Was looking through previous SA interview questions and encountered this question: If an LBO was bought for 100 million and sold after 5 years for 100 million, could the PE firm still realize a return?
What would be the right answer/explanation? Is it as simple as just saying that as long as the buyout used leverage and had FCFs to pay down the debt, they would realize a return?
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Imagine you bought a house for $100. To complete this purchase you made a $20 down payment (equity) and got $80 from a bank loan (debt). You rent out the house and are able to payoff the loan (debt) in 5 years. Therefore the capitalization of the home is now $0 of debt (since you paid it all off) and $100 in equity. What’s your return? Well, you only invested $20 but are able to receive $100 if you sell the home. Additionally you were able to keep any rental income left over after paying the monthly loan payments. Big picture: PE firms can boost returns by increasing FCFs. They can use this to accelerate debt repayment or pay themselves dividends.
Awesome, thank you for the detailed response
It’s basically baked into your answer, but it’s important to emphasize that the answer doesn’t depend on debt. If you buy an asset that yields 15% on an unlevered fcf basis, you’re obviously making a healthy return even without debt and without any price appreciation. Adding a tranche of lower CoC financing (e.g. bank debt) just juices the return further.
What's the typical debt / equity ratio in lbos nowadays?
Wouldn’t it kinda depend on debt though?…that’s how you’re getting the return you want in the answer regardless of FCF.
Yes and no. Obviously yes, equity returns depend on the debt. However, the commenter above had given an example with a house that was financed with debt. My point was that your example doesn't need to include debt. Let's stick with their house example:
Did we make a return? Obviously yes.
For the interview question in the OP, the question is getting at whether a candidate understands that the cashflows during the investment matter (whether you distribute those or use them to pay down debt). My point was that the answer to that interview question doesn't need to include debt.
Ah, a classic LBO question! You're on the right track. The key here is understanding that in a leveraged buyout (LBO), the private equity firm uses a significant amount of borrowed money (leverage) to finance the acquisition of a company.
So, let's say the PE firm bought the company for $100 million using $80 million of debt and $20 million of equity. If the company is sold for $100 million after 5 years, the PE firm doesn't necessarily make a loss.
Here's why:
During the 5 years, if the company has been generating free cash flows, these can be used to pay down the debt. So, by the time of the sale, the debt could be significantly reduced or even completely paid off.
When the company is sold, the proceeds first go to repay any remaining debt, and then the rest goes to the equity holders (i.e., the PE firm).
So, if the debt has been paid down to, say, $30 million by the time of the sale, the PE firm would get $70 million from the sale ($100 million sale price - $30 million remaining debt). That's a $50 million return on their $20 million equity investment, even though the sale price is the same as the purchase price!
Remember, this is a simplified explanation and actual LBOs involve many more factors, including interest payments, changes in working capital, and more. But hopefully, this gives you a good starting point to understand the concept. Keep swinging through those financial vines!
Sources: LBO Returns - Increasing Leverage Doesn't Increase Returns?, When did LBO become a valuation technique?, LBOs - Why repay debt instead of keeping cash flow?, Corp Dev LBO returns question: Levered and Unlevered IRR
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