- It's difficult sometimes to see things without modelling them
- We get less cash flow in Years 1 – 5 and we receive less in net proceeds from selling the property, but the lower purchase price more than makes up for those.
- Leverage doesn't boost returns, it amplifies returns
- If a deal does well, then you'll earn more if you paid less upfront (used leverage)
- Because money today is worth more than money tomorrow, and because you reduce the purchase price
- If a deal doesn't do well, then you'll lose more if you paid less upfront (used leverage)
- In the downside case, leverage makes returns worse
- In an LBO, the target company has to raise debt to buy its own shares - PE firm is dissociated from the effects. PE firm creates a shell corporation.
- Stable cash flows are important because the target company needs to be able to service its own debt
- Overlooked trait of good LBO candidate - having high fixed assets such as PP&E (as can be used as collateral) - having high fixed assets is a good thing
- 20-30% of Revenue as Capex is too high for most industries - you want minimal capex for good LBO candidate, ideally smaller working capital requirements
- You want growth Capex, as opposed to Maintenance Capex
- A PE firm can still make money with a slow-growing company, as long as the purchase price is low and exit price is high - but you don't want to bank on this
- Existing cash can make a company look more attractive, because PE firm could use that cash to pay-off debt
- Re-paying debt early could have some penalty fees associated with it, "Call Premiums" state a certain % of principal must be repaid e.g. 104%
- Existing management can roll-over their equity to get skin in the game
- Post-deal credit ratings (e.g. AA) will always go down after a deal, you want to make sure the drop isn't too significant
- Having a fragmented industry is more appealing than a non-fragmented industry because it reduces risk of monopolisation, and also means the PE firm can pursue bolt-on acquisitions
- PE firms avoid deals that are overly dependent on Multiple Expansion: they prefer deals where EBITDA growth is the main driver instead. High debt paydown will also drive returns. Price however is the most important factor.
- In terms of exit strats: a dividend recap or a leverage recap is less than ideal
- In M&A deals, buyers can use Cash, Debt and Stock...
- But in PE deals, buyers can only use Cash (Investor Equity) and Debt
- In M&A deals, you need projections for both the buyer and the seller... in LBOs - you only project the seller's financials
- The IRR formula of (Final Equity Value/Initial Investor Equity)^(1/# of years) -1 only applies if there were no cash flows in between the purchase and the sale If there were cash flows between the purchase and the sale, then you would have to use Excel's IRR function to calculate instead
- Deals can look good on an IRR basis, but poor on an MoM basis - and vice versa, so use both to compare
- Question of whether the IRR or MoM is more important depends on the holding period, as IRR is the factor which will be affected by years (holding period)
- If a PE firm does a “quick flip” in 1 year, the multiple is more important because the IRR is meaningless in such a short time frame.
- But if it holds a company for 5, 6, or 7 years, the IRR is far more important.
- A returns attribution analysis shows you what % of the return comes from a particular driver (e.g. EBITDA Growth, Debt Paydown, Multiple Expansion)
- We want to see deals which are driven by EBITDA Growth and Debt Paydown, as opposed to Multiple Expansion (speculative)
Returns in an LBO Model come from 3 main sources:
1) EBITDA Growth
2) Debt Paydown/Cash Generation
3) Multiple Expansion
- The IRR function in Excel doesn't work if you don't have "0" in between your cash outflow and your exit.
- You barely see LBOs of Airline companies because cash-flows aren't stable, subject to oil price fluctuations and Capex is typically locked in for future years (15-20% Capex is on high end), high fixed costs also make it unattractive
- Branded pharma companies are barely LBO'ed, because after patent the revenue just drops
- Sensitivity toggles show you what the deal would look like if a particular factor was changed e.g. Occupancy rate was changed or # of new hotels per year was changed
- So the sensitivity toggle will be a %, and you multiply that growth with your original hardcoded figure to get the new value post-toggle e.g.
- In your base case scenario, you'd want the exit multiple to be very close to the purchase multiple
- In LBO models - you typically use Options Outstanding as opposed to Exercisable, because in M&A you assume all options are vested
- An "Equity Rollover" will reduce the amount of cash or debt you need to fund the deal,
- Try and do the Uses before you do the Sources in Excel
For CFF in LBOs, you typically wipe out all the line items except the debt repayments, because you assume that now the company is Private, it will not need all that stuff
- In an LBO debt schedule, your beginning cash balance for the transaction year needs to subtract out any cash transaction fees
- FCF will allow you to see if the firm you're acquiring can take on more debt
- Early pre-payment isn't allowed on all types of debt
- In Excel IRR formula, you need to hardcode the 0s in between to show that you're not getting any cash back - bc otherwise it assumes that you get that return immediately (as opposed to over the years)
- From the final equity value that is generated after the deal, you need to do the % of it which is Investor Equity - because that is the amount that the PE firm owns
The initial equity outlay needs to be negative for the formula to work also
The 5 Most Important Assumptions in an LBO Model Are: 1) Purchase Price 2) Exit Price 3) Amount of Debt Used 4) Revenue Growth 5) EBITDA Growth
^ So those are the ones that you want to sensitise
Dividend recap is when the PE firm makes the company take on debt to pay itself a dividend
Fixed costs are riskier than variable expenses (bc you can reduce variable expenses in a downturn)
- Formula for "Cash Available for New Debt Repayment = Beginning Cash + FCF Generated - Repayments of Existing Debt - Minimum Cash Balance"
- So, Principal Repayments on New Debt isn't in the formula above (was a mistake on the LBO quiz)
- In a PE investment recommendation, the easiest way to to come up with risk factors is by looking at your sensitivity tables and seeing what would make the greatest impact
- Always flesh out Uses, before you do Sources... you have to know what you need, before you figure out how you can get it.
- In LBO, the new equity on the company's balance sheet, is the equity that you put in
- You can calculate FCF via EBITDA, in which case you don't have to get EBIT (and you don't have to add D&A - you just act like D&A has already been added)
- Remember that 'Investor Equity' is different to 'Equity Value' in the sense that it depends on your Equity % Ownership... Investor Equity is what you care about when you're calculating returns
PE Exit Strategies Are:
1) M&A 2) IPO 3) Dividend Recap
- A dividend recap can be issued using the company's cash and FCF each year, or by raising new debt
- The former is called a Non-Leveraged Dividend Recapitalization The latter is called a Leveraged Dividend Recapitalization Dividend recaps aren't just exit strategies, they can be done in the middle to boost returns further The IRRs from Dividend recaps are so low - PE firms prefer to avoid this strategy
- You can have Waterfall Returns and Performance Incentives that would allow Management to realise a higher IRR (used very commonly to align incentives)
- Can use Management Options (when more uncertain around performance) - will allow mgmt to gain equity proceeds if Exit Equity Value exceeds Initial Investor Equity (in-the-money in that case)... this will also incentivise management