LBO Case Study Analysis

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Got this recent case study for LBO/Returns Analysis modeling, and really need some help trying to figure out how to attack this - can anyone provide some help or answers (DM is also preferred)!

Specifically with:
- How do I structure this out (steps - i.e., make sources/uses, then P&L (do I go to interest and taxes), then CFS, then DCF; then debt returns/capital structure waterfall, etc.)?
- Proper method of attacking these questions.
- How to practice to do this within 2 hours?

Thanks!

  1. Sponsor acquires a US business for $300m and puts in place the following structure:
    • Sponsor invests $100m
    • $125m of external bank debt
    • The seller leaves in $75m
  2. Sponsor own 95% of the ordinary shares of the company with management owning the remaining at 5%
  3. Sponsor's money is in the form of a loan note and attracts an initial 15% non-cash pay coupon which is rolled-up annually. This note is subordinate to the bank debt and the vendor paper.
  4. The bank debt attracts a coupon of 8% per annum cash pay and is repaid 5% in year 1, 10% in year 2 and 12.5% in year three.
  5. The seller paper is also in the form of a loan note and attracts a 12.5% non-cash pay coupon which accrues annually. This note is subordinated to the bank debt.
  6. It is intended to raise some more bank debt at the end of year one in order to refinance the seller paper. The amount that can be raised is either:
    • £25m
    • £50m
    • £75m
    • £100m
  7. For the purposes of this exercise, assume that this new debt is put in as a new facility with the same terms as the existing facility and that the existing facility stays in place.
  8. Assume there is no cash sweep.
  9. The forecasts at the time of the deal were EBITDA is $40m in year 1, $42.5m in year 2 and $45m in year 3 (historic EBITDA at acquisition was $37.5m)
  10. It is thought that capex over this period will be $10m per annum (equal to depreciation).
  11. Change in working capital is 0 (not source or use)
  12. Tax will be charged at 30%.

13. Assume an exit after 3 years at 3 different enterprise values $300m, $350m and $400m.

Questions:

  • What is Sponsor's IRR, and multiple of investment at each of the three enterprise values at each of the 4 levels of refinancing?
  • What are the issues that we need to consider in deciding what the level of refinancing should be?
  • What is your recommended level of refinancing?
  • Which EV exit is realistic given the data provided and what return would you expect.
  • What return should you be looking for with this kind of business
  • Is the shareholder loan note interest tax deductible

THANKS ALL!

Comments (66)

 
Dec 13, 2011 - 8:51am

2 hours is plenty:
-30 to 45 minutes for model (assuming starting from scratch)
-10 minutes to format model to make it look pretty
-10 minutes to go through model to make sure there are no mistakes / mis-links
-10 to 15 minutes to answer questions

 
Dec 13, 2011 - 11:37am
  1. Build the 3 statements first. Start with historical P&L and BS. Build supplemental schedules (PP&E, D&A, Working Capital). Project P&L and BS (only current assets, PP&E, and current liabilities) next. Create sources and uses and opening balance sheet. Create debt and equity schedules. Link to BS and P&L. Create CF page. Calculate returns. I would have one switch for the amount of year 1 refinancing. I would have another for the 3 EVs in year 3. This order is not the only way , but I think it's fairly straightforward and will save time when linking all the tabs together.

  2. Once you have the model built and tested, then go about answering the questions. Consider adding a page to the model that analyzes credit and leverage statistics to evaluate the amount of debt to take on in the refinancing. With very steady and relatively high growth, you should definitely get more than the 300M you paid for it. You grew EBITDA at a CAGR of ~6.3%, so why would your EV/EBITDA multiple decrease from 8.0x to 6.7x (300M EV) or 7.7x (350M EV)? Without any information regarding how the growth was achieved, I think a 400M EV would be more likely. That said, there are a million reasons why you could be right back at a 300M EV. None of them are apparent from the information you've listed above, however.

  3. Practice doing the model as quickly as possible, but make sure that it's completely error-free each time. The less time it takes you to do the math, the more time you have to analyze the deal.

 
Dec 23, 2011 - 11:12pm

threatlevelmidnight:
1. Build the 3 statements first. Start with historical P&L and BS. Build supplemental schedules (PP&E, D&A, Working Capital). Project P&L and BS (only current assets, PP&E, and current liabilities) next. Create sources and uses and opening balance sheet. Create debt and equity schedules. Link to BS and P&L. Create CF page. Calculate returns. I would have one switch for the amount of year 1 refinancing. I would have another for the 3 EVs in year 3. This order is not the only way , but I think it's fairly straightforward and will save time when linking all the tabs together.

This is the kind of thing someone who spends all their time using group templates would do. If you actually read the situation and can picture what is needed, you would quickly see that the model required is actually a very basic EBITDA to FCF projection with a sensitivity table for the different EVs to see the effect on sponsor IRR and state which valuation is more likely given the limited information you have.

With regards to the questions,
1. Sponsor IRR calculation should be straight forward under the three EV scenarios. Don't forget to back out management's equity value when calculating this.
2. issues to consider for refi include effect of cash interest on FCF before investment exit, state of debt markets at the time of original debt financing, and general economic forecasts of debt markets at the time of refi (e.g. if this was a current situation, I would be worried about the prospects of being able to refi debt in the future at levels possible 6 months ago), possible need to increase coupon on existing bank debt to receive permission of insertion of new pari passu bank debt in the cap structure (assuming the prior bank debt have covenants protecting against this) etc. With regards to the refi situation, you have to think about it from a credit perspective.

Additional things you may want to think about and/or do (in addition to other good points mentioned by others in the thread):

  1. Build out your own "downside scenario" where you lower those EBITDA assumptions. I am constantly amazed by the bullishness of initial sponsor assumptions in some of the situations I've been analysing.

  2. Put the deal into context of what's going on in the economy today. Here you're looking at a company initially levered at 5x EBITDA. Will such a levered cap structure be justifiable at the refi date? If refi debt will be senior debt, what multiple of senior debt do you think is reasonable for such a company to have? If 3x, at $42.5m EBITDA, you're looking for senior debt of $127.5m, which means you may not even be able to refi with senior debt at all unless credit market conditions IMPROVE from conditions at transaction close. Note that senior debt at transaction close was only 3x as well. I haven't included the amort profile of existing senior debt, but if you count all of that, and assume a 3x senior debt to EBITDA multiple, you may only be able to raise about £25m in new senior debt to refi the seller loan. More likely you'll only be able to retire some of the sellers loan, and maintain the balance till transaction exit.

I'll stop there, but I hope you get the point. The "model" part of the case study should be where you spend the least amount of time. For this given case, you should be able to build the model in 20-30 mins, and focus on other areas that may really make or break the investment.

 
Aug 14, 2020 - 10:10am

Can you explain how you'd allocate the mgmt portion of the equity?

If you see something like 5% management, is it to be interpreted as you simply take 5% away from the final exit equity (multiply by 0.95 to get to the sponsor's allocated amount)?
Sponsor Exit = Exit Equity Value * 0.95

Or is it more of an options interpretation where if the exit equity > entry equity, you adjust the entry equity up by 5% and then subtract the pro-rata (5/105)% out of (the initial resulting exit equity + the upsize amount by 5%)?
Initial Exit = Sale TEV - Net Debt
Mgmt Injection = IF(Initial Exit > Sponsor Entry Equity, 5% * Sponsor Entry Equity, 0)
Mgmt Value = IF(Mgmt Injection > 0, -(Mgmt Injection/ (Mgmt Injection + Initial Exit)) * (Mgmt Injection + Sponsor Entry Equity),0)
Sponsor Exit = Initial Exit + Mgmt Injection - Mgmt Value

Array

 
Dec 13, 2011 - 12:12pm

IRR falls b/w 11% and 33% across the EVs and Refi scenarios.

In looking at the refi, you need to balance enhancing sponsor returns w/ the risk of additional debt. For example, under the 100m refi scenario the company is more leveraged that it was at close.

Refi at 75m...the returns aren't very sensitive to the refi level either way so no need to swing for the fences.

The sponsor paid 8.0x for it...assuming they can exit for the same amount the 350m exit is seems to be most likely.

Exiting at 350m having gone with the 75m refi puts the IRR around 25%. Not sufficient info to really go into the risk/return discussion.

No clue about tax treatment on shareholder loan notes in the UK.

 
Dec 13, 2011 - 10:06pm

I think this is actually easier than most case studies...you really dont need to make the full three statements and all the assumptions are given. You can just do a modified cash flow stament with a sperate debt schedule. If you cant get this running in 30-45 minutes you need to spend more time practicing....

 
Dec 15, 2011 - 6:27am

Yep, not that difficult techically. Your P&L and CF statement are merged into a basic EBITDA to cash spreadsheet.
I suppose they will expect thoughts about the business when it comes to refinancing. This is key in my view as you hardly make a good IRR on this EBITDA growth and cash-conversion of c. 50-60% after senior servicing.
You don't want to go 75/25 D/E on a cyclical business in my view which is the case if you raise $100m.

Only moot point is all the PIK in the capital structure.

 
Feb 1, 2012 - 4:39am

Shareholder loan is only tax deductible if at arms length - very complex legislation around it in the UK and best to have it not tax deductible.

Also on refi - if you are going to refi the seller paper then best to refi the accrued coupon as well otherwise it will keep accruing (the whole purpose of refi is to eliminate that particular tranch of debt).

 
Feb 1, 2012 - 9:08am

Need the 100 refi for the seller paper, with the remaining cash being used as a dividend.

 
Feb 1, 2012 - 10:17pm

my understanding is that seller and shareholder notes would be sub/mezz debt with PIK interest, similar to preferred equity with mandatory non-cash interest.
i think 2 hours is about right (or maybe i'm just slow). took me about an hour to build, 20-30 minutes to debug, and a few minutes to answer the questions.
i got 26%, assuming a dividend recap. link to model and questions below. i'd be interested in hearing thoughts on the questions.

http://www.mediafire.com/?015okul1ul5lnea

-- sm
 
Feb 1, 2012 - 9:36pm

Surefire:
http://www.mediafire.com/?v0m3fckcu1hchnu

Anybody care to take a look?

Also, what is a shareholder loan note and why is not considered debt?


take a look at cash impact of amortization. also should retire seller note and buyer note before equity at exit right? sponsor gets 0% of seller note (only matters in refi scenarios of $75 or lower), 100% of buyer note, and then 95% of remaining equity value.
-- sm
 
Feb 2, 2012 - 10:49am

Why does everybody ignore that the refi numbers are in GPB? The 75m and 100m are more than enough to repay the seller loan and pay a dividend

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger
 
Feb 2, 2012 - 11:02am

Ashley Schaeffer:
speedmerchant: I think your'e underestimating non-cash interest because you're not including the PIK on sponsor subordinated note

i ignored sponsor interest in the calculation of taxes because i didn't think the interest expense would be tax deductible. from an accounting standpoint, i think you would place that expense south of taxes but north of income, but because i didn't make a balance sheet and wasn't doing anything with retained earnings, i just left it out of the income statement altogether.
-- sm
 
Feb 2, 2012 - 4:49pm

speedmerchant:
Ashley Schaeffer:
speedmerchant: I think your'e underestimating non-cash interest because you're not including the PIK on sponsor subordinated note

i ignored sponsor interest in the calculation of taxes because i didn't think the interest expense would be tax deductible. from an accounting standpoint, i think you would place that expense south of taxes but north of income, but because i didn't make a balance sheet and wasn't doing anything with retained earnings, i just left it out of the income statement altogether.

Do payments from the debt amortization schedule always go in the income statement's amortization even if they are cash charges?

 
Feb 2, 2012 - 5:16pm

Ashley Schaeffer:
I think that is incorrect. Debt amortization is paydown of the principal, which should only impact the statement of cash flows and the liabilities side of the balance sheet, which in this case is non material. Paydown of debt shouldn't be tax deductable...

that's right. cash repayment in scheduled amort is just BS and CF. the tax deductible portion is the interest expense.
good catch. i think i had amort in the IS before taxes which would understate taxes.
-- sm
 
Jan 14, 2017 - 11:25am

I don't understand:

The bank debt attracts a coupon of 8% per annum cash pay and is repaid 5% in year 1, 10% in year 2 and 12.5% in year three.

Is the 8% PIK on the bank debt? If not, how are you paying 27.5% in cash, but actual coupon is 24% (8.0% x 3) over 3 years?

Can someone explain? Thanks.

 
Jan 28, 2017 - 8:49pm

I'm so confused with this scenario - a shareholders loan is basically the PE firm putting in a debt total instead of equity? The PIK interest accrues on this loan, and at exit, you deduct all outstanding debt, but add back the total principal + accrued interest (since you are receiving the payment). So it would look like:

Exit EBITDA x EBITDA Multiple = TEV at Exit
Less: Total Debt Outstanding (which includes the bank debt, the vendor from the seller, and the shareholders loan)
Plus: shareholders loan (principal plus accrued interest)
= equity value at Exit
Less: Mgmt. share of company
=Equity Value to Sponsor?

sorry to bump this again, I saw the case on "ask ivy" and there is no answer key.

 
Jan 29, 2017 - 8:38am

This is correct. I think it is easier to structure it as below however as you'd deduct 5% of the common equity to management.

Exit EBITDA x EBITDA Multiple = TEV at Exit
Less: Total Net Debt Outstanding (which includes cash, the bank debt, the vendor from the seller (if not refinanced), and the shareholder loan)
= equity value at Exit
Less: Mgmt. share of company (5% of common equity)
=Equity Value to Sponsor
Plus: shareholder loan (principal plus accrued interest)
= Total value to sponsor

 
Oct 3, 2017 - 2:02pm

Hey guys,

For someone who knows what he is doing, this case shouldn't take longer than 2 hrs (1.5 if you are fast). Certainly no need for a BS! All you need to do is to set a good debt schedule, P&L and LFCF, then do some sensitivity analysis.

WSO don't let me post links as i am a new member but I will post a link to the solved excel file once i can.

 
Mar 31, 2018 - 5:13pm

mna analyst:

Hey guys,

For someone who knows what he is doing, this case shouldn't take longer than 2 hrs (1.5 if you are fast). Certainly no need for a BS! All you need to do is to set a good debt schedule, P&L and LFCF, then do some sensitivity analysis.

WSO don't let me post links as i am a new member but I will post a link to the solved excel file once i can.

Hi guys...any links to the model?

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