LBO Practice Exam Questions and
Complete Solutions
What is private equity? ✅Private equity is equity capital that is not quoted on a public
exchange.
Private equity consists of investors and funds that make investments directly into private
companies or conduct buyouts of public companies that result in a delisting of public
equity
Capital for private equity is raised from retail and institutional investors and can be used
to fund new technologies, expand working capital within an owned company, make
acquisitions or to strengthen a balance sheet
What is a LBO fund? What are its characteristics? ✅A financial buyer that raises
capital from investors to purchase companies with a small amount of equity and uses a
significant amount of borrowed money to fund the remainder of the acquisition cost in
order to boost IRR
1. Short term investment (intend to exit 3-7 years)
2. High level of debt
3. Assets of the target company are used as collateral for loans
4. Delever / pay down with target company's cash flow
5. Exit the investment with little or no debt leftover, LBO fund collects higher percentage
of exit sale price and / or uses the excess cash flow to pay themselves a dividend
What does a PE firm do? ✅(1) Create fund
(2) Find target
(3) Structure deal
(4) Obtain financing
(5) Unlock value
(6) Exit the investment
Why lever up a firm? ✅1. by using leverage to help finance the purchase price, private
equity fund reduces the amount of money that must be contributed, which can
substantially boost returns upon exit
2. frees up remaining capital to be used to make other investments
3. interest payments on debt are tax deductible, can substantially reduce effective tax
rate
Strategic acquirers tend to prefer to pay for acquisitions with cash. If that is the case,
why would a private equity fund want to use debt in a LBO? ✅Two different scenarios:
,1. private equity funds do not intend to hold the company for long-term and thus are less
concerned with the "expense" of cash vs. debt, they are more concerned with using
leverage to boost returns by reducing the amount of capital it has to contribute up front
2. In a LBO, the "debt" is owned by the company so they assume the majority of the risk
(i.e. company's assets are used as collateral) vs. in a strategic acquisition, the buyer
owns the debt so riskier
What is a hedge fund? ✅an aggressively managed portfolio of investments that uses
advanced investment strategic such as leveraged, long, short and derivative positions in
both domestic and international markets with the goal of generating high returns (either
in an absolute sense or over a specified market benchmark)
What are the main differences between PE and HF? ✅-both lightly regulated, targeting
high net worth and institutional investors. Both types of funds are paid an annual
management fee (~2%) as well as a performance fee (~20%)
1) Time horizon--PE invest in long term, illiquid assets with the intent to buy, grow and
exit vs. HF are much more liquid / short term
2) Control--PE funds typically make highly concentrated investments by purchasing
whole companies vs. HF make short term investments across different assets
3) strategy--PE work closely with management vs. HF have different strategies (quant,
long / short, etc.)
4) Fee structure--HF take out their performance fees every quarter or every year, PE do
not get paid until they exit their investments so performance fees are taken for 5 years+
What is IRR? ✅Discount rate that makes the NPV of all cash flows from a particular
project equal to 0, measure of the return on a fund's invested equity
generally, the higher the IRR, the more desirable it is to undertake the project. As such,
the IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first
CAGR = end equity / beg equity ^(1/years) - 1
What is the hurdle rate? ✅Minimum required IRR. Historically, the hurdle rate for most
private equity funds was around 30%, but may be as low as 15% / 20% in adverse
economic conditions
Larger deals have lower hurdle rates
Run me through the changes between the existing balance sheet and the pro forma
balance sheet in an LBO model ✅1. Deduct cash used in the transaction
2. PP&E step up
3. Newly identified intangibles
4. New Goodwill
, 5. Capitalized financing fees
6. New debt + repayment of old debt if any
7. Deferred tax liability
8. New common equity
Walk me through an LBO analysis ✅1. transaction assumptions (S&U)
-Entry multiple / purchase price or implied premium to share price
-financing (leverage levels / cap structure)
-interest rates on debt tranches
-equity contribution = uses - other sources
2. Pro forma target balance sheet to reflect transaction / new cap structure
-add new debt, wipe out shareholder's equity
-replace with equity contribution
-adjust cash
-capitalize financing fees
-plug goodwill / intangibles
3. Integrated cash flow model
-operating assumptions (Rev growth, margins)
-pro forma income statement, balance sheet and statement of cash flows
-projected available FCF per year
-required debt repayment each year
4. Exit assumptions
-time horizon on investment
-EBITDA exit multiple
-Dividend recap
-calculate equity returns
-sensitize results
Note: absent dividends or additional equity infusions, the IRR = the average annual
compounded rate at which the PE's original equity investment grows to its value at exit
Let's say you run an LBO analysis and the PE firm return is too low, what drivers to the
model will increase the return? ✅1. EBITDA / Earnings growth by leading to higher
implied exit price and cash flow, which can leader to higher dividends and quicker debt
repayment
-organic revenue growth
-acquisitive revenue growth
-cost cutting
-reduced taxation
-reduce operating leverage (lower fixed costs)
2. FCF Generation / Debt Paydown
Complete Solutions
What is private equity? ✅Private equity is equity capital that is not quoted on a public
exchange.
Private equity consists of investors and funds that make investments directly into private
companies or conduct buyouts of public companies that result in a delisting of public
equity
Capital for private equity is raised from retail and institutional investors and can be used
to fund new technologies, expand working capital within an owned company, make
acquisitions or to strengthen a balance sheet
What is a LBO fund? What are its characteristics? ✅A financial buyer that raises
capital from investors to purchase companies with a small amount of equity and uses a
significant amount of borrowed money to fund the remainder of the acquisition cost in
order to boost IRR
1. Short term investment (intend to exit 3-7 years)
2. High level of debt
3. Assets of the target company are used as collateral for loans
4. Delever / pay down with target company's cash flow
5. Exit the investment with little or no debt leftover, LBO fund collects higher percentage
of exit sale price and / or uses the excess cash flow to pay themselves a dividend
What does a PE firm do? ✅(1) Create fund
(2) Find target
(3) Structure deal
(4) Obtain financing
(5) Unlock value
(6) Exit the investment
Why lever up a firm? ✅1. by using leverage to help finance the purchase price, private
equity fund reduces the amount of money that must be contributed, which can
substantially boost returns upon exit
2. frees up remaining capital to be used to make other investments
3. interest payments on debt are tax deductible, can substantially reduce effective tax
rate
Strategic acquirers tend to prefer to pay for acquisitions with cash. If that is the case,
why would a private equity fund want to use debt in a LBO? ✅Two different scenarios:
,1. private equity funds do not intend to hold the company for long-term and thus are less
concerned with the "expense" of cash vs. debt, they are more concerned with using
leverage to boost returns by reducing the amount of capital it has to contribute up front
2. In a LBO, the "debt" is owned by the company so they assume the majority of the risk
(i.e. company's assets are used as collateral) vs. in a strategic acquisition, the buyer
owns the debt so riskier
What is a hedge fund? ✅an aggressively managed portfolio of investments that uses
advanced investment strategic such as leveraged, long, short and derivative positions in
both domestic and international markets with the goal of generating high returns (either
in an absolute sense or over a specified market benchmark)
What are the main differences between PE and HF? ✅-both lightly regulated, targeting
high net worth and institutional investors. Both types of funds are paid an annual
management fee (~2%) as well as a performance fee (~20%)
1) Time horizon--PE invest in long term, illiquid assets with the intent to buy, grow and
exit vs. HF are much more liquid / short term
2) Control--PE funds typically make highly concentrated investments by purchasing
whole companies vs. HF make short term investments across different assets
3) strategy--PE work closely with management vs. HF have different strategies (quant,
long / short, etc.)
4) Fee structure--HF take out their performance fees every quarter or every year, PE do
not get paid until they exit their investments so performance fees are taken for 5 years+
What is IRR? ✅Discount rate that makes the NPV of all cash flows from a particular
project equal to 0, measure of the return on a fund's invested equity
generally, the higher the IRR, the more desirable it is to undertake the project. As such,
the IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first
CAGR = end equity / beg equity ^(1/years) - 1
What is the hurdle rate? ✅Minimum required IRR. Historically, the hurdle rate for most
private equity funds was around 30%, but may be as low as 15% / 20% in adverse
economic conditions
Larger deals have lower hurdle rates
Run me through the changes between the existing balance sheet and the pro forma
balance sheet in an LBO model ✅1. Deduct cash used in the transaction
2. PP&E step up
3. Newly identified intangibles
4. New Goodwill
, 5. Capitalized financing fees
6. New debt + repayment of old debt if any
7. Deferred tax liability
8. New common equity
Walk me through an LBO analysis ✅1. transaction assumptions (S&U)
-Entry multiple / purchase price or implied premium to share price
-financing (leverage levels / cap structure)
-interest rates on debt tranches
-equity contribution = uses - other sources
2. Pro forma target balance sheet to reflect transaction / new cap structure
-add new debt, wipe out shareholder's equity
-replace with equity contribution
-adjust cash
-capitalize financing fees
-plug goodwill / intangibles
3. Integrated cash flow model
-operating assumptions (Rev growth, margins)
-pro forma income statement, balance sheet and statement of cash flows
-projected available FCF per year
-required debt repayment each year
4. Exit assumptions
-time horizon on investment
-EBITDA exit multiple
-Dividend recap
-calculate equity returns
-sensitize results
Note: absent dividends or additional equity infusions, the IRR = the average annual
compounded rate at which the PE's original equity investment grows to its value at exit
Let's say you run an LBO analysis and the PE firm return is too low, what drivers to the
model will increase the return? ✅1. EBITDA / Earnings growth by leading to higher
implied exit price and cash flow, which can leader to higher dividends and quicker debt
repayment
-organic revenue growth
-acquisitive revenue growth
-cost cutting
-reduced taxation
-reduce operating leverage (lower fixed costs)
2. FCF Generation / Debt Paydown
