LBO MODEL GUIDE EXAM QUESTIONS AND
ANSWERS WITH COMPLETE SOLUTIONS VERIFIED
GRADED A++
Does reducing the amount of cash you pay upfront increase or decrease your
returns? Why?
Increase; money today is worth more than money tomorrow
Basic explanation of what a PE firm does
It buys a company using some combination of debt and equity and then sell it in 3-5
years for a return. The firm uses the company's cash flows to pay off interest and debt
principal
The 3 key reasons that an LBO works
1. By using debt, you reduce up-front cash payment for the company, which increases
your returns
2. Using the company's cash flows to pay interest and repay debt principal produces a
better return than keeping the cash flow
3. You sell the company in the future, which allows you to gain back the majority of the
funds used to acquire the company in the first place
Unlike a merger model, you do not assume that the PE firm keeps the company
for ______. If it did that, then you would not realize super high returns
the long term
,The Mechanics of an LBO -- Step 1
PE firm calculates how much it will cost to acquire all of the shares outstanding (public
comp) or simply buy the company (private comp)
The Mechanics of an LBO -- Step 2
To raise the funds, the PE firm will use a small amount of cash on-hand (usually less
than 50% of the company's total value) and then raise debt from investors to pay the
rest
The Mechanics of an LBO -- Step 3
It can raise debt from investors bc they can say, "we're using debt to buy an income
generating asset. and we'll repay everything because "we will sell this company in the
future and use the proceeds to pay you back"
The Mechanics of an LBO -- Step 4
PE firm raises debt from investors, and then it combines that cash with its own cash to
acquire the company
The Mechanics of an LBO -- Step 5
PE firm operates the company for years into the future, and uses its cash flow to pay
the interest and repay the debt that it borrowed
The Mechanics of an LBO -- Step 6
At the end of 3-5 years, the PE firm sells the company or takes it public via an IPO in
order to realize a return
What makes a good LBO candidate?
- stable and predictable cash flows
- undervalued relative to peers in the industry
,- low risk business
- not much need for ongoing investments such as CapEx
- Has an opportunity to cut costs and increase margins
- has a strong management team
- solid base of assets to use as collateral for debt
the first point is the most important -- its why LBOs rarely happen in oil & gas/other
commodities industries ... the price of commodities is volatile and can push cash flows
up or down from year to year
3 major components of basic model assumptions
1. assume a purchase price and the amount of debt and equity you will be using
2. figure out debt terms, including interest rate and annual repayment
3. create a Sources and Uses schedule that tracks where your funds are coming from,
and where they're going to
Bank debt generally has ___ interest rates bc it is less risky and secured by
collateral
lower
High yield debt tends to have _____ interest rates and no annual repayment bc it
is unsecured and therefore riskier so investors will demand higher returns as a
result
higher
Bank debt has maintenance covenants, which are...
, e.g. total debt/EBITDA must always be below 4x, or EBITDA/interest expense must
always be above 2x
financial requirements that the borrower must meet
High yield debt has incurrence covenants, which are ...
e.g. the company cannot acquire another company and cannot sell off its assets
Leverage ratio
Debt/EBITDA
Interest Coverage Ratio
EBITDA / Interest Expense
Factors that go into decisions about an LBO
Leverage ratio and how it stacks up against similar companies
Interest coverage ratio and how it stacks up
does company have any major expansion plans or acquisitions that would limit the
amount of debt it could take on
what are lenders comfortable with? will it be more difficult to get investors on board w/
certain debt structures
The PE firm may have to use funds to refinance debt, meaning WHAT in the case
of an LBO?
May have to pay off the debt of the company it is buying?
Most of the time, the PE firm will refinance the acquisition's debt and pay it off,
but sometimes it will ___ the debt, meaning what?
assume; the remaining debt remains on the company's BS after the acquisition
ANSWERS WITH COMPLETE SOLUTIONS VERIFIED
GRADED A++
Does reducing the amount of cash you pay upfront increase or decrease your
returns? Why?
Increase; money today is worth more than money tomorrow
Basic explanation of what a PE firm does
It buys a company using some combination of debt and equity and then sell it in 3-5
years for a return. The firm uses the company's cash flows to pay off interest and debt
principal
The 3 key reasons that an LBO works
1. By using debt, you reduce up-front cash payment for the company, which increases
your returns
2. Using the company's cash flows to pay interest and repay debt principal produces a
better return than keeping the cash flow
3. You sell the company in the future, which allows you to gain back the majority of the
funds used to acquire the company in the first place
Unlike a merger model, you do not assume that the PE firm keeps the company
for ______. If it did that, then you would not realize super high returns
the long term
,The Mechanics of an LBO -- Step 1
PE firm calculates how much it will cost to acquire all of the shares outstanding (public
comp) or simply buy the company (private comp)
The Mechanics of an LBO -- Step 2
To raise the funds, the PE firm will use a small amount of cash on-hand (usually less
than 50% of the company's total value) and then raise debt from investors to pay the
rest
The Mechanics of an LBO -- Step 3
It can raise debt from investors bc they can say, "we're using debt to buy an income
generating asset. and we'll repay everything because "we will sell this company in the
future and use the proceeds to pay you back"
The Mechanics of an LBO -- Step 4
PE firm raises debt from investors, and then it combines that cash with its own cash to
acquire the company
The Mechanics of an LBO -- Step 5
PE firm operates the company for years into the future, and uses its cash flow to pay
the interest and repay the debt that it borrowed
The Mechanics of an LBO -- Step 6
At the end of 3-5 years, the PE firm sells the company or takes it public via an IPO in
order to realize a return
What makes a good LBO candidate?
- stable and predictable cash flows
- undervalued relative to peers in the industry
,- low risk business
- not much need for ongoing investments such as CapEx
- Has an opportunity to cut costs and increase margins
- has a strong management team
- solid base of assets to use as collateral for debt
the first point is the most important -- its why LBOs rarely happen in oil & gas/other
commodities industries ... the price of commodities is volatile and can push cash flows
up or down from year to year
3 major components of basic model assumptions
1. assume a purchase price and the amount of debt and equity you will be using
2. figure out debt terms, including interest rate and annual repayment
3. create a Sources and Uses schedule that tracks where your funds are coming from,
and where they're going to
Bank debt generally has ___ interest rates bc it is less risky and secured by
collateral
lower
High yield debt tends to have _____ interest rates and no annual repayment bc it
is unsecured and therefore riskier so investors will demand higher returns as a
result
higher
Bank debt has maintenance covenants, which are...
, e.g. total debt/EBITDA must always be below 4x, or EBITDA/interest expense must
always be above 2x
financial requirements that the borrower must meet
High yield debt has incurrence covenants, which are ...
e.g. the company cannot acquire another company and cannot sell off its assets
Leverage ratio
Debt/EBITDA
Interest Coverage Ratio
EBITDA / Interest Expense
Factors that go into decisions about an LBO
Leverage ratio and how it stacks up against similar companies
Interest coverage ratio and how it stacks up
does company have any major expansion plans or acquisitions that would limit the
amount of debt it could take on
what are lenders comfortable with? will it be more difficult to get investors on board w/
certain debt structures
The PE firm may have to use funds to refinance debt, meaning WHAT in the case
of an LBO?
May have to pay off the debt of the company it is buying?
Most of the time, the PE firm will refinance the acquisition's debt and pay it off,
but sometimes it will ___ the debt, meaning what?
assume; the remaining debt remains on the company's BS after the acquisition
