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Leveraged Buyout Questions - (Wall Street Prep)
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Leveraged Buyout Questions - (WallStreet Prep)
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 an IRR of 20%
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, and even more like 50/50 in recent years. So that might
look like an EV/EBITDA multiple of 5 to 6.
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.
What types of industries attract more deal flow from financial buyers?
Non-Cyclical/Low-Growth: Industries with stagnant to low growth tend to attract higher
amounts of interest from private equity investors, as many companies will turn to inorganic
growth once organic growth opportunities seem to have diminished. In an effort to continue
growing and increasing margins, companies will turn to M&A and start acquiring smaller
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