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?
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What makes a good LBO investment candidate?
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What are the different ways to find the valuation of a company?
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How would you spend a million dollars if it were given to you?
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What two questions would you ask before deciding between two companies with different IRR?
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What are the four main drivers of change in IRR for an LBO scenario?
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How do you model in PIK notes?
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Walk me through the calculation of Free Cash Flow.
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Why would a private equity firm use a convertible preferred note?
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How do you calculate amortization of intangible assets?
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What are the uses of excess cash flow?
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What makes for a good management team?
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What three questions would you ask a CEO of a company you are looking to invest in?
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What are some reasons why different companies might have different EV/EBITDA multiples?
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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.