LBO Interview Studying Practice Questions and Correct Answers
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Course
LBO Modeling
Institution
LBO Modeling
LBO Acquisition of a company by an investor group Purchase price financed by debt PE firm uses the company's cash flows to pay interest expense on the debt and to pay off the debt principal
LBO valuation represents the maximum amount a sponsor can pay in order to achieve its required return object...
LBO Interview Studying Practice
Questions and Correct Answers
LBO ✅Acquisition of a company by an investor group
Purchase price financed by debt
PE firm uses the company's cash flows to pay interest expense on the debt and to pay
off the debt principal
LBO valuation represents the maximum amount a sponsor can pay in order to achieve
its required return objectives
Types of LBOs ✅Sponsor buyout: Financial sponsor buys all the equity of the target
Club deal: Two or more sponsors pool capital to acquire the target (used in megadeals)
Public to private: Taking a publicly listed company private
Management buyout (MBO): Existing management buys out the company
Management buy-in (MBI): New management buys into the company
Recapitalization: Existing levered company is refinanced allowing current shareholders
to partially exit investment
Financial sponsor ✅PE firm that raise pools of equity capital that supply the equity
contribution for its buyouts
Capital organized into funds that are limited partnerships
General partner manages fund on a day-to-day basis and limited partners (LP) serve as
passive investors
Debt investors ✅Capital provides for senior and junior debt
Bank lenders: Commercial banks, S&Ls, finance companies, investment banks; provide
capital for revolving credit facilities and bank term loans
Institutional and specialty lenders: Hedge funds, pension funds, insurance companies,
structured vehicles; provide capital for limited amortization term, second lien and
mezzanine loans
Bond investors: High yield mutual funds, hedge fund, pension funds, insurance
companies; provide capital for high yield bonds
Target management ✅Strong management team is crucial to realizing target financial
projections, paying down debt and achieving the required IRR
Frequently, management holds an equity interest in the post LBO company via
"rollover" equity
,- Aligns PE fund and management incentives
- Rewards management for achieving desired operating performance
Why high leverage? Pros ✅Pros
Increase in value goes to equity holders as debt is paid down
Debt holders have a fixed claim on the business and equity holders share in all the
upside
Interest tax shield -- interest is tax deductible
Cons
Strict financial covenants
Strict covenants can limit the company's ability to increase capex and pay dividends to
equity holders
Increased default risk
Refinancing risk: If exit opportunities are limited, company may run into refinancing risk
(risk that borrower may not be able to borrow at the same rate when rolling over debt)
ROIC vs ROE ✅ROIC = NOPAT / Invested capital
Looks at the return to all stakeholders
Indifferent to the capital structure of the company
ROE = NI / Equity
ROE considers how the company financed its operations
Equity investors get the benefit of the interest tax shield from debt financing
Returns and capital structure ✅All equity capital structure: ROIC and ROE are the
same, equity shareholders receive no benefit of having a diversified capital structure
Debt & equity mix: ROIC does not change from the all equity case, ROE increases as
equity holders benefit from the interest tax shield on debt
Shareholder indifference case: Cost of debt increased to the point where the ROIC and
ROE are equal; shareholders would be indifferent to the effects of leverage; if leverage
increases past this level then leverage is value destructive to existing equity holders and
the ROIC > ROE
Leverage increases returns to equity holders as long as... ✅Leverage increases
returns to equity holders as long as the after tax cost of debt is less than ROE
When the after tax cost of debt > ROE, leverage is value destructive to equity holders
Max cost of debt ✅ROE / (1 - MTR)
, Steps to LBO modeling (walk me through an LBO) ✅1. Acquisition and operating
assumptions
- Acquisition assumptions: Purchase price, leverage, interest rate on debt
- Operating assumptions: Revenue growth, EBITDA margin, D&A, CapEx, OWC
2. Sources and uses: Equity purchase price, refinancing net debt, fees (debt and
advisory)
Sources: New debt and sponsor equity
3. Pro Forma operating balance sheet
- Financing adjustment (new debt, new equity, debt / advisory fees)
- Accounting adjustments: Zap out Target C/S, R/E, target existing goodwill, and
refinanced net debt, wire in deal goodwill
4. Project I/S, B/S, and CFS and determine paydown schedule
- Debt paydown based on cashflow available for debt repayment after paying required
interest payments
5. Calculate enterprise value of business and residual equity value upon exit
6. Calculate internal rate of return (IRR)
7. Determine maximum offer price that equates to a minimum acceptable IRR to equity
holders
Sources and uses of funds: Sources ✅Equity
- New equity from LBO sponsor
- Potential equity contribution from existing management
- Potential continuing investment by existing shareholders
Debt
- Bank debt
- HY bonds
- Mezz debt
Sources and uses of funds: Uses ✅Purchase target equity
- Pay existing equity owners
- If public, share price plus premium
- Include cost of options, convertibles and other potentially dilutive securities
Retire existing debt
- Covenants on existing debt typically prohibit post-LBO leverage levels, so existing
debt is refinanced
Transaction fees and expenses
- Fee percentages depend on company's credit rating and deal structure
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