# Insider Tips on How to Ace Your Next Private Equity or LBO Interview

## How can you forecast financial accounts and calculate the amount of debt the company can pay off each year?

Forecasting financial accounts and calculating the amount of debt a company can pay off each year typically involves the following steps:

Projecting Revenues: Estimate the company's future revenues based on historical trends, industry data, and any potential changes in the business, such as new product launches or market expansion.

Estimating Costs: Estimate the company's future costs, including fixed costs such as rent and salaries, and variable costs such as raw materials and distribution expenses.

Calculating EBITDA: Calculate the company's Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) by subtracting costs from revenues. EBITDA is a measure of the company's operating cash flow, and is often used to estimate the company's ability to service debt.

Projecting Capital Expenditures: Estimate the company's future capital expenditures, such as investments in new equipment or facilities.

Calculating Free Cash Flow: Calculate the company's free cash flow, which is the cash available after accounting for debt service and other expenses. Free cash flow is the cash available to pay dividends, repay debt, or make other investments.

Estimating Debt Service: Estimate the amount of debt the company will need to service each year by calculating the annual interest and principal payments on the debt.

Comparing Free Cash Flow to Debt Service: Compare the company's free cash flow to the amount of debt service to determine the company's ability to service the debt. If the company's free cash flow is greater than the debt service, the company should be able to pay off the debt each year.

It's worth noting that forecasting financial accounts and debt service is an estimation, not a guarantee, and the future performance of the company may be different from the projections. Therefore, it is important to perform sensitivity analysis and stress test the model to evaluate the robustness of the estimates and to understand the risks involved. Additionally, it is important to consider external factors such as the economic conditions, interest rates, and regulatory environment that can affect the company's performance and ability to service debt.

## What if the business is already in debt? What effect does this have on the projections?

If the business is already in debt, the effect on the projections will depend on the size and structure of the existing debt. The existing debt will have an impact on the projected free cash flow and the company's ability to service additional debt.

When a business is already in debt, it will have a higher debt-to-equity ratio, which means that a larger portion of the company's assets are financed by debt. This can make it more difficult for the business to secure additional financing and will make the business more sensitive to interest rate changes.

The existing debt will also have an impact on the projected free cash flow, as the company will need to use a portion of its cash flow to service the existing debt. This will reduce the amount of cash flow available to pay dividends, repay additional debt, or make other investments.

It is important to consider the existing debt when forecasting financial accounts and debt service, as it will affect the company's ability to service additional debt and the potential return on investment. The existing debt will also affect the company's credit rating which can affect the cost of debt and the company's ability to secure additional financing.

When evaluating a business that is already in debt, it's important to analyze the existing debt and its structure, such as the interest rate, maturity, and covenants. It's also important to understand the company's ability to repay the debt and how it affects the company's overall financial position. This will help to determine the company's ability to support additional debt and the potential return on investment.

## When there are many debt tranches, what is the right repayment order?

When there is more than one debt tranche, the repayment order will depend on the specific terms and covenants of each tranche. Generally speaking, debt tranches are prioritized based on their seniority, which is determined by the priority of the claims of the creditors in case of default.

The most common seniority levels are as follows:

Senior debt: This is the most senior tranche of debt and has the first claim on the company's assets and cash flow. Senior debt is typically the most secure and is the first to be repaid in the event of default.

Mezzanine debt: This is the next level of debt and is typically less secure than senior debt but more secure than equity. Mezzanine debt is typically repaid after senior debt but before equity.

Subordinated debt: This is the lowest level of debt and is the last to be repaid in the event of default. Subordinated debt is typically considered the riskiest and the most speculative.

Equity: Equity holders are the last to be repaid in the event of default and have the lowest priority claim on the company's assets and cash flow.

It is worth noting that each debt tranche will have its own specific terms and covenants that dictate when and how the debt should be repaid. Some debt may have special features such as interest rate step-ups, call options, or mandatory repayments. Therefore, it is important to understand the specific terms and covenants of each tranche when determining the repayment order.

It's important to note that the repayment order can also be affected by the company's ability to pay off the debt, the credit rating and the overall economic conditions, which will affect the availability and cost of financing. Additionally, the company's management and the private equity firm may also have a strategic plan on how to pay off

## Is it necessary to project all three statements into an LBO model? Is there a way to do as in fast?

It is generally necessary to project all three financial statements (income statement, balance sheet, and cash flow statement) into an LBO model in order to accurately determine the company's ability to service the debt and generate a return on investment.

The income statement is used to project the company's future revenues and expenses, which is necessary to calculate the company's EBITDA, a measure of the company's operating cash flow.

The balance sheet is used to project the company's future assets and liabilities, which is necessary to determine the company's debt-to-equity ratio and to estimate the company's future net income.

The cash flow statement is used to project the company's future cash flow, which is necessary to determine the company's ability to service the debt and to make other investments.

Projecting all three financial statements can be time-consuming and requires a significant amount of data and assumptions. However, there are some shortcuts that can be taken to speed up the process.

One way to do this is to use a simplified LBO model which only projects the company's income statement and cash flow statement. This model can be less detailed, but it can still provide a rough estimate of the company's ability to service the debt.

Another way is to use pre-built LBO models that are available online. These models can be customized to reflect the company's specific financial data, but they may not be as accurate as a model built from scratch.

It's worth noting that LBO models are simplifications of the real world, and do not take into account all the potential risks and uncertainties that can affect the company's performance. Therefore, it's important to have a good understanding of the assumptions used in the model and to perform sensitivity analysis to evaluate the robustness of the estimates and to understand the risks involved.

Top of Form

## In an LBO, what does it mean to have a "tax shield"?

In an leveraged buyout (LBO), a tax shield refers to the tax benefits that a company can receive as a result of the high level of debt used to finance the transaction. Interest on debt is tax-deductible, which means that the company can reduce its taxable income by the amount of interest paid on the debt. This can help to lower the overall cost of the acquisition and increase the return on investment for the investors.

The tax shield is often used to calculate the Net Present Value (NPV) of the LBO. It's the reduction in the present value of the future tax payments. The NPV is the difference between the present value of the cash flows generated by the LBO and the present value of the costs of the LBO, including the cost of debt. The greater the tax shield, the greater the NPV and the greater the potential return on investment for the investors.

It's worth noting that the tax shield is based on the assumption that the interest payments are tax-deductible and that the tax rate will remain constant. This may not always be the case, as tax laws and regulations can change, which can affect the tax shield and the overall return on investment. Additionally, it's important to consider the company's ability to generate enough cash flow to service the debt and that the company is in compliance with the tax laws and regulations.

## What does the internal rate of return (IRR) in an LBO model mean and how do you calculate it?

The internal rate of return (IRR) in an leveraged buyout (LBO) model is a measure of the profitability of the investment. It is the discount rate that makes the net present value (NPV) of the cash flows from the investment equal to zero. The IRR is an annualized rate, typically expressed as a percentage, which represents the rate at which the investment generates returns.

To calculate the IRR in an LBO model, you need to take the following steps:

Project the cash flows of the LBO, including the cash outflows (the cost of the LBO) and the cash inflows (the cash generated by the investment)

Determine the net present value (NPV) of the cash flows, by discounting them to the present time using an assumed discount rate.

Solve for the IRR by finding the discount rate that makes the NPV of the cash flows equal to zero.

Compare the IRR to a benchmark rate, such as the cost of debt or the required rate of return of the investors, to determine if the investment is attractive.

IRR is a commonly used measure of the profitability of an investment, as it takes into account the timing of cash flows and the size of the investment. A higher IRR indicates a more profitable investment, while a lower IRR indicates a less profitable investment.

It's worth noting that IRR may not always provide a clear picture of the profitability of an investment, especially in the case of LBOs where the cash flows are highly leveraged, and the company is taking on a significant amount of debt. Therefore, it's important to consider other measures of profitability, such as the net present value (NPV) and the return on investment (ROI), and to understand the assumptions used in the model and to perform sensitivity analysis to evaluate the robustness of the estimates and to understand the risks involved.

## What is the typical IRR for private equity firms?

Most venture capital firms aim for an IRR of 20% or higher. However, it's important to consider the length of a project when evaluating an IRR. Depending on the fund size and investment strategy, a private equity firm may seek to exit its investments in 3-5 years in order to generate a multiple on the initial investment. Doing the same for all funds in our sample, we found that the top 25% as ranked by IRR had an average net-of-fees IRR of 35.32%. However, the top 25% as ranked by multiple had an average net-of-fees IRR of 22.02%. So, an appropriate target IRR for a low-risk, unlevered investment might be just 6%, while a high-risk, opportunistic project (like a ground-up development deal) might be closer to 20%.

## What is the typical NPV for private equity firms?

Net Present Value (NPV) is a measure of an investment’s potential profitability. It is calculated by subtracting the present value of the cash outflows from the present value of the cash inflows. A positive NPV indicates that an investment is expected to generate a return greater than the required rate of return. Most private equity firms use NPV to evaluate potential investments and look for investments that have a NPV greater than 0. This indicates that the investment has a positive expected return.

## In an LBO, how do you calculate the IRR? Are there any thumb rule?

In an LBO, the Internal Rate of Return (IRR) is calculated by dividing the discounted cash flow (DCF) of the deal by the initial equity investment. The IRR is used to measure the profitability of the transaction and is a way to compare the return of a leveraged buyout with other investments. Generally speaking, a higher IRR indicates a better return on the investment. The IRR calculation for an LBO is a complex process and there is no single “thumb rule” for calculating it. However, it is important to consider the level of risk associated with the transaction in order to accurately calculate the IRR. The higher the risk of the transaction, the higher the IRR is likely to be.

## Is it possible for a private equity firm to make a good profit if it acquires a company for $1 billion and sells it for $1 billion in five years?

It is possible for a private equity firm to make a good profit if it acquires a company for $1 billion and sells it for $1 billion in five years, but it would depend on the specifics of the transaction and the return on investment (ROI) generated by the investment.

In a leveraged buyout (LBO) transaction, private equity firms typically use debt to finance a significant portion of the acquisition, which allows them to acquire a larger company with a relatively small investment of their own capital. The interest on the debt is tax-deductible, which can help to lower the overall cost of the acquisition and increase the potential return on investment.

If the private equity firm acquires the company for $1 billion and sells it for $1 billion in five years, it would not make a profit on the sale of the company, but it could still make a good profit if the company generated significant cash flow during the hold period, and if the private equity firm was able to pay off the debt and generate a return on investment (ROI) in excess of the cost of debt.

Additionally, the private equity firm may also have generated revenue from dividends, management fees, or other revenue streams. Furthermore, if the private equity firm was able to improve the company's operations and increase its value during the hold period, it could be able to sell the company for more than $1 billion.

It's worth noting that private equity firms typically invest for a relatively short period, usually 3-5 years, and the success of the investment depends on the private equity firm's ability to improve the company's operations and increase its value in that period. Therefore, it's important to understand the specifics of the transaction and the return on investment generated by the investment.

## Explain to me how do dividends issued to the PE firm affect the IRR?

Dividends issued to the private equity (PE) firm can affect the internal rate of return (IRR) of an leveraged buyout (LBO) investment in several ways.

The IRR is a measure of the profitability of an investment, and it is calculated by taking into account the cash flows generated by the investment, including the cash outflows (the cost of the LBO) and the cash inflows (the cash generated by the investment).

Dividends issued to the PE firm are considered cash inflows, as they represent a return on the investment. The greater the dividends, the greater the cash inflows, and the greater the IRR.

However, dividends can also reduce the amount of cash available to service the debt and to make other investments, which can affect the company's ability to generate cash flow and increase its value. This can negatively impact the IRR.

Additionally, dividends can also affect the company's credit rating and its ability to secure additional financing, which can also negatively impact the IRR.

It's worth noting that the IRR is a measure of the profitability of an investment, but it's not the only measure, and it doesn't take into account the risks and uncertainties that can affect the investment. Therefore, it's important to consider other measures of profitability, such as the net present value (NPV) and the return on investment (ROI), and to understand the assumptions used in the model and to perform sensitivity analysis to evaluate the robustness of the estimates and to understand the risks involved.

## What if the initial equity contribution is the same as the net proceeds received by the PE firm after the company is sold?

If the initial equity contribution is the same as the net proceeds received by the private equity (PE) firm after the company is sold, it means that the PE firm has not generated a profit from the sale of the company. This is often referred to as a "break even" scenario.

However, it's important to note that this does not necessarily mean that the PE firm has not generated a return on investment (ROI) from the investment. The PE firm may have received dividends, management fees, or other revenue streams during the hold period, which can contribute to the ROI. Additionally, the PE firm may have improved the company's operations and increased its value during the hold period, which can result in a higher sale price for the company.

In a leveraged buyout (LBO) transaction, private equity firms typically use debt to finance a significant portion of the acquisition, which allows them to acquire a larger company with a relatively small investment of their own capital. The interest on the debt is tax-deductible, which can help to lower the overall cost of the acquisition and increase the potential return on investment.

Therefore, it's important to consider the company's cash flow and the company's ability to service the debt, as well as the dividends, management fees and other revenue streams that the private equity firm may have generated during the hold period, in order to determine the return on investment. Additionally, it's important to consider the internal rate of return (IRR) and the net present value (NPV) of the investment.

## Isn't it true that interest and debt principal repayments must be factored into the IRR calculations?

Yes, it is true that interest and debt principal repayments must be factored into the internal rate of return (IRR) calculations. The IRR calculation takes into account both the cash outflows (such as debt payments) and cash inflows (such as interest payments). The formula for calculating the IRR is: IRR = (PV + FV) / (FV + PV) - (1 + I) where I is the interest rate, PV is the present value of the investment, and FV is the future value of the investment. The IRR calculation factors in all the cash flows associated with the investment, including both the interest payments and the debt principal repayments.

## What is a "dividend recap" or "dividend recapitalization"?

A dividend recapitalization, or “dividend recap”, is when a company takes on new debt solely to pay a special dividend to the private equity owners. It is a way for the private equity owners to quickly cash out some of their invested capital. The company usually already has some debt, and this new debt is added to the existing debt in order to pay the dividend. This new debt can also be used to pay down existing debt, increasing the company's financial flexibility.

## How would a private firm LBO vary from a public company LBO?

A private firm LBO (leveraged buyout) is different from a public company LBO in a few key ways. Firstly, a private firm LBO is generally structured as a debt-financed acquisition, where the majority of the purchase price is funded by debt, whereas a public company LBO often involves a combination of debt and equity financing. Secondly, the private firm LBO is usually structured to provide a return to the private equity firm or its investors, while a public company LBO is structured to provide a return to shareholders. Additionally, a private firm LBO is generally much more highly leveraged than a public company LBO due to the higher risk associated with the former. Lastly, a private firm LBO typically involves more complex structuring and negotiation, such as dividend recapitalizations and other creative financing methods, than a public company LBO.

## What about a buyout where you only get a 30% ownership in the company?

A buyout where an individual or company only acquires a 30% ownership stake in a company is known as a minority investment or a minority buyout. In this type of buyout, the investor does not have control over the company's operations and decision-making processes, as they do not have a majority stake in the company. Additionally, the investor may not have the same level of financial returns as they would with a majority investment. It can also be a way for a company to bring in additional capital without giving up control of the company.

## When buying a business, why would you use leverage?

Leverage is the use of debt to finance the acquisition of a business. When buying a business, using leverage can have several advantages:

It allows the buyer to acquire a larger business than they would be able to with only their own capital.

It enables the buyer to preserve their own capital for other investments.

It can increase the potential return on investment, as the buyer is able to control a larger asset with a smaller amount of their own money.

It can also be a way to structure the deal in a tax efficient manner, as the interest on the debt used to finance the acquisition is tax-deductible.

Additionally, it can be a way to achieve a lower purchase price, as the seller may be willing to accept a lower cash amount in exchange for the buyer assuming the company's debt.

It's important to keep in mind that leverage also increases the risk. The buyer will be responsible for paying back the debt regardless of the success of the business, so it's important to have a clear understanding of the company's financials and ability to repay the debt before proceeding with a leveraged buyout.

Top of Form

## In an LBO model, how do you choose purchase and exit multiples?

Leverage is the use of debt to finance the acquisition of a business. When buying a business, using leverage can have several advantages:

It allows the buyer to acquire a larger business than they would be able to with only their own capital.

It enables the buyer to preserve their own capital for other investments.

It can increase the potential return on investment, as the buyer is able to control a larger asset with a smaller amount of their own money.

It can also be a way to structure the deal in a tax efficient manner, as the interest on the debt used to finance the acquisition is tax-deductible.

Additionally, it can be a way to achieve a lower purchase price, as the seller may be willing to accept a lower cash amount in exchange for the buyer assuming the company's debt.

It's important to keep in mind that leverage also increases the risk. The buyer will be responsible for paying back the debt regardless of the success of the business, so it's important to have a clear understanding of the company's financials and ability to repay the debt before proceeding with a leveraged buyout.

Top of Form

## How do you value a firm using an LBO model, and why is it utilised as a floor valuation?

Valuing a firm using an LBO (Leveraged Buyout) model involves estimating the company's future cash flows and the value of its assets, and then using that information to calculate the amount of debt and equity required to finance the buyout. The LBO model is commonly used as a floor valuation because it shows the minimum amount that a financial sponsor (e.g. private equity firm) would be willing to pay for a company based on the assumption that the company can generate enough cash flow to cover the cost of the debt used to finance the buyout.

The steps in an LBO model are:

Projecting future cash flows: This involves forecasting the company's revenue, expenses, and operating income for a period of time, typically 5-7 years.

Determining the target capital structure: This involves deciding on the optimal ratio of debt to equity that will be used to finance the buyout.

Calculating the required equity: Using the projected cash flows and the target capital structure, the LBO model calculates the amount of equity that is required to finance the buyout.

Valuing the firm: The value of the firm is equal to the required equity plus the present value of the future cash flows that will be generated by the company.

Comparing the value to the purchase price: If the purchase price is higher than the value derived from the LBO model, the deal is considered profitable, otherwise, the model is used as a floor valuation, meaning the financial sponsor is not willing to pay more than the value derived from the LBO model.

It's worth noting that LBO model does not take into account all the factors that can affect the value of a company, such as market conditions, industry trends, and competitive dynamics. Therefore, it's important to use other valuation methods as well and make sure to validate the LBO model with other analysis and market data.

## Can you describe how an LBO model adjusts the balance sheet?

In an LBO (Leveraged Buyout) model, the balance sheet of the company being acquired is adjusted to reflect the new capital structure that results from the buyout. The LBO model typically involves a significant increase in debt, which is used to finance the acquisition, and a corresponding decrease in equity.

Here are the key ways in which an LBO model adjusts the balance sheet:

Increase in liabilities: The LBO model typically involves a significant increase in debt, which is used to finance the acquisition. This results in a corresponding increase in liabilities on the balance sheet.

Decrease in equity: As the debt increases, the equity decreases in order to maintain the balance sheet equation of assets = liabilities + equity.

Increase in assets: The assets of the company remain unchanged after the LBO, but the company's debt-to-equity ratio increases, meaning that the assets are financed more by debt than equity.

Increase in net assets: The net assets increase in an LBO scenario as the company is financed with more debt than equity.

Increase in leverage: The leverage ratio (debt-to-equity ratio) increases as a result of the LBO, which can lead to greater risk for the company.

It's important to note that LBO models are highly sensitive to the assumptions made about future cash flows and the debt service coverage ratio (DSCR), which is the ratio of cash flow available for debt service to debt service. It's important to check the DSCR to ensure that the company will be able to service the debt in the future.Top of Form