LBO Technicals Study Questions and
Correct Answers
What 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 see 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 realize greater returns at exit.
, Therefore, private equity firms attempt to maximize 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 D/E 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 debt 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 rollover 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 incentive the management team to
meet financial targets.
What are the main levers in an LBO that drive returns? ✅1. 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.
2. 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.
3. 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 diversification, and
favorable transaction dynamics (e.g., competitive auction led by strategics).
What attributes make a business an ideal LBO candidate? ✅Strong Free Cash Flow
Generation: 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
