PE interview question - debt

1) EBITDA, CapEx, and W/C Change projections for 5 years. You may have to assume 38% cash taxes. Calculate unlevered FCF 2) Add unlevered FCFs over the 5-year period. This is a good approx. of max debt. You will have to adjust this number slightly to incorporate interest on the debt. Also - total debt at the end of the period doesn't need to be zero ... it just needs to be low enough so refi risk isn't huge 3) Depending on your calcuations given the above assumptions, assume a conservative exit multiple and back out the purchase price so return is 20%+.

Couldn't you just request FCF as one of the three financial metrics, rather than calculating it yourself? Also, wouldn't the WACC or cost of debt be a big factor?

FCF to EBITDA conversion ratio. From that %age I can tell you anything...

Next, I'd say give me EBITDA & it's 5 year projected CAGR.

Then I'm done

Mezzket, ever think of a career in academia ? Good on you for helping these kids out.

You are an absolute machine MezzKet.

Good job Mezzket. Lowdee, this is my take on the questions you have asked; not trying to pre-empt Mezzket in any sense but thought this might be helpful:

FCF conversion is "how much of your EBITDA gets converted to FCF" atleast for the purpose of this excercise thats how I would look at it.

I doubt there is a range, unless you talk specifically of sectors etc. Imagine two companies in the same sector, operating pretty much similar businesses, but with different FCF / EBITDA. As long as your purchase price, takes this into account (hence paying a lower multiple of FCF) you are accounting for the difference in FCF conversion.

Debt side:

You are taking 10% of the sum of FCF (sum of FCF = maximum debt), hence this is the proxy for interest cost on your debt.

You are multiplying by 60% because there is a tax shield on your interest which will help you lower your tax bill (60% x 10% x FCF) FCF). If your interest burden is lower, you will be able to paydown more of principal.

You are taking FCF - interest payments, because that will be the cash available to paydown principal. If you take that exact amount as starting debt, then as Mezzket mentions, you will have zero debt at exit and all of the sale price will go to the equity holders (i.e the PE sponsor)

Multiple of cost (money multiple): is a ratio that tells you how many times your initial investment you have made on a deal. Eg. if you invest 100m equity at deal date, and at exit sell the business for 400m enterprise value. Assume there is 100m outstanding debt, giving you 300m equity value at exit. Now your 100 investment is worth 300 so you have made 3times money. Obviously the time horizon that you generate this 3times will be important for your IRR and you should look at the two simultaneously.

Hi Acann, Thanks for your insight. I am confused by this step.

"You are taking 10% of the sum of FCF (sum of FCF = maximum debt), hence this is the proxy for interest cost on your debt. "

"3) I'd say, take 10% of that, multiply that amount by 60% (1-tax rate of 40%) to get a rough idea of what your "cash" interest payment actually amounts too in 1 year. Multiply that by 5 for all 5 years interest payments."

you are assuming 10% of the sum of FCF is the TOTAL cost on your debt (ie total interest payments) OR just interest payments for year 1? Why would you multiply by 5?

Also, do most pe firms assume debt (principal and interest) will be paid off at exit? In this case, 5 years? If not, how many times EBITDA is appropriate for level of debt? Are we assuming principal paydown for each year? For example( if FCF year 1 is 30, EBITDA was 100 and company was levered 2x ebitda, assuming 10percent interest , and assuming paydown off all debt by exit, now you have 200 total debt, 40 princiapl payments each year for 5 years at 10% interest of 20. 30 is enough to pay down the 20 in interest, but do you dont have enough to pay down principal for the year. I guess what im asking is how is debt payment usually structured?

When they talk about levered X times, do they mean X times EBITDA?

Thanks.

Question 1: What exactly is FCF conversion? Is there a strict definition or does it vary? Which is more widely accepted? (ex. FCF/EBITDA, FCF/Net Income?) Question 2: In private equity, what is a healthy ratio for FCF conversion? or range

Acaan hit it right on the head. Typically you like to see over 75% on average over the projected 5 yr period.

Why am I taking 10% of the sum of FCF's? Is that a typical approximation for the total interest payments throughout the investment horizon? Or do you mean 10% of FCF for each year? Wouldn't 10% of FCF for each year be underutilizing the FCF?

10% is your interest payment per year. Usually the WACDebt is about 8% on an LBO so 10% isnt outrageous. Secondly, 10% is your debt interest payment on an annual basis; we multiply it by 5 to assume total interest payment. If I'm assuming my total FCF is my benchmark for debt, 10% is my interest payment annually on that debt.

For simplicity in visualizing, assume you never decrease your debt until exit ie you accumulate the cash on the balance sheet. This assumption may help avoid the average balance argument.

Also, do most pe firms assume debt (principal and interest) will be paid off at exit? In this case, 5 years? If not, how many times EBITDA is appropriate for level of debt? Are we assuming principal paydown for each year?

They are paid down due to their change of control provisions, but in reality they typically delevrage by 20-30%. Principle paydown isnt precise. Its a factor of the mandatory amortizations and cash sweeps that are imposed on the Company by its credit agreements. Term Loan A aggressively amortize their debt balances while TLb & TLc loans basically look like bullets. All Term Loans have cash sweeps but it depends on market practices and specific tranche so there is no precise number I can give you.

For our calculations, we want to maximize our return and minizmize credit risk ie make sure it can completely eliminate its own debt and interest payments without having a refinancing risk. This is ideal for any LBO. Believe it or not, many LBOs over borrow. On a base case the balance sheet is testing the limits of solvency; they run the risk of defaulting if they hiccup in performance. Sure this is "maximum" borrowing capacity but I typically like to see a cushion on this case in order to consider it's borrowing capacity maximized. Without that cushion, I see it as overlevered.

In most cases, Leverage is defined as a multiple of EBITDA. Debt is structured both on the basis of projected ratios and market lending practices. Depending on prevailing headwinds, firms want to see certain rises and falls in multiples such as EBITDA / Interest, Net Debt / EBITDA, Senior Debt / EBITDA, Fixed Cover Charge Ratio. Depending on these projected levels, the bank and other lenders will adjust closing debt balances ie leverage of EBITDA accordingly. These adjustments are basically the adjustments from EBITDA to cash flow. Since ppl use EBITDA as a proxy for cash flow, these projected ratios allow the lender to more accurately precise future risk and attempt to minimize it by adjusting closing balances as necessary.

Great post. Learned alot. Sorry for asking this, but i just want to make sure i understand this completely. Lets put this exercise into numbers:

Unlevered FCF of 100 for 5 years Interest rate of 10% Tax rate of 30%

My total unlevered FCF over 5 years will be 500, 7% of that (10%*0.7, after tax cost of debt) will be 35 interest cost each year, times this by 5 will be 175, hence my max debt is 500-175=325.

However, my problem is that if now my max debt is 325, then lets say i go ahead and get this amount amount of debt , but then each year if i apply my 7% after tax cost of debt then my interest expense is lower because i only raised 325 debt (not the 500). I think you get what I am getting into, this is essentially a circular referece, as my total FCF after interest depends on my initial debt level, but my initial debt level depends on my total FCF after interest.

But, i guess what Mezzket really is saying that if we can fix the 35 after tax interest cost based on the 500 (benchmark debt), then this problem will be solved, in order words even if i only raise 325 debt, but my after tax interest is still 35. Then this exercise will make sense, as after 5 years, I would have zero debt. However, this would imply my real after tax interest rate is higher than 7%, i.e 10.8% in this case.

Mezzket, let me know whether you think what I have said above is consistent with what you are trying to say.

If my logic is correct, then during an interview, I would suggest to say a lower cost of debt, i.e less than 10%, as this % will be higher on the actual amount of max debt (i.e on the 325) just to show to my interviewers that I understand this point.

Also, I think the question asks what is maxmium amount of debt this company can lever, so i would also get the ideal capital structure of this company from the interviewer, for example if a good capital structure for this company is say 2x EBITDA, at which this company can be sold to others and can do an IPO as an exit etc etc. I would add 2x of my year 5 EBITDA on to my max debt amount calculated eariler. Of course there is a refinancing risk, but i could say assume i can refinance at year 5.

Not sure what i have said above make sense or not, happy for someone to correct me if it is wrong.

Thanks

Know this is an old thread but it helped me out and I wanted to contribute.

I think there's a slightly better way to estimate total debt - let's say you add up your 5 years of FCF and it comes out to $500. Essentially you want to figure out what figure of debt + its interest will get you a total of $500.

Good way of doing it is to write it out as Int(1-T)5x + x = 500, which becomes 10%(1-40%)5x + x = 500. Clean that up and you get 1.3x = 500 --> x = 385 = Max debt.

So 500 of FCF can pay down 385 of debt principal and pay its 10% interest over 5 years.

Will have to do some long division on paper but I think this way is more accurate. Let me know what you think.