Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes. Sometimes in LBO models, increasing the leverage increases the IRR up to a certain point – but then after that the … Read moreMost of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

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In an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell us about the company we’re modeling?

Yes, and it happens more commonly than you’d think. Remember, high-yield debt investors often get interest rates of 10-15% or more – which effectively guarantees an IRR in that range for them. So no matter what happens to the company or the market, that debt gets repaid and the debt investors get the interest payments. … Read moreIn an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell us about the company we’re modeling?

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How would you adjust the Income Statement in an LBO model?

The most common adjustments: • Cost Savings – Often you assume the PE firm cuts costs by laying off employees, which could affect COGS, Operating Expenses, or both. • New Depreciation Expense – This comes from any PP&E write-ups in the transaction. • New Amortization Expense – This includes both the amortization from writtenup intangibles … Read moreHow would you adjust the Income Statement in an LBO model?

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Walk me through how you calculate optional repayments on debt in an LBO model.

First, note that you only look at optional repayments for Revolvers and Term Loans – high-yield debt doesn’t have a prepayment option, so effectively it’s always $0. First, you check how much cash flow you have available based on your Beginning Cash Balance, Minimum Cash Balance, Cash Flow Available for Debt Repayment from the Cash … Read moreWalk me through how you calculate optional repayments on debt in an LBO model.

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Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use Section 338(h)(10) election?

In most cases, no – because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC shell company that “acquires” the company on paper.

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What are some examples of incurrence covenants? Maintenance covenants?

Incurrence Covenants: • Company cannot take on more than $2 billion of total debt. • Proceeds from any asset sales must be earmarked to repay debt. • Company cannot make acquisitions of over $200 million in size. • Company cannot spend more than $100 million on CapEx each year. Maintenance Covenants: • Total Debt / … Read moreWhat are some examples of incurrence covenants? Maintenance covenants?

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Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?

Unlike “normal” debt, a PIK loan does not require the borrower to make cash interest payments – instead, the interest just accrues to the loan principal, which keeps going up over time. A PIK “toggle” allows the company to choose whether to pay the interest in cash or have it accrue to the principal (these … Read moreWhy you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?

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Why might a private equity firm allot some of a company’s new equity in an LBO to a management option pool, and how would this affect the model?

This is done for the same reason you have an Earnout in an M&A deal: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment. The difference is that there’s no technical limit on how much management might receive from such an option pool: if they hit … Read moreWhy might a private equity firm allot some of a company’s new equity in an LBO to a management option pool, and how would this affect the model?

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Normally we care about the IRR for the equity investors in an LBO – the PE firm that buys the company – but how do we calculate the IRR for the debt investors?

For the debt investors, you need to calculate the interest and principal payments they receive from the company each year. Then you simply use the IRR function in Excel and start with the negative amount of the original debt for “Year 0,” assume that the interest and principal payments each year are your “cash flows” … Read moreNormally we care about the IRR for the equity investors in an LBO – the PE firm that buys the company – but how do we calculate the IRR for the debt investors?

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