Wall Street Prep: Private Equity Exam Questions With Verified Correct Answers

WALL STREET PREP: PRIVATE EQUITY EXAM QUESTIONS WITH VERIFIED CORRECT ANSWERS “What is an LBO? - CORRECT ANSWER In a leveraged buyout, 1) PE firm acquires a company using D + E 2) Operates it for a several years with operating improvements 3) sells it at the end of the period to realize a return on that investment" "Walk me through the mechanics of an LBO model. - CORRECT ANSWER 1) Assumptions 2) S&U 3) Adjust Balance Sheet - Debt and Equity - Goodwill 4) Project 3 statements 5) Project FCF 6) Debt and Interest Schedule 7) Exit Calc (MOic and IRR) 8) Sensitivity Tables" "How do you model in PIK notes? - CORRECT ANSWER "Walk me through the calculation of Free Cash Flow. - CORRECT ANSWER EBITDA Less: Interest Less: Taxes Less: CapEx Less: Change in NWC" "Why would a private equity firm use a convertible preferred note? - CORRECT ANSWER Access to upside in the equity of the company. Low-risk debt investment until the company proves to be successful, then becomes an equity investment. Has the best of both worlds." "What is the difference between senior and subordinated notes? - CORRECT ANSWER 1) Seniority - senior debt gets paid first in a bankruptcy 2) Covenants - (bank - covenants)" "What are the key considerations to structuring a carve-out transaction? - CORRECT ANSWER " "How would you decide what amount of leverage to use in building a company's capital structure? - CORRECT ANSWER Current capital structure and types of debt EBITDA and ability to handle interest expense Size of the company Industry (stable or cyclical) Current credit rating State of the credit markets" "Assume that your company sold an asset for a loss of $10 million (it had originally been bought for $20 million). Walk me through the impact of this transaction on the financial statements. - CORRECT ANSWER Record $10 loss on I/S, NI down $6. CFO add back $10 loss, CFI up by $10, CF up $14. Cash up $14, Asset down $20, Equity down $6." "Your company sells a yearly subscription for $120. Walk me through the impact that this sale has on the financial statements. - CORRECT ANSWER " "Buy a business at 8.0x EBITDA, sell in 5 years at 8.0x EBITDA. IRR 20%. Banks will lend up to 4x Debt/ EBITDA, and half will be repaid in 5 years. EBITDA Expansion? - CORRECT ANSWER Assume 10m EBITDA. 40m Debt to start, 20m Debt to end. 20% IRR in 5 years is approx. 2.5x MoM, so exit equity is 100m. Total EV is 120m. 120/8 = 15m. 50% expansion over 5 years." "Why do you want to pursue a career in private equity? - CORRECT ANSWER I want to be in private equity because I enjoy learning about businesses and working with management. The opportunity to use the operational knowledge I've gained while working at Disney with financial analysis to identify attractive investments and add value to portfolio companies is something that interests me. I really enjoy the process of understanding what makes a business stand out and identifying strategic initiatives that can increase the overall performance of the company. Learn the complete deal process and holistic soft skills in effect becoming a more well-rounded investor" "What is the most recent book you have read? - CORRECT ANSWER Da Vinci by Walter Isaacson. It's a biography of Da Vinci life and I found it fascinating." "What happened when you worked in a team and one member wasn't contributing appropriately? How did you respond? - CORRECT ANSWER During a recent project, one co-worker who was senior to me regularly failed to complete his assigned tasks and frequently said he would not be doing some of his tasks. I told him privately over coffee that this resulted in other people on the team picking up his work, in addition to their own, which felt unfair. I asked if there was a reason for this issue and he said that he felt slighted by management for not getting a promotion and he was going to be leaving the company so he didn't feel it was necessary to contribute anymore. I brought this to the attention of a trusted manager and worked with fellow members on the team to fairly distribute his work." "What do you feel are your greatest strengths? Greatest weaknesses? - CORRECT ANSWER Strengths: I am fast-learner that can pick up tasks really quickly and learn from mistakes the first time. I am good at working in groups yet am extremely efficient working on my own. I am a self-starter and can recognize what may be asked for in the future and complete the task before its asked. Fast learner (Flexible/adaptable) Honest -- very useful in the workplace Weaknesses: I would say I am a naturally introverted person which results in me not speaking up with people I haven't become comfortable with or figured out. I realized early on in my career, and after feedback from my manager that I needed to speak up and if I knew the answer or had something useful to say it. Over the past year, I've worked really hard out stepping out of my comfort zone and being confident enough to share what I'm thinking. I suggested to my manager that we set up presentations to the group from analysts and my manager has done a really good job in allowing me present my analysis and work to the segment CFO. Tend to take on too much responsibility and not say no when I'm over capacity." "Are you risk-averse or risk-seeking? Under what conditions do you seek risk the most and why? - CORRECT ANSWER " "If I asked your senior manager, what would he or she say about you? - CORRECT ANSWER " "Where do you see yourself in five years? - CORRECT ANSWER In five years I'd like to have an even better understanding of this industry. Also, I really love working with people. Ultimately, I'd like to be in some type of managerial role at this hospital, where I can use my people skills and nursing knowledge to benefit the nurses working for me, and the patients and hospital as a whole."" "Give an example of a time when you demonstrated that you were very driven / committed? - CORRECT ANSWER " "What motivates you? - CORRECT ANSWER What motivates me is the satisfaction of knowing I am a rare and valued member of the staff, being challenged on a daily basis, and learning about everything" "Why should we hire you? - CORRECT ANSWER I'm creative, dynamic, flexible. I like to solve problems, etc. I will bring a fresh perspective Provide a few reasons why you're interested in firm/PE, and what in particular sparked your interest. Networked across the entertainment industry, unique experience from operational point of view" "How are Call Protection and "Prepayment" different? Don't they refer to the same concept? - CORRECT ANSWER Call Protection refers to paying off the ENTIRE debt balance‚ whereas "Prepayment" refers to repaying PART of the principal early‚ before the official maturity date." "What are some examples of incurrence covenants? Maintenance covenants? - CORRECT ANSWER Incurrence Covenants: • Company cannot take on more than $2B of total debt. • Proceeds from any asset sales must be earmarked to repay debt. • Company cannot make acquisitions of over $200M in size. • Company cannot spend more than $100M on CapEx each year. Maintenance Covenants: • Total Debt / EBITDA cannot exceed 3.0x; Senior Debt / EBITDA cannot exceeds 2.0x • (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0x • EBITDA / Interest Expense cannot fall below 5.0x • EBITDA / Cash Interest Expense cannot fall below 3.0x • (EBITDA - CapEx) / Interest Expense cannot fall below 2.0x" "Why would you use PIK (Payment In Kind) debt rather than other types of debt‚ and how does it affect the debt schedules and the other statements? - CORRECT ANSWER • Unlike "normal" debt‚ a PIK loan does not require the borrower to make cash interest payments - instead‚ the interest accrues to the loan principal‚ which keeps going up over time. A PIK "toggle" allows the company to choose whether to pay the interest in cash or have it accrue to principal. • PIK is riskier than other forms of debt and carries with it a higher interest rate than traditional Bank Debt or High-Yield Debt. • Adding it to the debt schedules is similar to adding High-Yield Debt w/ a bullet maturity - except instead of assuming cash interest payments‚ you assume that the interest accrues to the principal. • You include this interest on the Income Statement‚ but you need to add back any PIK interest on the Cash Flow Statement‚ b/c it's a non-cash expense." "How does Preferred Stock fit into these different financing methods? Isn't it a type of Debt as well? - CORRECT ANSWER • Preferred Stock is similar to Debt and it would match the "Mezzanine" column in the table (on p. 43) most closely. • Just like w/ Mezzanine‚ Preferred stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt." "How do you treat Noncontrolling Interests (AKA minority interests) and Investments in Equity Interests (AKA Associate Companies) in an LBO model? - CORRECT ANSWER • Normally you leave these alone and assume that nothing happens - so they show up in BOTH the Sources AND Uses columns when you make assumptions in the beginning. • You could assume that the PE firm acquires one or both of these‚ in which case they would ONLY show up in the Uses column - similar to refinancing existing Debt." "Walk me through how you adjust the Balance Sheet in an LBO model. - CORRECT ANSWER • This is very similar to what you see in a merger model - you calculate Goodwill‚ Other Intangible Assets‚ and the rest of the Write-Ups in the same way‚ and then the B/S adjustments (e.g. subtracting Cash‚ adding in Capitalized Financing Fees‚ writing up Assets‚ wiping out Goodwill‚ adjusting the DTAs/DTLs‚ adding in new debt‚ etc.) are almost all the same. • The key differences are: 1) In an LBO model you assume that the existing Shareholders' Equity is wiped out and replaced by the value of the cash the PE firm contributes to buy the company; you may also add in Preferred Stock‚ Management Rollover‚ or Rollover from Option Holders to this number as well depending on your assumptions. 2) In an LBO model you'll usually add more tranches of debt compared to what you would see in a merger model. 3) In an LBO model‚ you're not combining two companies' Balance Sheets." "Why are Capitalized Financing Fees an Asset? - CORRECT ANSWER There are a couple ways to think about this: • It's just like Prepaid Expenses items on the Assets side: paid for in cash up-front and then recognized as an expense over many years. Since the company has already paid for it in cash‚ its not going to cost them anything more in future periods. • An Asset represents potential future income or potential future savings; Capitalized Financing Fees have already been paid in cash‚ so when the expense is recognized on the Income Statement over several years it reduces the company's taxes (similar to Prepaid Expenses)." "Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example‚ what happens when you have Existing Debt‚ a Revolver‚ Term Loans‚ and Senior Notes? - CORRECT ANSWER First off‚ note that you MUST make all mandatory debt repayments on each tranche of debt before anything else. So there is no real "order" there - you simply have to repay what is required. The "order" applies only when you have extra cash flow beyond what is needed to meet these mandatory repayments: • REVOLVER: You borrow additional funds here and add them to the balance if you don't have enough cash flow to meet the mandatory debt repayments each year; you use any extra cash flow each year to repay this Revolver first‚ before any other debt. • EXISTING DEBT: This comes first‚ before the new debt raised in the LBO‚ when setting aside extra cash flow to make optional repayments. • TERM LOANS: Payments on these come after paying off the Revolver and any existing debt. • SENIOR NOTES: These come last in the hierarchy and typically optional repayment is limited or not allowed at all. • To track this in an LBO model‚ you need to separate out the Revolver from the mandatory repayments from the optional repayments‚ and keep track of the cash flow that's available after each stage of the process." "Let's walk through a real-life example of debt modeling now. Let's say that we have $100M of debt w/ 5% cash interest‚ 5% PIK interest and amortization of 10% per year. How do you reflect this on the financial statements? - CORRECT ANSWER To simplify this scenario‚ we'll assume that interest is based on the beg. debt balance rather than the average balance over the course of the year. • Income Statement: There's $5M of cash interest and $5M of PIK interest‚ for a total of $10M in interest expense‚ which reduces Pre-Tax Income by $10M and Net Income by $6M assuming a 40% tax rate. • Cash Flow Statement: Net Income is $6M lower‚ but you add back the $5M in PIK interest b/c it was a non-cash charge. CFO is down by $1M‚ Since there's 10% amortization per year‚ you repay $10M of debt each year (and presumably the entire remaining amount at the end of the period) in the CFF section - so cash at the bottom is down by $11M. • Balance Sheet: Cash is down by $11M on the Assets side‚ so that entire side is down by $11M. On the other side‚ Debt is up by $5M due to the PIK interest but down by $10M due to the principal repayment‚ for a net reduction of $5M. Shareholders' Equity is down by $6M due to the reduced Net Income‚ so both sides are down by $11M and balance. • Each year after this‚ you base the cash and PIK interest on the new debt principal number and adjust the rest of the numbers accordingly." "Why do we show PIK interest in the Cash Flow from Operations section? Isn't it a financing activity? - CORRECT ANSWER • First‚ note that interest expense NEVER shows up in the CFF section b/c it is tax-deductible and it always appears on the I/S. So showing anything in that section for interest expense would be double-counting. • You show PIK interest in the CFO section b/c it is a non-cash expense - we're adding it back b/c it's just like D&A. It reduces taxes but is not actually paid out in cash." What is an LBO - CORRECT ANSWER Financial sponsor purchases an company using debt in the form of instruments such as loans and bonds. Firm then get majority control then work on making the business better through restructuring, operational improvements, restructuring and asset sales to make the company more efficient at generating cash flow to pay down debt quicker. Investment horizon is 5-7 years and firms exit through either sale of asset or an IPO." "What is the intuition underlying the usage of debt in an LBO? - CORRECT ANSWER High percentage of borrowed funds with small initial equity investment. As debt principal is paid down the sponsor will realize greater gains on exit. Therefore firms try to maximize leverage while keeping the debt level manageable to avoid bankruptcy risk. Want more debt because it is cheaper and interest expense is tax deductible which creates a tax shield." "What are the main levers in an LBO that drive returns? - CORRECT ANSWER 1. Debt Paydown: deleveraging the value of PE firms equity value grows over time as debt is paid down. 2. EBITDA growth: operational improvements to business margin profile 3. Multiple Expansion: higher exit multiple than entry through imporved investor sentiment, better economic conditions." "What attributes make a business an ideal LBO candidate? - CORRECT ANSWER 1. Strong Cash Flow Generation: predictable FCF generation with high margins 2. Recurring Revenue: little risk associate with cash flows 3. Economic Moat: differentiating factor 4. Favorable unit economics: high margins, well-managed cost structure 5. Strong committed management team 6. Undervalued company with strong value-added opportunities." "In the context of an LBO what is a tax shield? - CORRECT ANSWER Reduction of taxable income from the highly levered capital structure. Interest payments on debt are tax deductible" "Why not only finance with senior debt? - CORRECT ANSWER Senior lenders will only lend up to a certain point usually 2x 3x EBTIDA" "How do financial sponsors exit an investment? - CORRECT ANSWER Sale to a strategic buyer Secondary buyout IPO" "Downside of an IPO exit. - CORRECT ANSWER Not imideiate, time consuming and shares could be locked-up" "What is rollover equity and why do private equity firms perceive it as a positive sign. - CORRECT ANSWER When management will rollover some or all of its equity into the new company. This is an additional source of funds which reduces the amount of funds needed to be raised by the financial sponsor" "How can value be created during a consolidation play? - CORRECT ANSWER Increased pricing power: customers will pay more for a stronger brand and complementary product or service Improved cost structure: consolidated company can benefit from economies of scale and cost savings." "Common IRR estimates - CORRECT ANSWER 2x initial in 3 years = 25% 2x initial in 5 years = 15% 2.5x initial in 3 years = 35% 2.5x initial in 5 years = 20% 3x initial in 3 years = 45% 3x initial in 5 years = 25%" "The rule of 72 - CORRECT ANSWER states that in order to find out how long it would take an investment to double you take the annual return over 72" "Blackstone, Carlyle and Hellman & Friedman invest in Medline - CORRECT ANSWER Countries largest privately help manufacturer and distributor of healthcare supplies with 2020 revenue of $17.5 billion. Company will still be led by the Mills family (largest shareholders) but will use the funds to expand its product offerings, accelerate international expansion and continue to make new infrastructure investments to strengthen its global supple chain." "Blackstone buys out Australias Crown Resorts - CORRECT ANSWER 6.3 Billion buyout of casino firm. Cheap because of COVID setbacks. Blackstone will try to overcome some regulatory setbacks put in place by the australian govenment." "Corporate Capital Structure - CORRECT ANSWER Senior Debt Mezzanine Debt Convertible equity/ convertible debt Preferred Equity Common Equity" "How do you assess credit risk? - CORRECT ANSWER Leverage Ratios (never exceed 4x) (debt / equity - under 2x) Interest-coverage ratios (greater than 1 - maintenance - above 3x) Fixed Charge Coverage Ratio Look at the industry, growth. Credit - protection against bankruptcy Industry and Company perspective" "What are the different types of PE firms? - CORRECT ANSWER 1) (EARLY STAGE) VC (5-10% - preferred equity or warrants) 2) (MID STAGE) Growth Equity (10-30%) 3) (LATE STAGE) LBO (20-50%)" "What makes a good LBO investment candidate? - CORRECT ANSWER (S) Stable Cash FLows (A) assets (M) Margins (C) Low CapEx (L) Low - Risk (U) Undervalued (B) Badass Management" "What are the different ways to find the valuation of a company? - CORRECT ANSWER (1) Precedent Tran. (2) Public Comps (3) DCF (4) LBO (5) NAV (6) SOTP" "How would you spend a million dollars if it were given to you? - CORRECT ANSWER I would consider the investment options available to me (1) PE co-invest (2) bonds and (3) equities. I do not want to invest in something I do not understand well. Since I am 25 and won't be retiring for awhile, I want a high rate of return. (1) 10% PE coinvest - high return, BUT illiquid, investments of employer (2) 60% diversified stocks - (passive equity funds) - between domestic and international (half and half) (3) 30% bonds, low-cost, medium-maturity bonds (2-10 years)- uncorrelated with equity - buy a home in 5 years." "Company A has a potential IRR of 23% and Company B has a potential IRR of 30%. What 2 questions would you ask before you decide which one to invest in? - CORRECT ANSWER 1) How much investment 2) Timing 3) What industry to they operate in?" "What are the 4 main drivers of the change in IRR for an LBO scenario? - CORRECT ANSWER 1) Lower purchase 2) Exit Multiple 3) Amount of Leverage 4) EBITDA expansion" "How do you calculate amortization of intangible assets? - CORRECT ANSWER If it's Goodwill, test annually for impairment. Other intangibles you can estimate a useful life and amortize it over its lifetime. Typically companies will do a FMV of their intangible assets and determine the useful life of the assets. For example, for a patent, it is usually good for 15 years so you may straightline the amortization over the 15 year period." "What are the uses of excess cash flow? - CORRECT ANSWER Dividend, pay back debt, share repurchase, capex, M&A If the borrower has excess cash and the terms of the debt provide for early repayment at the borrower's option, the borrower may use excess cash to periodically repay debt ahead of schedule. This is called "cash sweep."" "What makes for a good management team? - CORRECT ANSWER (1) Solid MGMT team with experience (2) A team that has weathered storms (3) Been through an acquisition before" "What 3 questions would you ask a CEO of a company you were looking to invest in? - CORRECT ANSWER Growth: What do you expect the company's performance to look like in the short and long-term? Risk: What are the threats and risks to the business and what steps are you taking to mitigate them? Moat: What is the competitive advantage of your business and is it sustainable?" "You have two companies with different EV/EBITDA multiples in different industries. What are some reasons why their EBITDA multiples might be different? - CORRECT ANSWER One company is an acquisition target Company is in M&A process Companies have different EBITDA margins One company has controlling market share (position of company in market) One company has been hit by bad news or scandal recently Growth potential of the industry" "Company A has depreciation that is overstated by $10 million. Walk me through the impact of this overstatement on the financial statements. - CORRECT ANSWER Income Statement - Increase in expense by $10 to represent the increase in depreciation. Pre-tax income is down by $10. After tax (assuming a 40% tax rate), net income will be down $6. Statement of Cash Flows - Net Income flows onto the statement of cash flows as down $6. Then depreciation is added back due to the fact that it is a non-cash expense. -$6 + $10 = cash up $4 Balance Sheet - Cash is up by $4 on the assets side but PPE is down by $10 as depreciation is making that less valuable. Assets are down by $6. On the SE and Liabilities side, net income flows into retained earnings, making it down $6." "Tax depreciation is $20 million over 10 years, while financial statement depreciation for the asset is $10 million over 10 years. Walk me through the impact of these differences on the financial statements, assuming a tax rate of 40%. - CORRECT ANSWER Income statement same as $1 depreciation each year, CFO add back depreciation and additional $0.4 deferred taxes. Create DTL on liabilities worth 40% * $1 = $0.4." "Assume that your company bought an asset for $10 million, of which $7 million was financed through debt. Walk me through the impact of this transaction on the financial statements. - CORRECT ANSWER I/S = NOTHING C/F = CFI = down by 10, CFF = up by 7M B/S = Cash -3, PP&E= up by 10, L = up by 7" "What is the difference between gross revenue and net revenue? - CORRECT ANSWER Net Revenue - gross revenue net of discounts and returns Adjusts for price reductions, price adjustments and refunds" "The New York City subway currently costs $2.50 to ride one way. Pretend that tomorrow, the cost is going to increase to $3.00. Assuming you can lock in the $2.50 rate in the future by paying for the future rides now, how many coins would you purchase? What are the key considerations to make? - CORRECT ANSWER Tomorrow, the $3 you spend is approximately going to = $3 today (discount is only one day) However, 10 , 50, 100 years from now, $3 is worth MUCH less than the $2.50 today. At some point in the future $3 = $2.50 today Plan to buy as many tickets up to that date log 1.2 / log 1.1 = 2 years you would have to estimate potential customer demand...can other customers pre-purchase tickets, how many people use the subway on a daily basis, do the tickets expire, population growth/decline in the city, etc.? Are you constrained by financial resources? Are there modes of transportation that compete with the subway? Regulations to be aware of? Technological changes?" "What is the angle (in degrees) formed by the minute and hour hands on a clock when the time is 3:15? - CORRECT ANSWER 7.5 degrees" "What characteristics do you think are needed to be successful in private equity? - CORRECT ANSWER Self-starter with an ability to manage multiple workstreams. Having a good investment acumen -- being able to identify the various risks and rewards associated with different investments and being able to take a position on the future of an industry or market." "How does your experience translate into success in private equity? - CORRECT ANSWER I have extensive experience working with management and providing analysis that helps support strategic initiatives that can then be implemented by management." "Do you currently invest, perhaps via non-work-related investing? - CORRECT ANSWER I enjoy investing -- I am largely a passive investor in ETFs with a mix of international and domestic though I've largely shifted my holdings more domestic as slow growth has affected international markets. I allocate about 20% of my portfolio which I hold in a separate account to stock picking. I largely follow a Peter Lynch like philosophy of investing in companies that I am a believer in and have a strong consumer brand such as Costco. As I noted on my resume I do invest in Tesla because I think EV's will really take market share from combustion engines and Tesla is one of the only automakers who makes an integrated system from the motor to the software. They are the real disruptors and I believe in their future despite recent hiccups." "What is the biggest risk you took in your life? - CORRECT ANSWER Attending Culver for 3 summers in a row -- I really didn't want to go and I gave up a lot, not being able to go through summer football and thus being able to start the season and being behind. However, I think it really showed my resilience and my ability to take on tasks that were beyond me. It was ultimately a transformative experience where I learned leadership skills that enabled me to excel at the camp and when I got home and started on the football team. I believe this is a consistent theme throughout my life where I take on tasks that seem beyond me in order to learn something that is bigger than my current situation." "Tell me about the different types of debt you could use in an LBO - CORRECT ANSWER REVOLVER: Lowest Int. Rate‚ Floating Cash Int.‚ 3-5 year tenor‚ not amortized‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ No Call Protection‚ Maintenance Covenant • TERM LOAN A: Low Int. Rate‚ Floating Cash Int.‚ 4-6 year tenor‚ straight-line amortized‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ Sometimes Call Protection‚ Maintenance Covenant • TERM LOAN B: Higher Int. Rate‚ Floating Cash Int.‚ 4-8 year tenor‚ minimal amortization‚ prepayment allowed‚ typ. investor: conservative banks‚ Senior Secured‚ Secured‚ Sometimes Call Protection‚ Maintenance Covenant • SENIOR NOTES: Higher Int. Rate‚ Fixed Cash Int.‚ 7-10 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Senior Unsecured‚ Sometimes Secured‚ Yes Call Protection‚ Incurrence Covenant • SUBORDINATED NOTES: Higher Int. Rate‚ Fixed Cash Int.‚ 8-10 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Senior Subordinated‚ Not Secured‚ Yes Call Protection‚ Incurrence Covenant • MEZZANINE: Highest Int. Rate‚ Fixed Cash (or PIK) Int.‚ 8-12 year tenor‚ bullet pmt‚ prepayment not allowed‚ typ. investor: HFs/Merchant Banks/Mezzanine Funds‚ Equity‚ Not Secured‚ Yes Call Protection‚ Incurrence Covenant NOTES: • Each type of debt is arranged in order of rising interest rates - so Revolver has the lower interest rates‚ Term Loan A is slightly higher‚ B is slightly higher‚ Senior Notes are higher than Term Loan B and so on. • "Seniority" refers to the order of claims on a company's assets in a bankruptcy - the Senior Secured holders are first in line‚ followed by Senior Unsecured‚ Senior Subordinated‚ and then Equity Investors. • "Floating" or "Fixed" Interest Rates: A "floating" interest rate is tied to LIBOR. For" "What about "Excess Cash"? Why do you sometimes see that in a Sources & Uses table? - CORRECT ANSWER • This represents the scenario where the company itself uses its excess cash (i.e. if it only requires $10M in cash but has $50M on its B/S‚ $40M is the excess cash) to fund the transaction. This always shows up in the Sources column. • It's just like how you subtract Cash when calculating Enterprise Value: an acquirer would "receive" that Cash upon buying the company. • You do not always see this item - it's more common when the company has a huge amount of excess cash and has no real reason for having it." "Can you give a complete list of items that you might see in the Sources & Uses section and explain the less common ones? - CORRECT ANSWER • SOURCES: Debt and Preferred Stock (All Types)‚ Investor Equity (PE firm's cash)‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Management Rollover • USES: Equity Value of Company‚ Advisory and Legal Fees‚ Capitalized Financing Fees‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Debt Refinanced‚ Noncontrolling Interests Purchased. • Debt and Debt-like items such as existing Preferred Stock and Noncontrolling Interests can always be either assumed (remain on the B/S) or refinanced/purchased (paid off and disappear). • The "management rollover" refers to the option to let the management team reinvest their shares and options into the deal. For example‚ if the team currently owns 5% of the company‚ the PE firm might say‚ "We'll acquire 95% of the shares‚ and then let you keep the 5% you own to incentivize you to perform well over these next few years and reap the rewards."" "How would you adjust the Income Statement in an LBO model? - CORRECT ANSWER The most common adjustments: • Cost Savings - Often you assume the PE firm cuts costs by laying off employees‚ which could affect COGS‚ Operating Expenses‚ or both. • New Depreciation Expense - This comes from any PP&E Write-Ups in the transaction. • New Amortization Expense - This includes both the amortization from written-up intangibles and from capitalized financing fees. • Interest Expense on LBO Debt - You need to include both Cash and PIK interest here. • Sponsor Management Fees - Sometimes PE firms charge a "management fee" to a company to account for the time they spend managing it. NOTES: • Cost Savings and new D&A hit the Operating Income line; Int. Expense and Sponsor Management Fees affect Pre-Tax Income. • Common and Preferred Stock Dividends (e.g. from a Dividend Recap‚ or just a normal preferred stock issuance) are not on this list b/c theoretically‚ Dividends should always be listed on the SCF. • In many cases‚ however‚ they will actually be shown on the I/S in an LBO and will impact the Net Income line item only (no tax impact - they get subtracted after you've calculated Pre-Tax Income * (1 - Tax Rate)). Just be aware of this b/c you will see it from time to time‚ and remember that neither one is tax-deductible." "Explain how a Revolver is used in an LBO model. - CORRECT ANSWER • You use a Revolver when the cash required for Mandatory Debt Repayments exceeds the cash flow you have available to repay them. • REVOLVER BORROWING = MAX(0‚ Total Mandatory Debt Repayment - Cash Flow Available to Repay Debt) • The Revolver starts off "undrawn‚" meaning that you don't borrow money and don't accrue a balance unless you need it - similar to how credit cards work. • You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments. • Within the debt repayments themselves‚ you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans." "Walk me through how you calculate optional debt repayments in an LBO model. - CORRECT ANSWER • First‚ note that you ONLY look at optional repayments for Revolvers and Term Loans - High-Yield Debt doesn't have a prepayment option‚ so effectively it's always $0. • You start by checking how much cash flow is available based on your Beg. Cash Balance‚ Min. Cash Balance‚ Cash Flow Available for Debt Repayment from the Cash Flow Statement‚ and how much you've spent on Mandatory Debt Repayments so far. • Then‚ if you've used your Revolver at all‚ you pay off the maximum amount that you can with the cash flow you have available. • Next‚ for Term Loan A you assume that you pay off the maximum possible amount‚ taking into account the fact that you have less cash flow from having paid down the Revolver. You also need to take into account the fact that you might have paid off some of Term Loan A's principal as part of the Mandatory Repayments. • Finally‚ you do the same thing for Term Loan B‚ subtracting from the "cash flow available for debt repayment" what you've already used for the Revolver and Term Loan A. • Just like with Term Loan A‚ you need to take into account any Mandatory Repayments you've made so that you don't pay off more than the entire Term Loan B balance. • The formulas here get very messy and depend on how your model is set up‚ but this is the basic idea for optional debt repayments." "What types of industries attract more deal flow from financial buyers? - CORRECT ANSWER Non-cyclical/ low growth Potential synergies Favorable industry trends" "What would be the ideal type of product/service of a potential LBO target? - CORRECT ANSWER Product should be deeply imbedded in customers operations. Recurring/Contract based: long term contracts create predictable cash flow growth which is attractive to PE firms High tech: more technical the product the higher the barrier to entry the higher the moat" "What is the relationship between debt and purchase price? - CORRECT ANSWER debt usage allows PE firms to purchase companys of high value which it could not purchase on equity alone." "Why not use all debt to finance LBO's? - CORRECT ANSWER 1. Increased default risk, higher debt obligations 2. If the company goes bankrupt it could make future fundraising harder and more expensive making the overall fund return less." "What determines a company's debt capacity? - CORRECT ANSWER 1. Industry risk and analysis performed by Lev fin at IB 2. Analysis of company's competitive position and risk 3. Company history is analyzed to create a forecast model 4. Based on scenario analysis and forecast model companys debt capacity is dtermined. total debt/ EBITA used to determine how max leverage to sustain a cushion that enables it to meet all debt obligations even if company underperforms." "What is dividend recapitalization? - CORRECT ANSWER Sponsor raises additional debt to pay off more of the original debt and pay a dividend to capitalize on some of the intial investment without an outright exit" "Difference between operating highly levered companies and others with minimal or no debt. - CORRECT ANSWER Highly levered companies have less margin for error." "How can a PE firm increase profitability of achieving multiple expansion during the sale process? - CORRECT ANSWER building a higher quality buisness via entering new markets through geographic expansion, product development or strategic add-ons." "Why is multiple expansion viewed as less than ideal lever for value creation. - CORRECT ANSWER LBO modeling convention assumes that EV/EBITDA multiple is same at entry and exit. Deal environment is unpredictable and relying on multiple expansion to meet return threshold is risky." "Can you name a scenario when multiple contraction is common? - CORRECT ANSWER Normal for large companies to see minor contractions. Since the company is larger there are less buyers leading to lower exit multiples." "What are some risks to look out for when assessing potential investment opportunities? - CORRECT ANSWER 1. Industry Cyclicality: firms look for stability and predictability 2. Customer Concetration: no customer should account for more than 5-10% of total revenue as its too risky 3. Customer/employee churn rates. High for both create instability 4. Past institutional ownership: past PE ownership would use same strategies to cut costs."