LBO - Model Test - Questions

Hi,

Have a few LBO modelling tests coming up and have been preparing in advance.

One area that I am confused about is Preference Shares / Loan Notes. All of the model guides that I have seen all assume that the PEH invests only in ordinary shares (i.e. their return is just closing equity / opening equity). Is there a reason for this? From what I understand, in practice almost all deals are structured so the PEH has a preferred return using pref shares / loan notes. Should I be modelling this out in any case studies that I do, or is it over complicating it?

Secondly, this is a bit basic but I am confused with how ownership works with preferences shares / loan notes. Are preference shares / loan notes the same thing? Do they count towards my ownership % on exit?

E.g. If I have a 1,000 equity value on entry financed 900 PEH loan note, 50 ordinary PEH, 50 ordinary management. What is my ownership % on exit? Is it 50% or 95%?

Really appreciate any tips. Thanks.

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Comments (11)

  • Analyst 2 in IB - Cov
Jan 22, 2021 - 7:32am

From European Perspective:

- PEH (or SHL) grows by PIK (e.g. 10% p.a.), at the end at exit this 100% goes to the Sponsor

- After deduction of SHL from the "total equity value" (meaning exit multiple x EBITDA - net debt); Common equity is left. This is dividend according to initial investments into the common equity of the Sources & Uses. If split was 50:50; then 50 to management, 50 to Sponsor.

  • Analyst 3+ in IB-M&A
Jan 22, 2021 - 7:45am

Thanks. Super helpful. A couple of follow up qs:

(I) how is the common equity split determined? I.e. if on entry it is 900 SHL, 50 PEH Ords, 50 Mgmt Ords, that seems like a very unfair split on PEH (contributing 95%, but only getting 50% of equity upside)? Does it get adjusted to take this into account? I.e. SHL 900, PEH 90 Ords, Mgmt 10 Ords? - This still gives Mgmt an outsized equity amount for their investment (even ignoring any sweet equity / MIP)

(II) How should this be presented in an LBO test? As I said, all the materials I have reviewed have assumed PEH invests only in Ordinary equity. Is there a reason for that? Is it expected to model out the SHL in an LBO case study?

Thanks!

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  • Analyst 2 in IB - Cov
Jan 22, 2021 - 7:49am

Welcome!

(I) It depends on a reasonable amount that management can afford right? Usually, what I have seen, 85% SHL, 15% CE, 80/20 split Sponsor and Mgmt; which results in a couple of million for management (reasonable amount to rollover)

(II) I have, with one exception (US MF in Continental Europe), not seen modeling test incorporating these features; but rather just doing common equity; also due to timing reasons in a 1-2 h test. Would only model this in if explicitly asked - not a real value add but the potential to f*** up in a timed scenario.

  • Analyst 1 in IB - Gen
Jan 22, 2021 - 11:43am

Do you know why firms actually do SHL? Is it for tax purposes? They'd get wiped out anyways in pretty much all cases if going bankrupt 

  • Analyst 2 in IB - Cov
Jan 22, 2021 - 11:48am

Tax reasons, correct! PIK interest is tax-deductible (depends of course on the country etc.) And as outlined above as multiplier for management returns / incentivisation

  • Analyst 3+ in IB-M&A
Jan 22, 2021 - 12:35pm

Thank you again! 

Just on the case study / test element - is it not a bit weird to not include it? Seems an integral part of the transaction structure & how returns are generated and odd to not include on that basis. Would it get extra credit if it was included as part of an assessment?

Another point - does management rollover not often take a similar structure ("Mgmt loan notes"?). Whereby your structure may be something like this:

Entry: 1,000

PEH Loan Notes: 950

Mgmt Loan Notes: 45

PEH Ords: 4

Mgmt Ords: 1

Just trying to reconcile what I hear in real life around structuring & have read vs. What is presented typically in models / modelling guides.

Jun 3, 2021 - 6:35am

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