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.
Bump
Bump, curious too, this a good question
Bump
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.
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!
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.
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
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
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.
Bump
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