Private Equity LBO Flashcards

Questions and Answers

What is an LBO?

In a leveraged buyout, a PE firm acquires a company using debt and equity, operates it for several years with improvements, then sells it to realize a return on investment.

Walk me through the mechanics of an LBO model.

Assumptions, Sources & Uses, Adjust Balance Sheet (Debt and Equity - Goodwill), Project 3 statements, Project Free Cash Flow, Debt and Interest Schedule, Exit Calculation (MOIC and IRR), Sensitivity Tables.

How do you assess credit risk?

Leverage ratios (never exceed 4x), Interest-coverage ratios (greater than 1), Fixed Charge Coverage Ratio, considering industry growth.

What are the different types of PE firms?

Early Stage VC (5-10%), Mid Stage Growth Equity (10-30%), Late Stage LBO (20-50%). Signup and view all the answers

What makes a good LBO investment candidate?

Stable Cash Flows, Assets, Margins, Low CapEx, Low Risk, Undervalued, Strong Management. Signup and view all the answers

What are the different ways to find the valuation of a company?

Precedent Transactions, Public Comparables, DCF, LBO, NAV, Sum of the Parts (SOTP). Signup and view all the answers

How would you spend a million dollars if it were given to you?

Consider investment options: 10% PE co-invest, 60% diversified stocks, 30% bonds. Signup and view all the answers

What two questions would you ask before deciding between two companies with different IRR?

<ol> <li>How much investment is required? 2) What is the timing?</li> </ol> Signup and view all the answers

What are the four main drivers of change in IRR for an LBO scenario?

Lower purchase price, exit multiple, amount of leverage, EBITDA expansion. Signup and view all the answers

How do you model in PIK notes?

Refer to financial modeling resources for specific methodologies. Signup and view all the answers

Walk me through the calculation of Free Cash Flow.

EBITDA less Interest, Taxes, CapEx, Change in NWC. Signup and view all the answers

Why would a private equity firm use a convertible preferred note?

To access upside in equity while initially managing low-risk debt until the company proves successful. Signup and view all the answers

How do you calculate amortization of intangible assets?

Goodwill is tested annually for impairment; other intangibles can be amortized over their estimated useful life. Signup and view all the answers

What are the uses of excess cash flow?

Dividends, debt repayment, share repurchase, capex, M&A. Signup and view all the answers

What makes for a good management team?

Experienced team, ability to navigate challenges, prior acquisition experience. Signup and view all the answers

What three questions would you ask a CEO of a company you are looking to invest in?

<ol> <li>What do you expect the company's performance to look like? 2) What are the risks and threats to the business? 3) What is your competitive advantage?</li> </ol> Signup and view all the answers

What are some reasons why different companies might have different EV/EBITDA multiples?

One company may be an acquisition target or in the M&A process, have different EBITDA margins, or hold controlling market share. Signup and view all the answers

Study Notes

LBO Overview

A leveraged buyout (LBO) involves a private equity (PE) firm acquiring a company mostly financed by debt (D) and equity (E).
The acquired company is operated for several years with enhancements before being sold to yield a return on investment.

Mechanics of an LBO Model

Key steps in building an LBO model include making assumptions, analyzing sources and uses (S&U), and adjusting the balance sheet.
Important components to project include the three financial statements, free cash flow (FCF), and debt schedule.
Exit calculations involve evaluating multiple on invested capital (MOIC) and internal rate of return (IRR), alongside sensitivity tables.

Credit Risk Assessment

Credit risk is evaluated by leveraging ratios, with a threshold of 4x balance sheet debt and under 2x debt to equity.
Interest-coverage ratios should exceed 1 for maintenance, ideally above 3x for safety.
Analyzing industry trends and company growth provides insights into credit protection against default.

Types of Private Equity Firms

Early-stage venture capital (VC) firms typically allocate 5-10% in preferred equity or warrants.
Growth equity firms concentrate on mid-stage investments with a 10-30% stake.
Leveraged buyout firms focus on late-stage opportunities, investing 20-50%.

Characteristics of an Ideal LBO Candidate

A strong LBO candidate must demonstrate stable cash flows and possess valuable assets.
Preferable qualities include high margins, low capital expenditures (CapEx), minimal risk, being undervalued, and having a competent management team.

Company Valuation Methods

Company valuation can be performed using various methods: precedent transactions, public company comparables, discounted cash flow (DCF) analysis, leveraged buyouts, net asset value (NAV), and sum of the parts (SOTP).

Investment Strategy for a Million Dollars

Consider PE co-investments for high returns albeit with illiquidity.
Allocate 60% to diversified stocks, balancing between domestic and international markets.
Invest 30% in low-cost, medium-maturity bonds uncorrelated with equities, potentially funding a home purchase in five years.

Investment Decision Factors

When comparing investments with different IRRs, crucial questions include the required investment amount and timing, along with the operational industry context.

Factors Influencing IRR in LBOs

Key drivers affecting IRR changes in LBO scenarios include lower purchase prices, higher exit multiples, the degree of leverage employed, and EBITDA growth.

Accounting for PIK Notes

Pay-In-Kind (PIK) notes involve specific accounting methods that account for payments in the form of additional securities or equity instead of cash.

Free Cash Flow Calculation

Free cash flow is calculated by taking EBITDA and subtracting interest, taxes, capital expenditures, and changes in net working capital.

Convertible Preferred Notes in Private Equity

These notes provide access to equity upside with lower risk prior to proven success, allowing for investment flexibility.

Amortization of Intangible Assets

Goodwill must be tested annually for impairment, while other intangibles can be amortized based on estimated useful life, such as patents typically amortized over 15 years.

Uses of Excess Cash Flow

Excess cash can be utilized for dividends, debt repayment, share buybacks, capital expenditures, or mergers and acquisitions.
Cash sweep provisions allow early debt repayment using excess cash when permitted under the debt terms.

Components of a Strong Management Team

Effective management teams feature significant experience, resilience through challenging periods, and prior exposure to acquisitions.

Key Questions for CEOs

Three essential questions for a CEO include expectations for company performance, identification of business risks and mitigation strategies, and sustainability of competitive advantages.

Differences in EV/EBITDA Multiples

Varied EV/EBITDA multiples across industries may stem from different market positions, acquisition interests, EBITDA margin disparities, and varying competitive dynamics.

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Description

Test your knowledge on leveraged buyouts with these flashcards that cover essential concepts and mechanics of LBO models. Perfect for students and professionals interested in private equity. Get ready to enhance your understanding of how private equity firms operate and realize returns on their investments.