LBO Modeling Questions and Answer
1. How does the accounting treatment of financing fees differ from transaction fees in an
LBO? - ANS-Financing Fees: Financing fees are related to raising debt or issuing
equity. These fees are capitalized and amortized over the debt's maturity (~5-7
years).
2. Transaction Fees: Transaction fees refer to the M&A advisory fees paid to investment
banks or business brokers, as well as the legal fees paid to lawyers. Unlike financing
fees, transaction fees cannot be amortized and are classified as one-time expenses
deducted from a company's retained earnings.
How would you calculate the levered free cash flow yield for private equity investment,
and when would it be used? - ANS-1. Levered FCF=EBITDA -Taxes -Interest -Capex
-Increase in NWC−Mandatory Debt Amortization
2. Levered Free Cash Flow Yield (FCFY)=Levered Free Cash Flow / Initial Equity
Investment
3. How would you measure the credit health of a pre-LBO target company? - ANS-The two
most common types of credit ratios used are leverage ratios and interest coverage
ratios. The leverage ratio parameters will depend on the industry and the lending
environment. However, the total leverage ratio (total debt/EBITDA) in an LBO
ranges between 5.0x to 7.0x, with the senior debt ratio (senior debt/EBITDA)
around 3.0x. For interest coverage ratio parameters, as a general rule of thumb:
the higher the interest coverage ratio, the better. The interest coverage ratio
should be at least 2.0x in the first year post-buyout.
4. If a business that underwent an LBO has been operating as intended, why does the
private equity firm not hold on to the investment for a longer duration (e.g., 10+ years)? -
ANS-The average holding of a private equity firm is about 5 to 7 years. Traditional
private equity firms, unlike pension funds that target lower IRRs of around
~8-10%, cannot hold on to portfolio companies for longer durations since they
raise capital in fund structures, and therefore have to return money to their limited
partners (LPs) many times before fundraising for their next fund. Besides the need
to return capital to investors in the current fund, IRR is one of the LPs' primary
metrics to evaluate PE firms' performance. From a firm marketability perspective,
it would also be beneficial to avoid holding onto an investment for too long as
doing so decreases the fund's IRR.
5. If an acquirer writes-up the value of the intangible assets of a target, how are goodwill
and amortization impacted? - ANS-During an LBO, intangible assets such as
patents, copyrights, and trademarks are often written Recall that goodwill is
simply an accounting concept used to "plug" the and fair value of the assets in
the closing balance sheet purchased are actually worth more. Therefore, a higher
writeup in value. difference between the purchase price so a higher write-- up
means the assets being up of intangible assets means less goodwill will be
created on the transaction date. Publicly traded companies cannot amortize
1. How does the accounting treatment of financing fees differ from transaction fees in an
LBO? - ANS-Financing Fees: Financing fees are related to raising debt or issuing
equity. These fees are capitalized and amortized over the debt's maturity (~5-7
years).
2. Transaction Fees: Transaction fees refer to the M&A advisory fees paid to investment
banks or business brokers, as well as the legal fees paid to lawyers. Unlike financing
fees, transaction fees cannot be amortized and are classified as one-time expenses
deducted from a company's retained earnings.
How would you calculate the levered free cash flow yield for private equity investment,
and when would it be used? - ANS-1. Levered FCF=EBITDA -Taxes -Interest -Capex
-Increase in NWC−Mandatory Debt Amortization
2. Levered Free Cash Flow Yield (FCFY)=Levered Free Cash Flow / Initial Equity
Investment
3. How would you measure the credit health of a pre-LBO target company? - ANS-The two
most common types of credit ratios used are leverage ratios and interest coverage
ratios. The leverage ratio parameters will depend on the industry and the lending
environment. However, the total leverage ratio (total debt/EBITDA) in an LBO
ranges between 5.0x to 7.0x, with the senior debt ratio (senior debt/EBITDA)
around 3.0x. For interest coverage ratio parameters, as a general rule of thumb:
the higher the interest coverage ratio, the better. The interest coverage ratio
should be at least 2.0x in the first year post-buyout.
4. If a business that underwent an LBO has been operating as intended, why does the
private equity firm not hold on to the investment for a longer duration (e.g., 10+ years)? -
ANS-The average holding of a private equity firm is about 5 to 7 years. Traditional
private equity firms, unlike pension funds that target lower IRRs of around
~8-10%, cannot hold on to portfolio companies for longer durations since they
raise capital in fund structures, and therefore have to return money to their limited
partners (LPs) many times before fundraising for their next fund. Besides the need
to return capital to investors in the current fund, IRR is one of the LPs' primary
metrics to evaluate PE firms' performance. From a firm marketability perspective,
it would also be beneficial to avoid holding onto an investment for too long as
doing so decreases the fund's IRR.
5. If an acquirer writes-up the value of the intangible assets of a target, how are goodwill
and amortization impacted? - ANS-During an LBO, intangible assets such as
patents, copyrights, and trademarks are often written Recall that goodwill is
simply an accounting concept used to "plug" the and fair value of the assets in
the closing balance sheet purchased are actually worth more. Therefore, a higher
writeup in value. difference between the purchase price so a higher write-- up
means the assets being up of intangible assets means less goodwill will be
created on the transaction date. Publicly traded companies cannot amortize
