M&I Guide LBO Model Questions & Answers(RATED A+)

1. What is a leveraged buyout, and why does it work? - ANSWER -In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells the company at the end of the period to realize a return on its investment. -During the period of ownership, the PE firm uses the company's cash flows to pay for the interest expense on the Debt and to repay Debt principal. -It works because leverage amplifies returns: If the deal performs well, the PE firm will realize higher returns than if it had bought the company with 100% Equity. But leverage also presents risks because it means the returns will be even worse if the deal does not perform well. 2. Why do PE firms use leverage when buying companies? - ANSWER -To amplify their returns. Leverage does NOT "increase returns": Using leverage - borrowing money from others - to fund a deal simplify makes positive returns even more positive and negative returns even more negative. -All PE firms aim for positive returns above a certain IRR, and using leverage makes it easier to get there... if the deal goes well. -A secondary benefit is that the PE firm has more capital available to buy other companies since it won't use up all its funds on acquiring one company. 3. Walk me through a basic LBO model. - ANSWER -"In an LBO model, in Step 1, you make assumptions for the Purchase Price, Debt and Equity, Interest Rate on Debt, and other variables such as the company's revenue growth and margins. -In Step 2, you create a Sources & Uses schedule to show exactly how much how much in Investor Equity the PE firm contributes; you also create a Purchase Price Allocation Schedule to calculate the Goodwill. -In Step 3, you adjust the company's Balance Sheet for the new Debt and Equity figures, allocate the purchase price, and add Goodwill & Other Intangibles to the Assets side to make everything balance. -In Step 4, you project the company's Income Statement, Balance Sheet, and Cash Flow Statement, and determine how much Debt it repays each year based on its Free Cash Flow. -Finally, in Step 5, you make assumptions about the exit, usually assuming an EBITDA Exit Multiple, and you calculate the IRR and Money-on-Money multiple based on the proceeds the PE firm earns at the end." 4. Can you explain the legal structure behind a leveraged buyout and how it benefits the private equity firm? - ANSWER -In a leveraged buyout, the PE firm forms a "holding company," which it owns, and then this "holding company" acquires the real company. -The banks and other lenders that provide the Debt lend to this Holding Company so that the Debt is at the "HoldCo" level.