Technical LBO/Debt Qs

Can you describe the different types of Debt a PE firm might use in a leveraged buyout, and why it might use them?

Broadly speaking, Debt is split into Secured Debt and Unsecured Debt, which some people also label “Bank Debt” and “High-Yield Debt” or “Senior Debt” and “Junior Debt.”
Secured Debt consists of Term Loans and Revolvers, is backed by collateral, tends to have lower, floating interest rates, may have amortization, and uses maintenance covenants such as restrictions on the company’s EBITDA, Debt / EBITDA, and EBITDA / Interest.
Early repayment of principal is allowed, maturity periods tend to be shorter (~5 years up to 10 years), and the investors tend to be conservative banks.
Unsecured Debt consists of Senior Notes, Subordinated Notes, and Mezzanine, and is not backed by collateral; interest rates tend to be higher and fixed rather than floating, there is no amortization, and it uses incurrence covenants (e.g., The company can’t sell Assets above a certain dollar amount).
Early repayment is not allowed, maturity periods tend to be longer (8-10 years, and sometimes much longer or even indefinite), and the investors tend to be hedge funds, merchant banks, and mezzanine funds.

Why do the less risky, lower-yielding forms of Debt amortize? Shouldn’t amortization be a feature of riskier Debt to reduce the risk?

Amortization reduces credit risk but also reduces the potential returns. Since risk and potential returns are correlated, amortization should be a feature of less risky Debt.
If $100 million of 10% interest bonds stay outstanding for 10 years, and the company repays them, in full, after 10 years, the investors earn a 10% IRR on those bonds.
But if there’s amortization or optional repayment, that balance will decline to less than $100 million by the end, so the investors earn less than a 10% IRR. But the investors also take on less risk because more capital is returned earlier on.

Why might a PE firm choose to use Term Loans rather than Subordinated Notes in an LBO, if it has the choice between two capital structures with similar levels of leverage?

Term Loans are less expensive than Subordinated Notes since interest rates are lower, and they give the company more flexibility with its cash flows since optional repayments are allowed in most cases. Also, since Term Loans have maintenance covenants, they might be better if the company is planning to divest assets, make acquisitions, or spend a huge amount on CapEx, any of which might be forbidden with incurrence covenants found in Subordinated Notes.

Why might a PE firm do the opposite and use Subordinated Notes instead?

On the surface, this doesn’t make much sense because Subordinated Notes are more expensive than Term Loans.
However, a PE firm might prefer Subordinated Notes if they doubt a company’s ability to comply with the maintenance covenants found in Term Loans (e.g., if the company’s EBITDA is projected to decline for a few years).
Also, if the company wants to avoid paying cash interest (or the PE firm has doubts about its ability to do so), it may opt for Subordinated Notes with Payment-in-Kind (PIK) Interest so that the interest accrues to the loan principal.

Why might Excess Cash act as a funding source in an LBO, and why might its usage also cause controversy?

Excess Cash might act as a funding source in an LBO if a company uses its Cash to repurchase its shares, reducing the number of shares that a PE firm has to purchase.
It’s not that the PE firm “gets” the company’s Excess Cash before the deal takes place – it’s that the company uses its Cash to reduce the purchase price for the PE firm.
Pre-deal shareholders often object to such moves, saying that the company should have issued a Special Dividend to them or used the cash in a more productive way.
Using Excess Cash to fund a deal also increases the ownership stakes of existing investors that choose to roll over their shares – since Excess Cash reduces the Investor Equity the PE firm needs to contribute.

You’re setting up the Transaction Assumptions for an LBO, but you don’t have any information on the Debt Comps. How might you estimate the interest rates on Debt?

You could also estimate the Interest Rate on Debt by using default spreads, similar to the method you sometimes use with Cost of Debt in the WACC calculation.
Start with the yields of 10-Year Bonds issued by the central bank of the country you’re in, and then calculate the company’s interest coverage ratio and leverage ratio to get a sense of its credit rating (or use its actual credit rating). Then, look up the company’s default spread based on this credit rating and add that to the 10-Year Bond rate. For example, if the company’s leverage ratio will be 5x after the deal takes place, and that corresponds to a BB+ credit rating, you might look up BB+-rated companies and find that most of them have spreads of 4.0%. If the 10-Year Government Bond Rate is 3.0%, then the interest rate might be 3.0% + 4.0% = 7.0%.

What does “assuming” or “refinancing” Debt mean, and how do these two options affect an LBO model?

The terms of most Debt state that in a “change of control” scenario, the Debt must be repaid.
In LBO scenarios, PE firms must repay it with either Investor Equity (their cash) or new Debt.
In practice, most PE firms usually choose to “replace” a company’s existing Debt with new Debt in the same amount; using Investor Equity would reduce their returns.
“Assuming” Debt means that the PE firm keeps the existing Debt in place, or that it replaces it with new, identical Debt: In both cases, there’s no net impact on the Investor Equity required.
“Debt Assumed” shows up under both Sources and Uses in the S&U schedule.
“Refinancing” Debt means that the PE firm repays it using Investor Equity or some combination of Investor Equity and New Debt; in these cases, more Investor Equity (and, possibly, additional Debt) is required for the deal. “Debt Refinanced” shows up only on the Uses side of the S&U schedule.

How do the transaction and financing fees factor into the LBO model?

The company or PE firm must pay for these fees upfront in Cash, thereby increasing the purchase price, but the accounting treatment of the fees differs. Legal & Advisory Fees (e.g., fees paid to investment bankers, lawyers, accountants, etc.) are deducted from Cash and Retained Earnings.
Financing Fees (e.g., fees paid to lenders to arrange for the Debt), as of 2016 under both U.S. GAAP and IFRS, are deducted from the carrying value of the Debt and Cash on the other side of the Balance Sheet.
Even though the book value of Debt declines as a result of these fees, the company pays interest on the face value of the Debt, i.e. what it was before fees.
For a $100 million Debt issuance with $3 million in financing fees, the company pays interest on $100 million rather than $97 million.

Why might a company’s FCF in an LBO model differ from its Cash Flow Available for Debt Repayment?

It might differ because of the additional components that go into Cash Flow Available for Debt Repayment: The Beginning Cash, Minimum Cash, and Other Obligations.
For example, if a company generates $100 in FCF in the first year following an LBO, it won’t necessarily be able to repay exactly $100 of Debt; it might be more or less than that.
If it starts out with $100 in Cash that year, it might be able to repay $200 instead. But if its Minimum Cash Balance is $50, it can repay only $150.

What does the “tax shield” in an LBO mean?

All it means is that Interest on Debt reduces a company’s taxes because the Interest is tax-deductible.
However, the company’s cash flow is still lower than it would have been WITHOUT the Debt – the tax savings helps, but the additional Interest Expense still reduces Net Income.
Some people think this “tax shield” makes a huge difference in an LBO, but it makes a marginal impact next to key drivers such as the purchase and exit multiples.

How do you set up the formulas for Mandatory and Optional Debt Repayments in an LBO model?

Mandatory Principal Repayment for a tranche of Debt is based on the percentage that amortizes each year, the initial amount of Debt raised, and the amount of Debt remaining.
You should take the minimum between Amortization % * Initial Amount and Debt Remaining because you never want to repay more than the total remaining Debt (e.g., 20% * $100 million = $20 million per year, but if only $10 million is left, repay just the $10 million).
The Optional Debt Repayment formula is similar, but it’s based on the minimum between the Cash Flow Available at the current point and amount of Debt remaining at the current point.
For example, if, after Mandatory Repayments, the company has $100 million in cash flow and $250 million of Debt remaining, it would repay $100 million.
But if it had only $50 million remaining, it would repay that entire remaining $50 million.

How do you use a Revolver in an LBO model?

You draw on the Revolver when the company doesn’t have enough cash flow to meet its Mandatory Debt Repayments.
For example, if the company needs to repay $150 million in Debt principal, but it has only $100 million in Cash Flow Available for Debt Repayment, it would draw on $50 million from its Revolver to make up for the deficit and repay the full amount.
The company will then pay interest and fees on this additional borrowing, and it will repay the Revolver balance as soon as it can do so.
The Revolver is similar to a personal overdraft account at a bank.

Which Key Metrics and Ratios might you calculate in an LBO, and what do they tell you?

You calculate key metrics and ratios such as Debt / EBITDA, EBITDA / Interest, and FCF Conversion because they give you better insight into how a deal performs over time. They can also indicate how risky a deal is, what the key risks are, and if the PE firm can do anything to boost returns.
For example, if the company goes from 5x Debt / EBITDA to 3x in 1-2 years, perhaps the PE firm could use more Debt in the beginning, or it could do a Dividend Recap at that stage to boost its returns.
And if the company’s FCF Conversion increases from 10% to 30%, the deal is more attractive because it’s a sign that more of the returns come from Debt Paydown and Cash Generation.