LBO case study help

Hi guys, I saw the following case study in one old post, appreciate if anyone is willing to take a crack at it. Particularly, I'm a bit confused on how to get ending net debt at exit.

THANKS!!
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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

Sponsor own 95% of the ordinary shares of the company with management owning the remaining at 5%
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.

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.

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.

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:
PS25m
PS50m
PS75m
PS100m

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.

Assume there is no cash sweep.

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)

It is thought that capex over this period will be $10m per annum (equal to depreciation).

Change in working capital is 0 (not source or use)

Tax will be charged at 30%.

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!

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Comments (15)

Apr 13, 2020 - 9:06am

What is your question? It is all explained in the case study? There are just 4 scenarios (25-50-75-100) for debt and 3 for exit proceeds (300,350,400).

Build a cashflow starting from EBITDA and calculate how much you can repay on the debt after cash interest payments (and capex, tax, etc).

Main consideration is that you probably will be low on cash available for debt servicing after a refi as you have a lot of cash out on the bank debt (interest + repayment of c. 20m p.a.) and capex (10), leaving c. 10m of cash --> restricting additional debt to c. 50m max. Questionmark if this is desirable/can be financed leaving you with 0 cashflow each year for unforeseen expenses.

  • Intern in IB-M&A
Apr 14, 2020 - 11:22pm

Some quick questions I had while reading this (sorry, am still trying to get some more exposure to LBOs here, really appreciate any help):

1) From a modeling perspective, do you treat the sponsor loan note as debt that accrues interest annually like PIK?

2) Refinancing the seller paper is essentially taking out new bank debt and using it to pay the seller, right? Isn't $25m / $50m not enough new debt to take out to refinance the $75m liability (given Y1 EBITDA of $40m, doesn't seem like cash flow generated will be enough to pay out the debt)? Or do you not refinance the whole thing?

3) The sponsor / management split means that the common equity pool at exit will be split 95% / 5%?What if the implied common equity is negative (which is what I'm getting in a $300m exit scenario and only $25m is refinanced)

  • Analyst 1 in IB - Gen
Apr 13, 2020 - 4:07pm

I saw that thread too and built up a quick model.

One thing I struggled with was the tax-deductibility of the mezzanine PIKs (apparently mgmt rollover is not deductible?), since it can lead to NOLs. Not sure if I should be having NOLs.

Also wasn't sure of the amort of the refi facility – same as senior debt (5-10-12.5) or one year delayed (0-5-10) in line shorter term?

Also, with the 75 refi you can't repay mgmt fully because of the PIK. Do you top this up with cash? With the 100 you have excess cash I just accrued to BS, but not sure if correct.

Finally, I'm getting negative equity value with 25 refi at 300 exit. Still 13.0% IRR – not sure if correct.

As for your question, just take the EV, add cash, and subtract debt balances to get to equity value. Remember to subtract 5% mgmt stake to get to sponsor equity value.

  • Analyst 1 in IB - Ind
Apr 13, 2020 - 11:49pm

I got ~13% IRR for the 25 refi too, but overall 3rd case ($75 refi) seems to give me the highest IRR with 14.2%, 25.7%, and 35% across 3 scenarios. Is it true for you as well?

All cases give me negative Net Income, for a simple model like this I don't think we would need to model NOL? What about when we are actually doing modeling tests?

Thanks!

  • Analyst 1 in IB - Gen
Apr 13, 2020 - 11:59pm

Hm, my IRRs increase through the 100 refi. Do you accrue the excess cash to BS?

Also I only have negative net income with 75/100 refi. I think people in the other thread were saying the management rollover interest is not tax-deductible, so it doesn't flow through to net income.

I haven't gone through the process so I don't really know. How do you deal with taxes in case of negative net income? max(0, EBT * t) or just (EBT * t), so you're essentially getting a same-year tax credit?

Here's my IRR grid, doubt it's fully right though:

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Apr 15, 2020 - 12:43am

this assumes $25 at refi

IRR 7.4% / 19.9% / 30.2%
MOIC 1.24x Jesus you can do the others

entry mult is 8x so exit on LTM Ebitda at yr 3 is expected to be 320mm EV. so IRR likely high single digits

the more you refi with bank debt, the lower the IRR (bank debt amortizes so less leverage over time)

pik is deductible

for refi, consider amort / covs / DSCR ... blah blah blah

  • Intern in IB-M&A
Apr 15, 2020 - 9:25am

When you refi with bank debt, aren't you replacing debt that has no repay / PIK interest with debt that has repay amount and interest doesn't accrue? Confused, because replacing seller paper with bank debt should therefore decrease leverage at exit, and for a given exit enterprise value, less leverage at exit will mean higher equity and higher IRR no?

Apr 15, 2020 - 1:58pm

the new bank debt has similar amort to the existing facility. the thing is the horizo ln is short and prepaying debt 1-2 years early can swing IRR a bit with cash out of the system sooner

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