Best practice answer paper LBO debt assumption
In most live paper LBOs I wasn't given a debt assumption but instead they ask you to figure out what it should be. Curious to know what a best practice answer looks like. My current answer looks a bit like the following:
1) Determine Debt-to-equity convenants to set max value of debt (e.g. max 50% debt)
2) Understand how much debt company can carry from cashflow perspective in year 1: (EBITDA-CapEx-Unlevered Tax)/(Interest (post tax)+Amortization) or take cash conversion (EBITDA * Cash conversion) / debt service coverage ratio / cost of debt (post tax)
3) Take the max value of the two, and voila that's the debt we can carry
Am I missing something major? Do they expect you to talk to how you think about e.g. cyclicality of the business, assets we own and can use as collateral, state of the debt market, comparable transaction debt structures etc.? I'm just not sure what they expect
Either assume a typical industry comp (4-6x turns of EBITDA) possibly segmented with senior leverage 2-3x and 2-3x mezz/junior.
Or look at your gross PP&E/hard asset value to see how much leverage the business can take.
That's very short no - not sure that suffices?
Any other opinions/experiences, especially from people in the industry, would be very helpful
I presume they’d want to pick your brain about 1) debt sizing methods and 2) determining how much debt a business can hold.
With regards to (1), cash flow based debt sizing (NPV of CFADS over tenure at fixed post-tax rate) is very helpful to understand the theoretical maximum amount a company could borrow if cash flows were 100% guaranteed i.e. not a single dollar less of cash was generated. Clearly this analysis is used hand in hand with turns of EBITDA based on precedents and leveraged loan market volumes.
(2) I’d expect them to want to you to outline a number of things including capital intensity, defensibility / cyclicality of cash flow generation, sustainability of growth / margins to name a few. Downside to cash flow sizing in (1) above is conducted, the extent of which depends on factors such as cash flow cyclicality. Does a snacking brands business have more defensible cash flows than a high growth tech start up? Absolutely- therefore the ultimate debt quantum will be closer to the maximum amount determined under CF based sizing than the tech start up
Thanks, very helpful. If you take NPV of CFADS, does this imply you assume they want you to pay off the full amount of debt at the end of the holding period? Not sure why would you take the NPV rather than Year 1?
That's correct, by taking NPV of CFADS over the tenure you are implicitly assuming it is an amortising loan.
If you wanted to have a bullet, you would take CFADS/(1+Kd post-tax).
Debt sculpting is something I'd doubt you'd get into in the context of this case study but a great thing to know.
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