LBO Advanced Questions and Answers
1. 1. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-First,
the Liabilities & Equity side is adjusted - the new debt is added, and the
Shareholders' Equity is "wiped out" and replaced by however much Investor
Equity the private equity firm is contributing (i.e. how much cash it's paying for
the company).
On the Assets side, Cash is adjusted for any cash used to finance the transaction
and for transaction fees, and then Goodwill & Other Intangibles are used as a
"plug" to make the Balance Sheet balance.
There will also be all the usual effects that you see in transactions: Asset
Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing Fees, and so on.
2. How could you determine how much debt can be raised in an LBO and how many
tranches there would be? - ANS-Usually you would look at recent, similar LBOs and
assess the debt terms and tranches that were used in each transaction.
You could also look at companies in a similar size range and industry, see how
much debt outstanding they have, and base your own numbers on those.
3. Let's say we're analyzing how much debt a company can take on, and what the terms of
the debt should be. What are reasonable leverage and coverage ratios? - ANS-This is
completely dependent on the company, the industry, and the leverage and
coverage ratios for comparable LBO transactions.
To figure out the numbers, you would look at "Debt Comps" showing the types,
tranches, and terms of debt that similarly sized companies in the industry have
used recently.
There are some general rules: for example, you would never lever a company at
50x EBITDA, and even during bubbles leverage rarely exceeds 10x EBITDA.
For interest coverage ratios (e.g. EBITDA / Interest), you want a number where the
company can pay for its interest without much trouble, but also not so high that
the company could clearly afford to take on more debt.
For example, a 20x coverage ratio would be far too high because the company
could easily pay 2-3x more in interest. But a 2x coverage ratio would be too low
because a small decrease in EBITDA might result in disaster at that level.
4. 2. Why are Goodwill & Other Intangibles created in an LBO? - ANS-These both
represent the premium paid to the Shareholders' Equity of the company. In an
LBO, they act as a "plug" and ensure that the changes to the Liabilities & Equity
side are balanced by changes to the Assets side.
, So if the company's Shareholders' Equity was originally worth $1 billion and the
PE firm pays $1.5 billion to acquire the company, roughly $500 million in Goodwill
& Other Intangibles will be created.
5. How do you project the financial statements and determine how much debt the
company can pay off each year? - ANS-The same way you project the financial
statements anywhere else: assume a revenue growth rate, make key expenses a
percentage of revenue, and then tie Balance Sheet and Cash Flow Statement items
to revenue and expenses on the Income Statement - and to historical trends.
To project the cash flow available to repay debt each year, you take Cash Flow
from Operations and subtract CapEx.
Just as in the DCF analysis, you assume that other items in the Investing and
Financing sections are non-recurring and therefore do not impact future cash
flows.
Note that this calculation only determines how much in debt principal the
company could potentially repay - interest expense has already been factored in
on the Income Statement, and its impact is already reflected in the Cash Flow from
Operations number.
6. 3. What is the difference between Bank Debt and High-Yield Debt? - ANS-This is a
simplification, but broadly speaking there are 2 "types" of Debt: "Bank Debt" and
"High-Yield Debt."
There are many differences, but here are a few of the most important ones:
• High-Yield Debt tends to have higher interest rates than Bank Debt (hence the
name "high-yield") since it's riskier for investors.
• High-Yield Debt interest rates are usually fixed, whereas Bank Debt interest rates
are "floating" - they change based on LIBOR (or the prevailing interest rates in the
economy).
• High-Yield Debt has incurrence covenants while Bank Debt has maintenance
covenants. The main difference is that incurrence covenants prevent you from
doing something (such as selling an asset, buying a factory, etc.) while
maintenance covenants require you to maintain a minimum financial performance
(for example, the Total Debt / EBITDA ratio must be below 5x at all times).
• Bank Debt is usually amortized - the principal must be paid off over time -
whereas with High-Yield Debt, the entire principal is due at the end (bullet
maturity) and early principal repayments are not allowed.
7. What if the company has existing debt? How does that affect the projections? - ANS-If
the company has existing debt and the PE firm refinances it (pays it off), it's a
non-factor because it goes away. If the PE firm assumes the debt instead, you
need to factor in interest and principal repayments on that debt over future years.
1. 1. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-First,
the Liabilities & Equity side is adjusted - the new debt is added, and the
Shareholders' Equity is "wiped out" and replaced by however much Investor
Equity the private equity firm is contributing (i.e. how much cash it's paying for
the company).
On the Assets side, Cash is adjusted for any cash used to finance the transaction
and for transaction fees, and then Goodwill & Other Intangibles are used as a
"plug" to make the Balance Sheet balance.
There will also be all the usual effects that you see in transactions: Asset
Write-Ups and Write-Downs, DTLs, DTAs, Capitalized Financing Fees, and so on.
2. How could you determine how much debt can be raised in an LBO and how many
tranches there would be? - ANS-Usually you would look at recent, similar LBOs and
assess the debt terms and tranches that were used in each transaction.
You could also look at companies in a similar size range and industry, see how
much debt outstanding they have, and base your own numbers on those.
3. Let's say we're analyzing how much debt a company can take on, and what the terms of
the debt should be. What are reasonable leverage and coverage ratios? - ANS-This is
completely dependent on the company, the industry, and the leverage and
coverage ratios for comparable LBO transactions.
To figure out the numbers, you would look at "Debt Comps" showing the types,
tranches, and terms of debt that similarly sized companies in the industry have
used recently.
There are some general rules: for example, you would never lever a company at
50x EBITDA, and even during bubbles leverage rarely exceeds 10x EBITDA.
For interest coverage ratios (e.g. EBITDA / Interest), you want a number where the
company can pay for its interest without much trouble, but also not so high that
the company could clearly afford to take on more debt.
For example, a 20x coverage ratio would be far too high because the company
could easily pay 2-3x more in interest. But a 2x coverage ratio would be too low
because a small decrease in EBITDA might result in disaster at that level.
4. 2. Why are Goodwill & Other Intangibles created in an LBO? - ANS-These both
represent the premium paid to the Shareholders' Equity of the company. In an
LBO, they act as a "plug" and ensure that the changes to the Liabilities & Equity
side are balanced by changes to the Assets side.
, So if the company's Shareholders' Equity was originally worth $1 billion and the
PE firm pays $1.5 billion to acquire the company, roughly $500 million in Goodwill
& Other Intangibles will be created.
5. How do you project the financial statements and determine how much debt the
company can pay off each year? - ANS-The same way you project the financial
statements anywhere else: assume a revenue growth rate, make key expenses a
percentage of revenue, and then tie Balance Sheet and Cash Flow Statement items
to revenue and expenses on the Income Statement - and to historical trends.
To project the cash flow available to repay debt each year, you take Cash Flow
from Operations and subtract CapEx.
Just as in the DCF analysis, you assume that other items in the Investing and
Financing sections are non-recurring and therefore do not impact future cash
flows.
Note that this calculation only determines how much in debt principal the
company could potentially repay - interest expense has already been factored in
on the Income Statement, and its impact is already reflected in the Cash Flow from
Operations number.
6. 3. What is the difference between Bank Debt and High-Yield Debt? - ANS-This is a
simplification, but broadly speaking there are 2 "types" of Debt: "Bank Debt" and
"High-Yield Debt."
There are many differences, but here are a few of the most important ones:
• High-Yield Debt tends to have higher interest rates than Bank Debt (hence the
name "high-yield") since it's riskier for investors.
• High-Yield Debt interest rates are usually fixed, whereas Bank Debt interest rates
are "floating" - they change based on LIBOR (or the prevailing interest rates in the
economy).
• High-Yield Debt has incurrence covenants while Bank Debt has maintenance
covenants. The main difference is that incurrence covenants prevent you from
doing something (such as selling an asset, buying a factory, etc.) while
maintenance covenants require you to maintain a minimum financial performance
(for example, the Total Debt / EBITDA ratio must be below 5x at all times).
• Bank Debt is usually amortized - the principal must be paid off over time -
whereas with High-Yield Debt, the entire principal is due at the end (bullet
maturity) and early principal repayments are not allowed.
7. What if the company has existing debt? How does that affect the projections? - ANS-If
the company has existing debt and the PE firm refinances it (pays it off), it's a
non-factor because it goes away. If the PE firm assumes the debt instead, you
need to factor in interest and principal repayments on that debt over future years.
