LBO Model Interview Questions: What to Expect
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- Опубликовано: 15 июл 2024
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In this tutorial, you'll learn about the most common LBO modeling-related questions and some tricks and rules of thumb you can use to approximate the IRR and solve for assumptions like the purchase price and EBITDA growth in leveraged buyouts.
Table of Contents:
2:36 Question #1: LBO Model Walkthrough
5:34 Question #2: Ideal LBO Candidates
8:09 Question #3: How to Approximate IRR
11:46 Question #4: How to Solve for EBITDA or the Purchase Price
13:58 Question #5: How to Approximate the IRR in an IPO Exit
16:03 Recap, Summary, and Key Principles
Lesson Outline:
Will you get LBO-related questions in interviews?
Yes, possibly, but full case studies are unlikely unless you're interviewing for PE roles or more advanced IB roles.
Interviewers now ask trickier questions about the fundamentals, they ask progressions of questions on the same topic or scenario, and they're more likely to give you simple cases and numerical tests rather than complex ones.
A typical progression for LBO models might be as follows:
Question #1: LBO Model Walkthrough
"In a leveraged buyout, a PE firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells it; the math works because leverage amplifies returns; the PE firm earns a higher return if the deal does well because it uses less of its own money upfront."
In Step 1, you make assumptions for the Purchase Price, Debt and Equity, Interest Rate on Debt, and Revenue Growth and Margins.
In Step 2, you create a Sources & Uses schedule to calculate the Investor Equity paid by the PE firm.
In Step 3, you adjust the Balance Sheet for the effects of the deal, such as the new Debt, Equity, and Goodwill.
In Step 4, you project the company's statements, or at least its cash flow, and determine how much Debt it repays each year.
Finally, in Step 5, you make assumptions about the exit, usually using an EBITDA multiple, and calculate the MoM multiple and IRR.
Question #2: Ideal LBO Candidates
Price is the most important factor because almost any deal can work at the right price - but if the price is too high, the chances of failure increase substantially.
Beyond that, stable and predictable cash flows are important, there shouldn't be a huge need for ongoing CapEx or other big investments, and there should be a realistic path to exit, with returns driven by EBITDA growth and Debt paydown instead of multiple expansion.
Question #3: Approximating IRR
"A PE firm acquires a $100 million EBITDA company for a 10x multiple using 60% Debt.
The company's EBITDA grows to $150 million by Year 5, but the exit multiple drops to 9x. The company repays $250 million of Debt and generates no extra Cash. What's the IRR?"
Initial Investor Equity = $100 million * 10 * 40% = $400 million
Exit Enterprise Value = $150 million * 9 = $1,350 million
Debt Remaining Upon Exit = $600 million - $250 million = $350 million
Exit Equity Proceeds = $1,350 million - $350 million = $1 billion
IRR: 2.5x multiple over 5 years; 2x = 15% and 3x = 25%, so it's ~20%.
Question #4: Back-Solving for Assumptions
"You buy a $100 EBITDA business for a 10x multiple, and you believe that you can sell it again in 5 years for 10x EBITDA.
You use 5x Debt / EBITDA to fund the deal, and the company repays 50% of that Debt over 5 years, generating no extra Cash. How much EBITDA growth do you need to realize a 20% IRR?"
Initial Investor Equity = $100 * 10 * 50% = $500
20% IRR Over 5 Years = ~2.5x multiple (2x = ~15% and 3x = ~25%)
Exit Equity Proceeds = $500 * 2.5 = $1,250
Remaining Debt = $250, so Exit Enterprise Value = $1,500
Required EBITDA = $150, since $1,500 / 10 = $150
Question #5: Approximating IRR in an IPO Exit
"A PE firm acquires a $200 EBITDA company for an 8x multiple using 50% Debt.
The company's EBITDA increases to $240 in 3 years, and it repays ALL the Debt. The PE firm takes it public and sells off its stake evenly over 3 years at a 10x multiple. What's the IRR?"
Initial Investor Equity = $200 * 8 * 50% = $800
Exit Enterprise Value = Exit Equity Proceeds = $240 * 10 = $2,400
"Average Year" to Exit = 1/3 * 3 + 1/3 * 4 + 1/3 * 5 = 4 years
IRR: 3x over 3 years = ~45%, and 3x over 5 years = ~25%
Approximate IRR: ~35% (This one's a bit off - see Excel.)
RESOURCES:
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Thanks! Glad to hear it and congrats on your internship.
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I've never done an LBO model in my life and I understood the questions pretty clearly. Great video
Thanks for watching!
learn a lot from the tutorial
Thanks a lot, Great Video!. Quick Questions: (1)in approximating IRR in question 3, how do you choose the most relevant "
If you 2x your money, it's around 75%; 3x is around 65%; and 4x is around 55%. If it's something else, approximate based on those (e.g., 3.5x would be around 60%).
Great video, thanks! Not to be too nit-picky but we didn't completely answer the 2nd question since it asked for a growth figure (50% over 5 years) not an EBITDA value.
Yes, that's true, sometimes we go quickly and miss things. The complete answers are in the written version of this in the interview guide.
Would like to hear your input on P5: Would it not be prudent as an interview candidate to ask about the considerations of what "evenly over 3 years" means, as the proper interpretation of discount periods is essential and "evenly" could be considered with a continuous compound in theory.
Furthermore, I think it would be necessary to ask the interviewer how much of a "stake" the PE firm retained after the IPO, as it is highly unlikely they maintained 100% stake for a full year post IPO, which calls back into question the sell off distribution.
This leads into the last consideration that your solution seems to assume the IPO and sell of runs concurrently with the growth, where it is more practical that this IPO and sell off would take place after the EBITDA growth. The problem then would become more interesting on the needed assumptions of its post IPO growth and consequently equity stake value. Thus leading to differing valued cash flows discounted over the total 6 year transaction life.
I love your content and thought Id see if what comes to my mind is too nitpicky or it makes sense
I Have an IB analyst interview in 3 weeks
Thanks for the great video
I think you may be over-thinking this and worrying about things that will never come up in an IB interview. These types of questions are much more common in PE interviews, to start with. Also, frankly, bankers have gotten dumber over time and are less likely to dig into these types of details (we find that many people at the Associate and VP levels now are fairly clueless).
You could certainly ask for clarification on all these points, what "continuously" means, how much of a stake the PE firm retains, and in a real interview setting, you might do that. The goal here was to provide a quick/simple walkthrough of this question with certain assumptions in place.
thankyou bro
Thanks for watching!
Thank you
Thanks for watching!
@15:29 If follow the equation exactly, you get the IRR 200/4*0.65=32.5%, which is pretty close to 32% in the excel
Also, what do you consider as a good answer if the interviewer asks why moving from IBD (where I summer interned) to private capital management firm? My initial intention is it's easier to break in.
Yes, that's true. For why IB to private capital management, what type of firm is it, exactly? A hedge fund? Private equity firm? Wealth management firm? What is your specific function, which clients do you work with (if any), and what is the firm's strategy?
It's a really bad idea to say that you're doing it because "it's easier to break in" - you want to highlight the specific points that are different vs. IB and cite those.
Hi! in #4, how do you know from "5x Debt/EBITDA" that debt is 50% of the funding? Thanks!
The full purchase price is 10x EBITDA. The Debt used is 5x EBITDA. 5x / 10x = 50%.
Hi! Thank you for this amazing video!
Would you mind sharing the excel file used in this lecture?
We don't really have an Excel file here because it's just a blank sheet with random numbers entered. The presentation slides go through the numbers.
Can you please explain how you would calculate the average exit year with a dividend recap and an M&A exit? Also, you keep on assuming that no extra cash is generated...what is this is not the case?
With a dividend recap and M&A exit, you'd have to take the weighted average of the proceeds across all the years, which is tough to do in your head unless the scenario is extremely simple (e.g., exit in Year 5 and dividend recap for 50% of exit value in Year 3). If extra cash is generated, you would have to increase the Exit Proceeds to Investors to reflect it. You typically ignore that in these questions because it is tough to keep track of the cumulative change in cash without being able to write down the numbers or save them somewhere.
Do we need to memorize the IRR multiples or we'll be able to use excel =IRR() for the interview?
You should know at least the basics, such as doubling or tripling your money in 5 years and the corresponding IRRs. Quick IRR math questions will come up in PE interviews.
Brian, where does the $500 in the "Exit Equity Proceeds = $500 * 2.5 = $1,250" come from? Did you just add up the 100EBITDA per year x 5?
No. $500 is the initial investor equity contributed because the deal is done at 10x EBITDA and the Debt used equals 5x EBITDA, and the company's initial EBITDA is $100. To earn a 20% IRR over 5 years, we need to earn 2.5x of that amount back at the end. 2.5x * $500 = $1,250.
@@financialmodeling Awesome videos! For clarity, how would this problem change if Debt used equals 7x EBITDA? Thanks again.
@@jeter22591 It's the same idea, just with different numbers. At 7x Debt, the Initial Investor Equity is $300 rather than $500. The required Exit Equity Proceeds are $300 * 2.5 = $750. The company repaid 50% of the Debt, which in this case means $700 * 50% = $350, so the Exit Enterprise Value is $750 + $350 = $1,050. $1,050 / 10 = $105, so only $5 of EBITDA growth is required for a 20% IRR.
Brian how are you doing these mental maths in your head so quickly? Are there any shortcuts or tips you have?
There are some tips in this article: www.mergersandinquisitions.com/sales-trading-interview-technical-questions/ Beyond that, maybe get a book on mental math on Amazon. We don't really cover it here because the examples in these questions are fairly straightforward... in an IB interview, no one is going to ask you, "365 x 416. Quick, calculate it!"
I got this question recently never intuitively understood the answer. LBO companies look for targets with large excess cash balances because it lowers the cost of acquisition. I get acquiring it grants you access to the cash but it seems like a wash at best and more expensive at worst. For example an extra $10M of cash on balance sheet you would need to finance through equity or debt. All equity would be a wash dollar for dollar and all debt would be more expensive than the cash cause of interest. How do you make heads or tails of this?
That is not really a key attribute that PE firms look for because Excess Cash does not really "do" anything - if the company distributes it, yes, its Equity Value goes down, but if the company keeps it, the PE firm can then take the Excess Cash for itself. So either way, the effective price is the same. But Excess Cash itself is not inherently good or bad - what matters is what the company's core business is worth and how that might change (i.e., the Enterprise Value).
An interviewer asking this question or making this claim doesn't understand LBOs.
Min @5:25, where does the 2.4x come from? Shouldn't be 9035.8/4313.5= 2.09x? And for IRR = CAGR fórmula = 15.94%?
No. The IRR is based on the Investor Equity, not the Equity Value. There are differences because of various purchase adjustments (excess cash, fees, etc.) and non-100% ownership percentages.
I am confused, is the IRR you are talking about more like an annualized rate of return or is it the discount rate at which NPV will equal to zero.
IRR means both in this context.
@@financialmodeling But the number wouldn't be the same right. Thanks for answering by the way.
Hi Brian,
One question regarding Question #5: if the PE firm still has shares during the IPO, shouldn't we account the cash generated from the business as cash to the PE firm, multiplied by its current shares?
We might have to assume some value for that cash generated. However, I think it's a more realistic assumption that assuming no extra cash is generated by the company after it pays all its debt.
What do you think?
Thank you for your help,
Bruno
Potentially yes, but there's no information about what cash flow, if any, it generates. Also, we don't know whether or not the company keeps this cash, distributes it, or does something else with it. So... yes, it might be worth mentioning, but it's not feasible to calculate it unless they give you all the numbers and assumptions.
@@financialmodeling Thank you for the answer.
How did you come up with the average year to exit numbers?
They're arbitrary, based on actual PE interview questions collected over time. Most LBOs exit in 3-7 years, so it's most important to know the IRRs for these periods.
Would you be allowed to use a pen and paper for these sorts of questions?
For the types of questions covered here, no, probably not. For a 30-minute exercise that requires you to create a mini-LBO model, sure.
Hello where can I get the excel ?
There is no Excel file because these are interview questions, not modeling exercises. If you click "Show More" there is a presentation link at the bottom.
Hi, Both holding and exit periods should be 3,5,7 only to use these tricks. it won't work otherwise. Did I get it correct?
These tricks work best when the holding period is 3-7 years. As you go higher or lower, the math starts to change, so they won't work as well. You might still get an OK estimate if it's 8-10 years, but if you go to 15 or 20 years, it won't work.
@@financialmodeling thanks
2:42
How does the rule of 72 or 114 apply here?
You could use them if you want, but we don't think they're necessary if you know the basic rules for 3 and 5-year periods and 2x and 3x multiples.
@@financialmodeling I am more concerned with inaccuracy. It feels like the rule of 114 should actually be the rule of 125 for 3 or 4 year hold periods, because it way undercuts the actual IRR figure. I’d rather use this method than memorizing IRRs - any recommendations for rules for 3x ?
@@tejaskashyap1392 Sorry, no, and I don't think any of this matters for purposes of quick approximations in interviews.