Lbo Modeling Exam From Wall Street Prep Questions And Answers

LBO MODELING EXAM FROM WALL STREET PREP QUESTIONS AND ANSWERS “Walk me through a basic LBO Model. - CORRECT ANSWER In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity Ratio, Interest Rate on Debt and other variables; you might also assume something about the company's operations such as Revenue Growth or Margins, depending on how much information you have. Step 2 is to create a Source and Use section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is requried, Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also add in Goodwill and Other Intangibles on the Assets side to make everything balance. Step 4, you project out the company's income statement, balance sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments. Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm." "What is a leveraged buyout? - CORRECT ANSWER In an LBO, a private equity firm will acquirer another company using a combination of debt and equity, they'll operate the company and sell the company at the end to hopefully realize a return on the investment. The PE firm will use the cash flows generated to pay off the interest expense on Debt and often the principal payment its self. The acquired company is often used collateral for the debt and this method works because leverage amplifies returns." "Why would you use leverage when buying a company? - CORRECT ANSWER To boost your return. Remember, any debt you use in an LBO is not "your money" so if you're paying $5 billion for a company, it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs $3 billion of your own money and $2 billion of borrowed money" "How to set up a basic simple LBO Model-Paper LBO - CORRECT ANSWER Step 1- Make Basic Transaction Assumptions. At a bare minimum you need to know - The Purchase Price and how much Debt and equity are used *Equity really means cash used to purchase outstanding shares* Step 2- Project cCash Flows and Debt Repayment. To project cash flows, you need information on the company's Revenue, EBITDA, Taxes and other key items such as Working Capital and CapEx. Cash flow in an LBO model is neither unlevered or levered but just Cash flow from Operations-Capex Step 3- Make exit assumptions and calculate the returns Almost always have to be repay debt. Standard is to subtract Net debt at the end to calculate proceeds to the PE Firm." "PE firms recognize minimum IRR when? - CORRECT ANSWER PE firms will recognize minimum IRR when Equity Proceeds are at minimum level. For that to happen the company must repay no debt and generate no additional cash. IF they generate more cash or repay debt IRR will increase obviously because greater return" "What is residual debt? - CORRECT ANSWER Residual debt= Debt started with- debt repaid. It's just the outstanding debt." "What is the formula for Exit Proceeds? - CORRECT ANSWER Exit Proceeds= + Equity Proceeds - Residual Debt + Dividends paid/ FCF in excess of debt payments. Can just lump FCF in excess of debt payments into dividends" "How do you use an LBO model to value a company, and why does it set the "floor valuation" for the company? - CORRECT ANSWER You use it to value a company by setting a targeted IRR, such as 25%, and then using Goal Seek in Excel to determine the purchase price that the PE firm could pay to achieve that IRR. For example, if the exit multiple is 11x, which translates into $1,000 in Equity Proceeds for the PE firm, Goal Seek in Excel might tell you that the firm could pay $328 in investor equity to achieve a 25% IRR over for 5 years. AT a 50% Debt/Equity split, that translate into a Purchase Enterprise Value of $656. This method produces a "floor valuation" because it tells you the maximum amount a PE firm could pay to realize a certain IRR. Other methodologies are not constrained in the same way." "How is an LBO valuation different from a DCF valuation? Don't they both value the company based on cash flows? - CORRECT ANSWER They are both based on cash flows, but in a DCF you're saying, "What could this company be worth, based on the Present Value of its cash flows?" But in an LBO, you're saying, "What could we pay for this company if we want to achieve an IRR of, say 25%, in 5 years?" Both methodologies are similar but with the LBO valuation you're constraining the values based on the returns that you're targeting." "How could a private equity firm boost its return in an LBO? - CORRECT ANSWER The obvious answer is always to pay less. The main return drivers are Multiple Expansion, EBITDA Growth and Debt DownPayment and Cash Generation: Multiple Expansion- decrease purchase price or increase exit multiple EBITDA Growth- improve company's rev growth rate or boost margin by cutting expenses Debt downpayment and cash generation- increase leverage or cut Capex and working capital Easiest way to alter returns, since the PE firm has most control over this, would be to alter the debt" "What are the attributes of Secured Debt/Bank Debt - CORRECT ANSWER - Collateral - Interest Rates are floating Libor plus 375 basis points - They don't usually amortize - Maintanece covenants- cannot exceed X Debt/EBITDA - Can prepay - Tenor is usually 5-10 - Bankers and conservative investors" "What are the attributes of unsecured/heigh yield debt? - CORRECT ANSWER - No Collateral - Junior to Secured debt - High fixed interest rate - Entire balance due upon maturity, no early payback - Covenenats are INCURRENCE which may include having to repay debt ahead of dividends - Investors are merchant bankers, hedge funds and mezzanine funds" "Why might a PE firm choose to use Term Loans rather than Subordinated Notes in an LBO, if it has the choice between two capital structures with similar levels of leverage? - CORRECT ANSWER Term Loans are less expensive than Subordinated Notes since interest rates are lower, and they give the company more flexibility with its cash flows since optional repayments are allowed in most cases. Also, since Term Loans have maintenance covenants, they might be better if the company is planning to divest assets, make acquisitions, or spend a huge amount on CapEx, any of which might be forbidden with incurrence covenants found in Subordinated Notes." "Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause controversy? - CORRECT ANSWER "If existing management uses its excess cash to repurchase existing shares within the company prior to the LBO take over, they are reducing the cash for equity that the Sponsor firm will have to put up. It also means that the existing ownership will have a larger stake if their is a stock rollover. Pre LBO shareholders will find this to be a poor usage of funds Excess Cash might act as a funding source in an LBO if a company uses its Cash to repurchase its shares, reducing the number of shares that a PE firm has to purchase. It's not that the PE firm "gets" the company's Excess Cash before the deal takes place - it's that the company uses its Cash to reduce the purchase price for the PE firm. Pre-deal shareholders often object to such moves, saying that the company should have issued a Special Dividend to them or used the cash in a more productive way. Using Excess Cash to fund a deal also increases the ownership stakes of existing investors that choose to roll over their shares - since Excess Cash reduces the Investor Equity the PE firm needs to contribute." "How do you project free cash flow and cash flow available for Debt Repayment in an LBO model? - CORRECT ANSWER You start with Net Income and add back D&A, factor in the change in working capital and subtract Capex aka (FCF CFO- Capex) Cash flow available for Debt Repaymnet is the same thing except you add in beginning cash balance and mandatory debt repayments" "How is the "FCF" in an LBO model different from the FCF in a DCF? - CORRECT ANSWER 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 a company. Secondly, we're using discretionary cash flow aka FCF in a DCF and unlevered free cash flow in a DCF." "Why might a company's FCF in an LBO model differ from its Cash Flow available for Debt Repayment? - CORRECT ANSWER It might differ because FCF doesn't include beginning cash balance or mandatory debt repayment. How" "What does the "tax shield" in an LBO mean? - CORRECT ANSWER All it means is that the Interest on Debt reduces a company's taxes because the interest is tax deductible. That said, its taxes are still higher than if the debt didn't exist" "How can you determine how much Debt a PE firm might use in an LBO and how many tranches there would be? - CORRECT ANSWER You look at recent, similar LBOs and use the median DEBT/EBITDA levels from them as references, you could also look at highly leveraged public companies in the industry and check their debt/EBITDA levels. Then you would test these assumptions by checking out the debt/EBITDA and EBITDA interest ratios." "Can you describe the different types of Debt a PE firm might use in an LBO and why it might use them? - CORRECT ANSWER Broadly speaking, Debt is split into Secured Debt and Unsecured Debt also known as bank debt and high-yield debt, or senior debt and junior debt Secure Debt consists of Term Loans and revolvers, is backed by collateral, floating interest rates and uses maintenance covenants such as DEBT/EBITDA and EBITDA/Interest Early repayment is generally allowed. High yield debt is fixed interest payments that are high and tends to be longer term, covenants usually include restrictions on the usage of cash. They're not collateralized either" "Why do the less risky, lower-yielding forms of Debt amortize? Shouldn't amortization be a feature of riskier Debt to reduce the risk? - CORRECT ANSWER Amortization reduces credit risk but also reduces the potential returns, since risk and potential returns are correlated, amortization should be a feature of less risky risky debt" "Why might a PE firm choose to use Term Loans rather than Subordinated Notes in an LBO, if it has the choice between two capital structures with similar levels of leverage? - CORRECT ANSWER Term loans are less expensive than subordinated notes (high yield loans) since interest rates are lower, and they also allow companies more flexibility with cash flow since optional repayments are allowed in most cases. They also only feature covenants in the terms of maintenance, which allows for more flexibility." "How is Purchase Price Allocation different in LBO models? Does it matter more or less than in an M&A deal? - CORRECT ANSWER It's the same process as an M&D deal, but it matters far less as we care more about cash flow than we care about EPS effects. Write ups and write downs have bigger affect on EPS than they do cash flows." "Why do we set a Source and Use schedule? - CORRECT ANSWER Because the amount a company pays will be much different than the "purchase price". The true amount will depend on the treatment of existing cash and debt. Not to mention various transaction fees involved. For LBO also need to consider equity rollover" "Why do we create a Purchase Price Allocation? - CORRECT ANSWER We do this because when one company acquires another its SE gets wiped out as the acquiring company inherits the balance sheet, they'll often be paying a premium so this schedule is used to create Goodwill an write down and write up assets" "What variables impact an LBO model the most? - CORRECT ANSWER Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as Revnue growth and EBITDA margins." "How do you pick purchase multiples and exit multiples in an LBO Model? - CORRECT ANSWER The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity tables. Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but this is just for valuation purposes if you're using an LBO model to value the company." "What is MoM? - CORRECT ANSWER Money-on-Multiple, also known as the Multiple of Invested Capital (MOIC) or the Returns Capital, because deals can look good on an IRR basis but poor on a MOM basis or vice versa Money received/ Money invested up front" "How do you calculate the internal rate of return (IRR) in an LBO model, and what does it mean? - CORRECT ANSWER The IRR in an LBO is "the effective annual compounded interest rate". For example if I invested $100 in the beginning and got back $200 after 5 years, what interest rate would turn that $100 into $200? Answer is 15. You calculate the IRR by making the investor equity that a PE firm contributes negative, and then using positives for dividends to the PE firm and the Net proceeds to the PE firm at the end Money Received/Exit Proceeds= Exit Price- residual debt + dividends IRR= (Exit Proceeds/Investor Equity)^ (1/#n)-1 Aka MOM multiple raised to (1/n)-1" "How quickly can you approximate the IRR in an LBO? Are there are any rules of thumb? - CORRECT ANSWER Yes. If you double your money, you can divide by 100% by the # of years and multiply by ~75% to account for the compounding and that gives you the approximate IRR: Example: Double in 3 yr-100/3 * .75= 25% Double in 5 yr- 100/5 *.75= 15% If you triple your money, divide 200% by the # of years and multiple by ~65% Triple in 3- 200/3 *.65= 45% Triple in 5- 200/5 * 65= 25%" "Three ways to exit an LBO? - CORRECT ANSWER 1. Sell to another sponsor/strategic acquirer 2. IPO 3. Pay dividends to yourself" "What is formula for exit proceeds? - CORRECT ANSWER Exit Equity Proceeds-Residual debt + dividends paid This is the numerator on the money on money multiple" "Can you explain the legal structure behind a leveraged buyout and how it benefits the private equity firm? - CORRECT ANSWER In a leveraged buyout, the PE firm forms a "holding company," which it owns and then this "holding company" acquires the real company. Banks and other lenders will provide this debt to the holding company so its held at the holding company level. This structure is important because it means the P/E firm is not on the hook for the debt it uses in the deal. It's up for the target company to repay it . They boring other peoples money and no even directly" "What assumptions impact a leveraged buyout the most? - CORRECT ANSWER The purchase and exit assumptions, usually based on EBITDA multiples, will make the biggest impact on a leveraged buyout. A lower Purchase Multiple results in higher returns, and a higher exit multiple results in higher returns. After that, the % debt used makes the biggest impact. More leverage will make the deal perform better if it does well, and will make the deal perform worse if it does now" "How do you select the purchase multiples and exit multiples in an LBO model? - CORRECT ANSWER For public companies, typically you assume a share-price premium and check the implied purchase multiple against the valuation methodologies to make sure it's reasonable. For example, you might assume a 30% premium to the company's share price of $10.00, which implies an EV/EBITDA multiple of 10x For private companies, you determine the purchase multiple by looking at comparable companies, precedent transactions and the DCF analysis. The exit multiple is typically similar to the purchase multiple but could go higher or lower depending on the company's FCF growth and the ROIC by the end. ROIC-Return on invested capital. You can always use a range of purchase and exit multiples to analyze the transaction via sensitivity tables." "An ideal candidate for an LBO? - CORRECT ANSWER - Stable cash flows always most impotant - Product or expansion growth opportunity - Unused debt, so opportunity for further debt - Low Capex necessity - Strong and Stable mgmt" "How is a leveraged buyout different from a normal M&A deal? - CORRECT ANSWER In an LBO, you assume the company is sold after 3-5 years (and sometimes a bit more than that), As a result, you focus on the IRR and MoM multiples as the key metrics. Also, PE firms can use only Debt and Equity (equity meaning "Cash" in this context to fund deals, they can't issue stock). Whereas, normal companies in M&A deals can use Cash, Debt and Stock. Synergies and EPS accretion/dilution matter a lot in M&A deals but not at all in LBOS. You determine the Purchase price in similar ways, but in an LBO, you'll often "back into" the Purchase Price based on the price required to achieve a targeted IRR." "What type of cash flow do we use an LBO model? - CORRECT ANSWER Levered free cash flow. Need to account for the interest payment when looking at Cash flow in excess of debt" "A strategic acquirer usually prefers to pay for another company with 100% cash - if that's the case, why would a PE firm want to use debt in an LBO? - CORRECT ANSWER There's a few reasons why a P/E firm would want to use debt. For starters, using debt will amplify returns by reducing the upfront cost of capital. Because they're going to sell the company, they're less concerned with cost of debt as they are with amplification of returns. The P/E firm also doesn't assume the risk of debt, the target company so. Whereas, in a standard M&A deal the combined entity is responsible for the debt. Also, the P/E firm is given the opportunity to use cash elsewhere" "What is mezzanine debt? - CORRECT ANSWER Highest interest rate that's fixed, unsecured with no full repayment option" "How do you determine how much Debt a PE Firm might use in an LBO and how many tranches there would be? - CORRECT ANSWER You might look at recent similar lbos and see what the DEbt/EBITDA , EBITDA/Interest levels were as well as the term loans and take the median in your comparable universe. Then you would test these assumptions by projecting the company's cash flows/financials to check if the ratios hold true." "Can you describe the different types of debt a PE firm might use in an LBO and why it might use them - CORRECT ANSWER Broadly speaking, Debt is split into Secured Debt and Unsecured Debt, which some people will label as Bank Debt and High yield debt or "Senior Debt" and "Junior Debt" Secured debt consists of Term Loans (A and B) and revolvers ( which acts as a company credit card and is drawn on quickly and repaid back). Secured debt is backed by collateral assets, has low variable interest rates and maintenance covenant restrictions around Debt/EBITDA and coverage ratio. Early repayment is allowed and maturity tends to be shorter on these instruments. Unsecured debt consists of senior notes, subordinated notes and Mezzaine and is not backed by collateral and has high fixed interest rates, and incurrence covenants." "Why might a PE firm choose subordinated notes instead of term loans? - CORRECT ANSWER They likely wouldn't? Unless they have already maxed out their term loans and still require additional debt, or if they doubt their ability to stay within maintenance covenants" "Why do the less risky, lower-yielding forms of Debt amortize? Shouldn't amortization be a feature of riskier Debt to reduce the risk? - CORRECT ANSWER Amortization reduces credit risk but also reduces the potential returns. Since risk and potential returns are correlated, amortization should be a feature of less risky Debt. Early payback is allowed so this ultimately reduces the credit risk and the potential returns. If $100 million of 10% interest bonds stay outstanding for 10 years, and the company repays them, in full, after 10 years, the investors earn a 10% IRR on those bonds. But if there's amortization or optional repayment, that balance will decline to less than $100 million by the end, so the investors earn less than a 10% IRR. But the investors also take on less risk because more capital is returned earlier on." "Assuming Debt v Refinancing Debt - CORRECT ANSWER Assuming debt means you either take the debt as is or alter the terms of existing debt ever so slightly..ASSUMING WILL NOT ALTER PURCHASE PRICE Assuming debt shows up under both source and usage schedule (at least in an LBO model) Refinancing debt means paying off the debt entirely with cash or with new debt (or a combo of both) to replace the existing terms. Refinancing debt shows up in the uses side of the S&U" "How is purchase price allocation different in LBO Models? Does it matter more or less than in M&A deals? - CORRECT ANSWER It's the same process as in M&A deals, but it tends to matter far less because leveraged buyouts are based on cash flow, Debt repayment and the IRR from acquiring and then selling a company. Many of the new items that get created in the PPA process, such as D&A on Asset Write-ups, affect the company's EPS, but barely make an impact on its cash flows, which is why many LBO models leave out this schedule." "What's the true Purchase Price in an Leveraged Buyout? - CORRECT ANSWER Just as in a merger model, you always start with the equity purchase price. The cost of acquiring all the company's common shares. Then depending on the treatment of cash and debt, equity rollovers and other transaction fees, the true purchase price may be different. Which is why you create a source and use schedule. For example, if existing debt is "assumed" (kept in place or replaced with new debt that's the same), it wont affect the purchase price..but if the company is refinancing or repaying the debt, then it willl increase the price. Using excess cash to fund the deal will reduce the purchase price as will equity rollovers True price is always close to Enterprise value, but wont be the same because of these issuues"