No template LBO test: creating reasonable assumptions?
I recently had a 24h LBO test. All I was given was a CIM, a few data room items, and I was told to create a basic model.
I got the feedback that while my model was technically correct, the assumptions were not realistic. Given that I come from a non-traditional background (equity research), I'm not sure how I could have done any better.
Can someone provide guidance on reasonable assumptions for the following:
- % debt vs equity? (I believe it's commonly 40-60% debt, but how do I decide?)
- Purchase multiple? I based it on public comps (I wasn't aware of precedent transactions in the space) and basically did the max multiple we could pay, while still getting 25% IRR (based on the sensitivity table I built)
- Interest coverage ratio? (Y1 and Y5)
- Net debt to EBITDA? (Y1 and Y5)
- Debt structure? (I just did "revolver", "bank debt," "senior notes")
- Reasonable interest rate for each? (I assumed SOFR + 400 for the revolver, S + 500 for bank debt, and S + 600 for senior notes — and then looked up projected SOFR for the 5-years)
- Any good model templates?
I don't know what I don't know, so I don't know what exactly I did wrong. Can anyone please provide guidance on the above, as well as any flaws in my thinking, and common pitfalls you see?
Thank you!
Can you add a little more context? You sound quite prepared and these assumptions seem reasonable.
Did they give any specific feedback as to which assumptions?
Do you find these assumptions reasonable? They didn't give any specific feedback. Obviously, having never been on the job, it won't be perfect. That's why I was wondering if anyone has any model templates / any thoughts on the assumptions. If it makes any difference, I used P___ Frameworks to learn (when I type out the name, I get flagged for promoting a service), and I based on my model on their formatting.
Yeah definitely reads like PF. I guess my question was driving at did you miss something major. As in, you used a 6x EBITDA multiple for a high growth, high margin software business, or the CIM + files from the data room would suggest a drastically different growth rate than the one you chose. Ultimately without seeing the test, it’s hard to know what assumptions were off and why
Debt quantum determination is an art, not a science. Total Leverage will be based on leverage comps, LBO precedents, and deleveraging ability - aka, how much debt can the target handle while staying solvent / financially compliant with debt service and tests / and still achieve a decent IRR and MOIC.
Senior notes should have been fixed rate. No actual reason to include bonds for that matter unless instructed to or you had a rationale behind it. Interest on the RCF and term loan (bank debt is a rookie wallstreetprep training term) will normally be the same in the case of them both being new money same time issuances, and slightly lower rates than what you described, although it varies by CFR / Industry / company.
Generally DSCR and FCCR are the focal points in terms of assessing coverage - unless there are other covenant tests specified.
Source: I facilitate and grade LBO tests / case studies.
Thank you, this is a very helpful! I guess, for a no template LBO test, would the following be reasonable: just 2 tranches of debt... RCF and term loan... interest rate SOFR + 300... no mandatory amortization. For SOFR you would look up SOFR forward curve to get SOFR for all 5 years.
For DSCR, there's two ways of calculating it: EBITDA/(principle+interest) or (EBITDA+Capex)/(principle+interest). Which one would you advise, and do you know what would be a reasonable DSCR to maintain?
For FCCR, my understanding is a reasonable ratio is >1.2x all 5 years.
Interest coverage ratio should be above >2 in the 1st year and definitely above 1.
Sorry for these basic questions. Just trying to understand what a simple, reasonable debt structure would be.
Without any additional context - generally speaking for a generic assumption, if the term loan is sub ~$400mm in size, then it would probably be a Term Loan A in the context of US IB (I've seen plenty of exceptions to this). If it is ~$400mm+ then probably a term loan B (I've seen exceptions to this).
The TLA ("Bank debt" - because banks are funding / investing the capital) would have higher amort (~5%+ / annually and usually stepping). TLA would traditionally have a slightly lower rate than the TLB comparatively (Because of the higher amort + maintenance covenants, the TLA is a less risky investment on paper vs TLBs, for the smaller regional banks (Citizens, TD commercial, BofA commercial, etc.) that fund these tranches.
The TLB ("Institutional tranche" - bond like investors (Insurance, pensions, credit funds - MetLife, BlackRock, Ares, Oakhill, Oaktree, Blackstone Credit, etc.) are funding / investing the capital) would have ~1-2% amort usually ("Nominal amort").
^If the senior 1L leverage stats start to become inflated, the TLB market looks grim (TLBs are traded which factor into their ultimate pricing), or the bank is capped on senior leverage from a risk standpoint - then we would look into alternative sources of capital, de-lever the TL proposal potentially, and potentially look into adding HY bonds. However, HY bonds can complicate things for a number of reasons. Namely restrictions on incurring additional debt, a non-call period that prevents you from paying back the debt early, amendments are more challenging than on term loans, covenants can limit or cap the sale of assets (This could obstruct the company's strategy to a certain degree), limits or caps on M&A (Could inhibit bolt-on acquisitions). Some Sponsors and companies also just don't like bond issuances (Ex: Thoma Bravo).
For the SOFR curve - yes, I would probably just use "Chathamfinancial"(.com) to look up curves if you don't have Bloomberg or another similar support service at your disposal.
I've personally seen DSCR calculated differently at different firms / funds. For the sake of simplicity - I would show both to be exhaustive, with the metric inclusive of capex labeled as "Adjusted DSCR". In real life during a presentation this could be a notable point to highlight in relation to capex impacting paydown. In real life, credit stats like this would be clearly defined by seniors / lawyers and it would not be up to a brand new analyst to decide what the best course of action is initially.
^the differing calculations will also convolute the consistency regarding "what a good coverage multiple would / should be".
Your assumptions around what a reasonable ratio should be for DSCR / FCCR / ICR are in the right zip code. There's some variability obviously, but those figures you described could very well be the floor defined by the respective hypothetical covenant / risk trigger / set of investment mandate parameters, in which for the covenant - dropping below said limits would indicate a breach of contract as it relates to the relevant counterparties, and likely commend some sort of equity cure, amendment or other form of financial recoupment. The truth is - it depends on how risky the opportunity is, what the target / investment actually is (A cash flow challenged distressed buyout will have more leniency than a vanilla corporate LBO), what does growth look like, who is the investor? Different funds will have different mandates which entail different risk appetites. Nonetheless, the higher the cushion the better off.
From the perspective of a lender, a LevFin team at an IB would ideally like to stay above ~1.25x DSCR throughout the investment horizon in a highly levered LBO type transaction to avoid scrutiny from the OCC / risk management as it relates to leverage lending restrictions. But that's not to say it doesn't sink below that in specific situations that involve a fast growing, high cash generative business or your MD's favorite Tier 1 client.
These sorts of hurdles are a huge driver of why the private credit space has exploded in recent years. A private credit firm may be okay with lower coverage, but they will normally charge the client higher rates / fees accordingly to compensate the risk at play - the aforementioned S+300 could evolve into a hypothetical S+~500-700 PC solution.
Most of this probably goes beyond what was expected for your assessment. At the end of the day, I think the important part is understanding why you chose your assumptions, having well thought out reasons behind them and being able to defend them to a certain degree.
Ex:
1. "I added a DCSR metric to incorporate capex, because this is a capital-intensive industrials manufacturer and we need to be cognizant of how that is impacting cash flow".
2. Didn't use HY bonds because the negative covenants would potentially compromise TargetCo's strategic M&A growth plans and asset sales in year 2 of the investment horizon.
EDIT: Finished typing this at brunch - will add a few details / clarify a few points after I get a few thinking beers in my system.
you didn't mention anything about your operating assumptions - it's kinda surprising to have 25% IRR with the max purchase multiple. usually i aim for 15-20% irr in the base case (which is not max purchase multiple)
Was this for a PE interview?
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