LBO Capital Structure Considerations with 100% correct answers

Why are capital structure considerations relevant for LBOs? The nature of LBOs is to rely heavily on leverage to produce attractive returns to equity investors. What is a primary pitfall to leverage? Creates investment risk and could jeopardize an equity holder's ability to recoup his/her initial investment. Choosing the _________________ ______________ ________________ is extremely important and will influence how the target company runs its operations? Optimal capital structure With regard to leverage, what are three primary things a PE firm must weigh? (1) Cost of debt (2) Capital structure flexibility (3) How much debt is suitable for the target company What are the four main tranches of capital that will typically be involved in an LBO, in terms of seniority? (1) Bank (senior) debt (2) High yield debt (3) Quasi equity (mezzanine) (4) Common equity What are the six primary characteristics of bank debt? (1) Low financing costs (2) Lowest default risk in the capital structure (3) Floating rate (4) Callable instrument (sometimes) (5) Restrictive maintenance covenants (sometimes) (6) Ability to increase line of credit / additional debt In a typical LBO, how much of the capital structure is comprised of bank debt? 30-60% What are the normal expected returns on bank debt? 4-8% What does lowest default risk mean for senior debt? The holders are the first in line in the capital structure to receive its money during the liquidation of a company Is bank debt often secured or unsecured by a company's assets? Secured What is one drawback to a company taking on bank debt? It typically becomes burdened with strict maintenance covenants to protect the bank debt investors? What are two common maintenance covenant requirements? (1) Total leverage covenants (2) Interest coverage covenants What is one factor of senior debt that sometimes creates a burden on a company to generate sufficient cash flow? Mandatory debt amortization repayments What is the typical maturity of senior debt? 5-7 years What does it mean to be floating rate? The interest rate of a debt instrument fluctuates based on an index such as LIBOR. What are three primary characteristics of high yield debt? (1) Typically fixed rate loan (2) Prepayable penalties for first few years (3) Limited flexibility in raising additional debt In a typical LBO, how much of the capital structure is comprised of high yield debt? 0-15% What is the typical expected return profile of high-yield debt? 8-14% High yield debt is also called ___________________ debt. Subordinated High yield debt usually has ___________________ financial costs, _________________ restrictive covenants and a _______________ time to maturity than senior debt. (1) Higher (2) Less (3) Shorter What percentage of principal does high yield debt typically require in annual mandatory amortization payments? TRICK QUESTION: High yield debt typically does not require amortization payments. High yield (subordinated) debt typically matures after how many years? 6-8 What is a prepayable penalty, and why does it matter for high-yield debt? The debt is often not pre-payable by the issuing company for a few years. It matters so that high-yield investors can lock-in their high interest rate for at least a few years. In what situation will a PE firm typically try to avoid a high yield debt structure, and why? When the PE firm is looking to raise additional debt within the first few years of an investment (e.g. bolt-on acquisition). If allows the PE firm to avoid incurring high prepayment penalties. What are three key characteristics of common equity? (1) Has a combination of debt and equity characteristics (2) Downside protection (like debt) (3) Upside potential (like pure equity) What are some other names for quasi equity? (1) Bridge financing (2) Mezzanine financing In an LBO, what percentage of the capital structure is typically comprised of quasi equity? 0-15% What is the typical expected return profile of quasi equity in an LBO? 15-20% Together, what percentage of the LBO capital structure is typically comprised of the combination of high yield debt and quasi equity? 20-30% What are four key characteristics of common equity? (1) Riskiest security in the capital structure (2) No downside protection with unlimited upside potential (3) Private market equity is owned by a financial sponsor (GP) (4) Public market equity is owned by common shareholders What percentage of an LBO's capital structure is typically comprised of common equity? 20-50% What is the typical expected return profile of common equity in an LBO? 20-40%