Interview questions on LBOs

thadonmegaIf ever, when investor demand for high yield debt and junk bonds returns, to maximize LBO IRR just before exiting:

1. Negotiate the lowest purchase price possible during negotiations.
2. Use as much leverage as possible, but don't be too aggressive, i.e. 60-85% leverage tops.
3. Plug in PIK toggles (tough sell, but try) and other hybrids such as Mezzanine debt to minimize the equity portion. If the MZ loan has an "equity kicker", or warrant call option on the target's stock, minimize it as much as possible. 3b. Aim to raise more debt from "cheaper", lower rate, secured bank loans to lower interest expenses after closing, and minimize the more "expensive" junk bonds, and leveraged/MZ loans.
4. Maximize your cash flows at an increasing pace up till the point of exit, by improving your cost structure and improving margins. If you can boost revenues, great, but operationally you're more likely to improve margins by lowering costs.
5. Lower taxes via interest tax shields from debt, depreciation tax shields from asset step ups (assuming the tax structure permits step-ups), and tax-deductible goodwill amortization expenses on the tax side, not the financial accounting side. Note: I said "tax" goodwill not GAAP.

6. If the target has accumulated NOL's, it could be carried over to Acquisition-SubCo, thus helping taxes, and freeing up cash flows to aggresively pay down debt.

7. Try to pay down as much debt as possible by "focusing" the firm by selling off unrelated & underperforming units. The market always rewards "focus" and industry leadership. The #1 and #2 players in any industry, always have much higher P/E multiples and command higher valuations.

8. Split up diversified conglomerates to unlock value, do some follow-on acquisitions to bolster leadership, and spin them off!
9. Lower debt/leverage levels to optimal debt levels (optimum capital structure) which minimizes the WACC, and in turn maximizes your LBO equity value just before exit.

• The Key is paying down debt until you reach your optimal leverage level, usually around 30% debt ratio for most industries, then exit via strategic sale or IPO.

*You don't want to completely pay down the debt, implying an unlevered firm financed with 100% equity, because such a firm is not optimal, and won't command maximum value, that's why the F500 Co's continuously issue bonds and commercial paper to maintain optimal debt levels that maximize shareholder value, so always maintain optimal debt on the target's books until you exit, and reap your returns.

Goodluck on the interviews!

good input. can you explain why companies with low leverage make more attractive targets? I've seen an explanation on here before but i found it was not very compelling.

pleasehelpme

But it's usually a debt ratio (around ~30%) at which the weighted average cost of capital is fully minimized, so firm value is maximized.

It is calculated by evaluating the Rwacc (ReL, Rd*(1-t)) at various D/E ratios and plotting a graph to find a minimum point.

For various D/E ratios: 1. You get an expected interest coverage ratio 2. Getthe expected credit rating 3. Then get the expected cost of debt from moody's/s&p 4. Then get the cost of equity using the CAPM for each D/E ratio. 5. For each D/E get the WACC.

Plot a graph of ReL, Rd, and Rwacc.

What you'll notice is that as leverage (D/E) goes up, ReL and Rd will go up, as expected.

But, the Rwacc is unique, in that instead of increasing with leverage, initially from 0% leverage, the Rwacc actually goes down, then reaches a minimum.

The D/D+E ratio at which the Rwacc is at a minimum is the optimal capital structure for that firm, and is usually around 30% leverage. Also, because the Rwacc is minimized, at this point firm value is maximized.

You're saying that after 30% leverage, Wacc starts to go up? For firms generally?

I'm very skeptical about this. Wacc will often continue to go down well beyond 30% leverage, because debt at those levels (even now) is often cheaper than unlevered equity. What makes wacc turn upward is the expected cost of financial distress (ie bankruptcy) which is exceedingly difficult to estimate. The cost of bankruptcy itself can be estimated, but the probability multiplied to it is anyone's guess. Not enough comparable firms with comparable capital structures go bankrupt under comparable market conditions to give you a reasonably good predictor.

Corporate finance academics (the ones I've read) are virtually unanimous in that there is no way to conclusively arrive at an "optimal" capital structure - for many more reasons that I've outlined above.

ArtsA company has finite debt capacity. Targets with lower existing leverage have higher debt capacities targets with higher existing leverage. You cant LBO a company if you cant lever it up from existing levels. Make sense?

i see what you're saying, but isn't it the case that the acquirer will often pay down the existing debt and refinance it with new debt, thus making the current debt levels less relevant? or does this all vary from one situation to the next?