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Leveraged Buyout Questions - (Wall Street Prep) graded A+
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Leveraged Buyout Questions - (Wall StreetPrep)
hat is a leveraged buyout (LBO)?
In a leveraged buyout, a private equity firm (often called the financial sponsor) acquires a
company with most of the purchase price being funded through the use of various debt
instruments such as loans, bonds. The financial sponsor will secure the financing package
ahead of the closing of the transaction and then contribute the remaining amount.
Once the sponsors gain majority control of the company, they get to work on streamlining the
business - which usually means operational improvements, restructuring, and asset sales
intending to make the company more efficient at generating cash flow so that the large debt
burden can be quickly paid down.
The investment horizon for sponsors is 5-7 years, at which point the firm hopes to exit by either:
- Selling the company to another private equity firm or strategic acquirer
- Taking the company public via an initial public offering (IPO)
FInancial sponsors usually target returns of -20-25% when considering an investment.
Explain the basic concept of an LBO to me using a real-life example?
One metaphor to explain an LBO is "house flipping" using mostly borrowed money. Imagine you
found a house on the market selling for a low price, in which you seen an opportunity to sell it
later for a higher price at a profit. You end up purchasing the house, but much of the purchase
price was financed by a mortgage lender, with a small down payment that came out of your
pocket. In return for the lender financing the home, you have a contractual obligation to repay
the full loan amount plus interest.
But instead of purchasing the house to live there, the house was bought as a property
investment with the plan to put the house back on the market in five years. Therefore, each
room is rented out to tenants to generate monthly cash flow. The mortgage principal will
gradually be paid off and the periodic interest payments are paid down using the rental income
from the tenants. Home renovations are completed with the remaining amount and any existing
property damages are fixed - again, using the rental income.
After around five years, the house is sold for a price higher than the initial purchase due to the
improvements made to the house and because the house is located in an area where home
values have been increasing. The remaining mortgage balance will have to be paid in full, but
you pocket a greater percentage of the proceeds from the sale of the house because you
consistently paid down the principal.
What is the intuition underlying the usage of debt in an LBO?
,The typical transaction structure in an LBO is financed using a high percentage of borrowed
funds, with a relatively small equity contribution from the financial sponsor. As the debt principal
is paid down throughout the holding period, the sponsor will realise greater returns at exit.
Therefore, private equity firms attempt to maximise the amount of leverage while keeping the
debt level manageable to avoid bankruptcy risk.
The logic behind why it's beneficial for sponsors to contribute minimal equity is due to debt
having a lower cost of capital than equity. One reason the cost of debt is lower is that debt is
higher on the capital structure - as well as the interest expense being tax-deductible, which
creates a "tax shield." Thus, the increased leverage enables the firm to reach its returns
threshold easier.
What is the typical capital structure prevalent in LBO transactions?
LBO capital structures are cyclical and fluctuate depending on the financing environment, but
there has been a structural shift from debt to equity ratios of 80/20 in the 1980s to around 60/40
in more recent years.
The different debt tranches include leveraged loans (revolver, term loans), senior notes,
subordinated notes, high-yield bonds, and mezzanine financing. The majority of the debt raised
will be senior, secured loans by banks and institutional investors before riskier types of debts
are used. In terms of equity, the contribution from the financial sponsor represents the largest
source of LBO equity. Sometimes, the existing management team will roll over a portion of their
equity to participate in the potential upside alongside the sponsor.
Since most LBOs retain the existing management team, sponsors will usually reserve anywhere
between 3% to 20% of the total equity to incentivise the management team to meet financial
targets.
What are the main levers in an LBO that drive returns?
Debt Paydown (Deleveraging): Through deleveraging, the value of the private equity firm's
equity grows over time as more debt principal is paid down using the acquired company's free
cash flows.
EBITDA Growth: Growth in EBITDA can be achieved by making operational improvements to
the business's margin profile (e.g., cost-cutting, raising prices), implementing new growth
strategies, and making accretive add-on acquisitions.
Multiple Expansion: In the ideal scenario, the financial sponsor hopes to exit an investment at a
higher multiple than entry. The exit multiple can increase from improved investor sentiment,
better economic conditions, increased scale or diversifications, and favourable transaction
dynamics (e.g., competitive auction led by strategics).
What attributes make a business an ideal LBO candidate? (things financial sponsors look for)
, Strong Free Cash Flow Generation: The ideal LBO candidate must have predictable, FCF
generation with high margins given the amount of debt that would be put on the business. To
make the interest payments and debt paydown, consistent FCF generation year-after-year is
essential and should be reflected in the target's historical performance.
Recurring Revenue: Revenue with a recurring component implies there's less risk associated
with the cash flows of the company. Examples of factors that make revenue more recurring
include long-term customer contracts and selling high-value products or services required by
customers, meaning the product/service is necessary for business continuity (as opposed to
being a discretionary, non-essential spend).
"Economic Moat": When a company has a "moat", it has a differentiating factor that enables a
sustainable competitive advantage, which leads to market share and profit protection from
outside threats. This effectively creates a barrier against competition. Examples of deterrents
include branding, patents, proprietary technology, economies of scale, network effects, and
switching costs.
Favourable Unit Economics: High margins are a byproduct of good unit economics, a
well-managed cost structure, low capital expenditures, and minimal working capital
requirements. These factors all lead to more FCFs being available to make interest payments,
paydown debt principal (required and optional), and re-invest more into operations of the
business. In addition, when a company's unit economics is consistently better than the rest of
the market, this is oftentimes an indication of a competitive advantage.
Strong Committed Management Team: Qualified management teams will have a proven track
record, which can be proxied by the number of years working with one another and their past
achievements. THe importance of the management team cannot be overstated, as they're the
ones executing the strategic plan.
Undervalued (Low Purchase Multiple): While finding undervalued companies has become
increasingly difficult as more capital has flooded the private capital markets, many private equity
firms pursue opportunistic buyouts where the company can be acquired for a lower price due to
external factors. For example, an industry may have fallen out of favour temporarily or come
under pressure due to macro or industry-related trends, which could allow a firm to complete the
purchase at a discount. Since a lower entry multiple was paid, the opportunity for value creation
through exiting at a higher multiple (i.e., multiple expansion) is greater while the risk of having
overpaid is reduced.
Value-Add Opportunities: For traditional LBO firms, the ideal target will be very well-run, but
there should be some areas of inefficiencies that can be improved upon. These represent
opportunities for value creation such as selling non-core business assets, taking cost-cutting
measures, and implementing more effective sales and marketing strategies.
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