{"id":21879,"date":"2020-01-22T18:25:15","date_gmt":"2020-01-22T23:25:15","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?post_type=biws_kb&#038;p=21879"},"modified":"2024-10-18T19:00:39","modified_gmt":"2024-10-19T00:00:39","slug":"lbo-capital-structure","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/lbo-capital-structure\/","title":{"rendered":"Leveraged Buyout &#8211; Debt Equity Ratio (19:48)"},"content":{"rendered":"<p>Question that came in the other day\u2026<\/p>\n<p>\u201cHelp! I just got a case study from a private equity firm I\u2019m interviewing with.\u201d<\/p>\n<p>\u201cI have to pick a consumer\/retail company, download its filings, complete a leveraged buyout model for the company, and recommend for or against the deal.\u201d<\/p>\n<p>\u201cHow can I determine how much debt to use in the deal? They didn\u2019t give me any instructions!\u201d<\/p>\n<p>You can figure this out simply in most cases without wasting a ton of time sifting through company\u2019s filings. Here\u2019s the 3-step process:<\/p>\n<p>Step 1: Estimate the purchase multiple, purchase price, and Debt \/ EBITDA by looking at comparable buyout deals (NOT publicly traded companies, as they almost always have lower debt levels).<\/p>\n<p>Step 2: Test your assumptions in Excel and see if the company can manage that much debt.<\/p>\n<p>Step 3: Go back and tweak your assumptions as necessary.<\/p>\n<style>.enteremail__large--inline{margin:60px auto!important}<\/style>\n<p>The purchase price and Debt \/ EBITDA are very closely linked \u2013 for example, you can\u2019t assume 6x Debt \/ EBITDA if you\u2019re paying only 5x EV \/ EBITDA for the entire company.<\/p>\n<p>For most public companies, you need to assume at least a 20-30% share price premium, and then make sure the implied EV \/ EBITDA multiple is in-line with those of other recent deals in the market.<\/p>\n<p>Let\u2019s say you pick Bed, Bath &amp; Beyond [BBBY] for your LBO candidate.<\/p>\n<p>To find 2-3 comparable LBO deals, you can do Google searches for terms like:<\/p>\n<p>\u201cconsumer retail\u201d \u201cleveraged buyouts\u201d [This Year or Last Year]<br \/>\nconsumer leveraged buyouts<br \/>\nretail leveraged buyouts<\/p>\n<p>In this case, we find 3 relevant deals: the buyouts of Petco (10x EV \/ EBITDA and 6x Debt \/ EBITDA), Life Time Fitness (11x EV \/ EBITDA and 5.5x Debt \/ EBITDA), and Belk (7x EV \/ EBITDA and 5-6x Debt \/ EBITDA).<\/p>\n<p>So our deal will likely be done at 8-10x EV \/ EBITDA with 5-6x Debt \/ EBITDA.<\/p>\n<p>BBBY\u2019s share price has fallen by ~50% in the past year, so we think a 50%, 75%, or even 100% premium would be more reasonable than the standard 20-30%, and would imply a purchase multiple of 6.5x \u2013 8.5x instead.<\/p>\n<p>But can the company support that much debt?<\/p>\n<p>To answer this question, you can create a simple Excel model with revenue growth, EBITDA margins, Cash Flow from Operations as a % of EBITDA, and CapEx as the key drivers.<\/p>\n<p>The after-tax interest will also be subtracted from CFO \u2013 CapEx to determine debt repayment capacity.<\/p>\n<p>Then you can evaluate debt repayment, Debt \/ EBITDA, and EBITDA \/ Interest over time to see if the debt level is too low, too high, or just about right.<\/p>\n<p>Focus on the downside cases \u2013 What happens if revenue, EBITDA, cash flow, etc. decline? Margins and growth HAVE declined historically for BBBY!<\/p>\n<p>Ideally, Debt \/ EBITDA should decline over time and EBITDA \/ Interest should rise as the company repays debt.<\/p>\n<p>So if Debt \/ EBITDA rises instead, or EBITDA \/ Interest falls, you\u2019ll have to assume a lower debt level.<\/p>\n<p>In this deal, we run into trouble when revenue declines or when we pay closer to a 100% premium for the company because Debt \/ EBITDA approaches 8x in some later years.<\/p>\n<p>Even if revenue growth stays positive and the premium is only 75%, the credit stats and ratios still don\u2019t look &#8220;great.&#8221;<\/p>\n<p>So we\u2019d say that 5-6x Debt \/ EBITDA is a stretch, and 4-5x is more feasible. At a 75% premium, this might be 60% debt (4.5x) and at a 100% premium it might be 50% debt (4.2x).<\/p>\n<p>Once you\u2019ve come up with baseline estimates for these figures, you would continue to build the model, come up with something more complex, and then ultimately make your investment recommendation on the company and present it.<\/p>\n<p>But you can save a lot of time and finish case studies more efficiently if you know how to find and confirm simple figures like these before you do anything more complex.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this tutorial, you\u2019ll learn how to determine the proper debt level to use in a leveraged buyout case study given by a private equity firm \u2013 all from using Google and free information you can find online.<\/p>\n","protected":false},"featured_media":21881,"template":"","class_list":["post-21879","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-leveraged-buyouts-and-lbo-models"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/21879","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/21881"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=21879"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}