LBO Question - Clarification?
So I got asked what I knew about LBO valuation in an interview, and although I haven't yet touched on this in my classes, I had recently read up on it on Investopedia. I mentioned, per Investopedia, that it is when a company purchases another company using a significant amount of borrowed money. I said that the the debt to equity ratios typically are 90% and 10% respectively (again, according to Investopedia). I also said that they borrow against the assets of the company being acquired as well as the assets of the acquiring company.
The banker (who was a VP) said I had basically gotten it right, but that it was more often 60% debt, 40% equity. WSO FAQs say it is normally 70/30. He also mentioned that they borrow against the acquiring companies CASH FLOWS, and would certainly NEVER borrow against the assets of the company being acquired.
With more interviews coming up, can somebody please clarify this for me, because I am getting a lot of conflicting information. Thanks in advance!
What he said is dead accurate... you said debt to equity ratio, no one uses that... he is talking about debt to total capitalization, and equity to total capitalization. Lenders don't collateralize the loans on assets, but rather on the whole Company therefore their main concern is the company has sufficient liquidity going forward to meet it's obligations, that's why it's coverage ratios all tackle cash flow characteristics...
Total Debt/EBITDA is a big metric. At least in the high yield fund I worked for. They want to see debt vs. cash flow bc that's what matters (can you service it).
Yep -- total leverage will generally be a multiple of EBITDA, i.e. a company's cash flow (EBITDA is a proxy for cash flow).
Actually it's not. Which is why so many LBOs go awry. The interesting stuff with EBITDA is that it is not subject to firms' D&A accounting policies so it's more comparable from one deal to another. I use this metric less and less when evaluating leverage and I tend to think that for most businesses undergoing an LBO (usually, mature businesses) EBIT is a better cash flow proxy (because capex is close to D&A in a mature business).
I'm confused what you're saying...can someone expound? And regardless, wouldn't it be more accurate to subtract capex from EBITDA to get a cash flow proxy? Or am I just sounding lost?
Yes, it is definitely more appropriate to deduct CAPEX from EBITDA to get a real leverage multiple. Depreciation is an accounting representative of what CAPEX would in theory look like, however CAPEX is the actual cash spent, Depreciation is just an accounting number. Additionally since CAPEX is often discretionary there can be a divergence between Depreciation and CAPEX.
So why is EBITDA used instead of (EBITDA - capex)? And how capex is "discretionary"?
Mezz- I don't mean to digress. Hopefully such relevant questions will help OP.
Where are you guys coming from? He's asking about the capitalization of a company and you guys are talking about multiples.... a multiple is irrelevant unless you know the bigger picture, if i tell you that it's 4.0x leveraged at closing, tell me how much equity is in there? If Sources is 5.0x than it's 20%, if Sources are 100x, then it's 95% equity... but what does the multiple have to do with the balance of debt and equity at funding?
He talks about the mix between the two and why companies borrow on cashflow and not assets, and he gets an earful of multiples...
amatuers
Seemed to me the original post just wanted clarification on capitalizing LBOs, and multiples do play a role in this.
From the lenders' perspective debt/cap is less relevant than leverage and coverage ratios because it doesn't show the company's ability to repay debt. Obviously if the equity/cap is very low lenders will think twice, but the place to start in building up an LBO is assuming a certain amount of debt, usually through some leverage multiple, and then adding equity until you get to the total amount of $ you need.
Typically the sponsor would be ok if that equity works out to be around 40%, but that isn't a hard rule. I've seen a few tech buyouts where the equity contribution was 60%-70%.
Capex is usually thought of as being made up of two parts, maintenance and expansion capex. Expansion capex can be put off until later if needed, and itself should result in a good investment return, whereas maintenance capex is needed to run your current business.
EBITDA - capex tends to be used more frequently for interest coverage ratios and EBITDA by itself is more popular for total debt multiples. I don't know a good reason for why this is. In Europe they seem to use EBITA a lot, which I like because in a way it reflects only the maintenance capex.
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