LBO (Advanced) Practice Questions and Correct Answers
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Course
LBO Modeling
Institution
LBO Modeling
Tell me about the different types of debt you could use in an LBO. Revolver TLA TLB Senior Notes Subordinated Notes Mezzanine
Each type of debt is arranged in order of rising interest rates - so the Revolver has the lowest interest rates, Term Loan A is slightly higher, B is slightly higher, Senio...
LBO (Advanced) Practice Questions and
Correct Answers
Tell me about the different types of debt you could use in an LBO. ✅Revolver
TLA
TLB
Senior Notes
Subordinated Notes
Mezzanine
Each type of debt is arranged in order of rising interest rates - so the Revolver has the
lowest interest rates, Term Loan A is slightly higher, B is slightly higher, Senior Notes
are higher than Term Loan B, and so on.
Seniority meaning ✅The order of claims on a company's assets in a bankruptcy - the
Senior Secured holders are first in line, followed by Senior Unsecured, Senior
Subordinated, and then Equity Investors.
"Floating" or "Fixed" Interest Rates ✅A "floating" interest rate is tied to LIBOR. For
example, L + 100 means that the interest rate of the loan is whatever LIBOR is at
currently, plus 100 basis points (1.0%). A fixed interest rate, on the other hand, would
be 11%. It doesn't "float" with LIBOR or any other rate.
"Tenor" ✅Just a fancy word for "How many years will this loan be outstanding? What is
its maturity period?"
Wait a minute, how are Call Protection and "Prepayment" different? Don't they refer to
the same concept? ✅Call Protection refers to paying off the entire debt balance,
whereas "Prepayment" refers to repaying part of the principal early, before the official
maturity date.
What are some examples of incurrence covenants? Maintenance covenants?
✅Incurrence Covenants:
- Company cannot take on more than $2 billion of total debt.
- Proceeds from any asset sales must be earmarked to repay debt.
- Company cannot make acquisitions of over $200 million in size.
- Company cannot spend more than $100 million on CapEx each year.
Maintenance Covenants:
- Total Debt / EBITDA cannot exceed 3.0 x
- Senior Debt / EBITDA cannot exceed 2.0 x
, - (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0 x
- EBITDA / Interest Expense cannot fall below 5.0 x
- EBITDA / Cash Interest Expense cannot fall below 3.0 x
- (EBITDA - CapEx) / Interest Expense cannot fall below 2.0 x
Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and
how does it affect the debt schedules and the other statements? ✅Unlike "normal"
debt, a PIK loan does not require the borrower to make cash interest payments -
instead, the interest accrues to the loan principal, which keeps going up over time. A
PIK "toggle" allows the company to choose whether to pay the interest in cash or have it
accrue to the principal.
PIK is riskier than other forms of debt and carries with it a higher interest rate than
traditional Bank Debt or High-Yield Debt.
Adding it to the debt schedules is similar to adding High-Yield Debt with a bullet maturity
- except instead of assuming cash interest payments, you assume that the interest
accrues to the principal.
You include this interest on the Income Statement, but you need to add back any PIK
interest on the Cash Flow Statement because it's a non-cash expense.
How does Preferred Stock fit into these different financing methods? Isn't it a type of
Debt as well? ✅Preferred Stock is similar to Debt and it would match the "Mezzanine"
column in the table above most closely. Just like with Mezzanine, Preferred Stock has
the lowest seniority in the capital structure and tends to have higher interest rates than
other types of Debt. It's not included in the table above due to space constraints.
How do you treat Noncontrolling Interests (AKA Minority Interests) and Investments in
Equity Interests (AKA Associate Companies) in an LBO model? ✅Normally you leave
these alone and assume that nothing happens - so they show up in both the Sources
and Uses columns when you make assumptions in the beginning.
You could assume that the private equity firm acquires one or both of these, in which
case they would only show up in the Uses column - similar to refinancing Debt.
What about "Excess Cash"? Why do you sometimes see that in a Sources & Uses
table?t "Excess Cash"? Why do you sometimes see that in a Sources & Uses table?
✅This represents the scenario where the company itself uses its excess cash (i.e. if it
only requires $10 million in cash but has $50 million on its Balance Sheet, $40 million is
the excess cash) to fund the transaction. This always shows up in the Sources column.
It's just like how you subtract Cash when calculating Enterprise Value: an acquirer
would "receive" that Cash upon buying the company.
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