x. They use 75% debt and 25% equity. At the end of the 3-year
, period, they sell the company at an exit EBITDA multiple of 12.0x. However, EBITDA has
not changed at all. Finally, the PE fund has paid off $150 million worth of debt. What is
the approximate IRR on this deal?
a. Approximately a 44% IRR
b. Approximately a 15% IRR
c. Approximately a 25% IRR
d. Approximately a 26% IRR - ANS-Explanation: The correct answer choice is A. We
can refer to the rules of thumb provided in the LBO Guide to approximate the IRR
returns. In this case, the PE sponsor tripled their money in 3 years, which
corresponds to a 44% IRR. Here is how we do the calculation: the PE sponsor
used $125M in cash to acquire the company and borrowed the remaining $375M. 3
years later the company is sold and the exit multiple expanded to 12.0x. However,
EBITDA remained the same. Since the company was initially purchased at 10.0x
EBITDA for $500M, that implies an EBITDA of $50M per year. So we take this $50M
EBITDA and multiply it by the exit multiple of 12.0x, which results in an exit price
of $600M. The net proceeds to the PE sponsor is $375M (i.e. exit price less
remaining debt outstanding), resulting in 3.0x the initial investment (i.e. $375M net
proceeds / $125M initial investment = 3.0x).
4. All of the following characteristics make for a good LBO target EXCEPT:
a. High PP&E and/or Fixed Assets on the Balance Sheet
b. Relatively low Capital Expenditures
c. Non-volatile, non-cyclical, cash flow producing business
d. Early-stage fast growth company - ANS-Explanation: The correct answer choice is
D. Answer choice A
represents an asset-rich company which can pledge its current assets and PP&E
as collateral for high levels of bank debt (which is necessary for an LBO). Answer
choice B refers to companies with negligible large cash outflows in the form of
capital expenditures; that is a good sign since the company can use those cash
flows to pay interest and debt principal post-LBO instead. Answer choice C
represents companies that produce lots of cash flow and exhibit no volatility in
those cash flows from year to year. Usually, PE firms prefer very mature
companies and industries, sometimes even if they are in the decline phase of their
lifecycle. Something very early-stage with high growth would probably produce
cash flows that are too volatile to make consistent and periodic interest payments
and debt repayment. Usually early-stage hyper growth companies are not
