LBO Model Interview Questions: What to Expect

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welcome to another tutorial video this time we're going to be going through some sample interview questions and answers related to leveraged buyouts and lvo models so a typical question that we get on this topic goes something like this if I don't have much of a finance background how much do I need to know about LBO models and interviews should I expect case studies or modeling tests and how quickly should I be able to build a model the short answer to these types of questions is that LBO related questions could definitely come up but key studies are not terribly likely except for private equity interviews or if you have more experience and you're going for more advanced roles within Investment Banking one trend recently is that interviewers have been asking more difficult questions on the fundamentals and in this context what it really means is giving you a trickier or more complicated scenario and asking you to approximate the internal rate of return or the IRR in an LBO another point is that interviewers have begun to ask you more of a progression of questions on the same topic or the same scenario to see how much you know and they'll keep asking more and more difficult questions until you reach your limit and you can no longer answer the questions and then finally although people freak out sometimes over complex case studies very simple ones and short tests with basic numbers are actually far more common even in private equity interviews yes longer case studies will come up especially as you approach the finish line and you get to the final round of interviews but before that in initial rounds they're still going to ask you to do the quick math for LBOs and to determine whether or not at a glance a deal might work so here's a typical progression of questions that you might get related to lbo models in interviews first you might be asked to walk through a basic model and to explain why the math works then they might ask you about what makes for an ideal LBO kende and what types of qualities you would look for then they might get into math questions and ask you to approximate the IRR if certain conditions are true they might ask you what purchased multiple or EBIT are growth are required to realize a certain IRR and then they might also ask you to approximate the IRR more unusual scenario such as an IPO exit or dividend recap or something else like that as opposed to the standard M&A exit in a leveraged buyout so let's go through all these questions and learn what you might say and how you might present them for this first one can you walk me through a basic LBL model and explain why the math works you could say something like this in a leveraged buyout a private equity 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 lots of its own money up front and you should know that if you've been through any of our other material on this topic that yes if a deal performs reasonably well then using say 70% debt might boost the IRR from 8 or 9 percent up to 15 or 16 percent but if the deal doesn't do so well let's say that we have to sell the company at a discount to the initial purchase price at the end then leverage is going to make us do even worse we go from a three point three percent IRR down to a negative one point three percent IRR with leverage so that's the key point to keep in mind that leverage amplifies returns and PE firms always of course try to go for positive returns in which case leverage will help them now to walk through the LBL model step one is you have to make assumptions for the purchase price the debt and equity the interest rate on debt and then revenue growth margins and other operational assumptions we have an example of it right here in this model for seven days in we've made some assumptions for the purchase price based on various multiples and then also for the debt that's being used in the deal of the senior notes and subordinated notes here step 2 is to create a sources and use the schedule to figure out how much in investor equity the private equity firm has to pay and we have that down here there's a rollover and a steal and so the private equity firm has to pay for the shares of the company uses debt to fund some of that and then the fact that it has this rollover and the fact that existing investors are coming in reduces how much money the private equity firm has to pay once you have that then you can adjust the company's balance sheet for the new debt inequity issued and then also for any goodwill creating and any other acquisition effects then in step four you project the company's statements or leases cash flow and you figure out how much debt it can repay each year so here for example we don't have a full set of financial statements for this company seven days in but we do have an income statement and then we have a partial cash flow statement that at least lets us get how much cash flow the company has available for debt repayment each year and those are the most important parts then once we figured out the cash flow and the debt repayment and what eBay dot and cash flow the company gets up to by the end we make assumptions about the exit so here for example we have assumed that the exit multiple is the same as the purchase multiple and we calculate the money on money multiple and the IRR based on that those are the basic steps in a leveraged buyout model that's probably the most basic question you'll get on leveraged buyouts a slightly more advanced question is this one about ideal leveraged buyout candidates what makes for an ideal LBO catenate there are many factors you could list but the most important ones are the following first off price almost any deal and almost any leveraged buyout can work at the right price but if the company is too expensive the chances of failure are quite high if a company is relatively cheap and undervalued next to similar companies you can have a lot of trouble and perhaps an exit that doesn't go so well but if you didn't pay that much for it in the beginning and you've got a bargain on the deal then the math might still work quite well but if you pay a very high multiple for a company and it's possibly overvalued then even one small thing going wrong can completely ruin the deal so the price is probably the most important part after that stable and predictable cash flows are important because all companies and leveraged buyouts have to pay interest on debt and then have to repay the debt principle possibly over time possibly just at the end but regardless of what happens stable cash flows are very very important related to cash those are the need for ongoing capital teachers and other big investments and then possibly room to expand margins over time generally speaking if a company has to spend a lot to fund its growth in the form of new factories equipment working capital things like that it's less of an ideal candidate also if there's a way to improve its margins and therefore improve its cash flow that makes it a better LBO can Nate and then finally there has to be a realistic path to exit and that means a market with active buyers and sellers that means a market where it's possible to take the company public if the PD firm goes down that path and you also want the returns to be driven mostly by eBay the growth and debt pay down instead of multiple expansion so in this model for seven days in for example 68% of the returns come from eBay de growth and 32% from debt pay down and cash generation which is exactly what we want to see if this deal were predicated on multiple expansion and the numbers only worked if the eBay done multiple increase the 10x or 12x your 15 X we'd be a whole lot more skeptical of this deal so you almost always want to see realistic exit assumptions and a market where it's possible to sell the company or take it public in the future so those are a few the basic questions you can get on this topic if you get those right the interviewer will probably start going into more advanced questions and get into some of the math around leveraged buyouts now with these math questions to approximate the IRR you can always take the relevant percentage 100% 200% 300% divide it by the number of years in the period and then multiply it by some smaller percentage to account for the effect of compounding so if you double your money you can take 100% divided by the number of years I'm multiplied by around 75% to get to the IRR if you triple your money it's 200 percent divided by the number of years and then you multiply by around 65% you can round that to about two-thirds to get the IRR and then if you could triple your money it's 300% divided by the number of years and you can multiply by 55% to get the approximate IRR the key is that you need to figure out the initial investor equity and then the exit equity proceeds if you have both of those and the number of years you can always get to the IRR a few simple examples of this will our that if you double your money in three years it's around a 25 or 26 percent IRR and if you double your money in five years it's run a fifteen percent IRR and then if you triple your money in three years it's around a forty four forty five percent IRR and if you do it in five years it's around a twenty five percent IRR so let's look at a simple example of a question related to this topic a BU firm acquires a 100 million EBIT company for a 10x EBIT on multiple using 60% debt the company's ebay dollar is to 150 million by year five but the exit multiple drops to 9x the company repays 250 million of debt and generates no extra cash what is the IRR so once again you need to know the initial investor equity the exit equity proceeds and then the number of years in a period in this case it's pretty simple because we know it is a five-year holding period and we can easily get to the initial investor equity the initial investor equity is just the 100 million of EBIT ah times this 10x multiple and then we know they're using 60% debt which means they're using 40% equity so 100 million times 10 times 40% is 400 million now the exit enterprise value we know that epidote goes to 150 million and we know the multiple drops 10 9x so 150 million times nine is 1,350 million or 1.35 billion of course the p/e firm doesn't get all that it has to repay the remaining debt at the end now the debt remaining on exit we know is equal to the 60% times that upfront purchase price so 600 million and then the instructions say that the company repays 250 million which leaves us with 350 million at the end so putting those together the exit equity proceeds are just the exit enterprise value of 1.35 billion minus the remaining debt of 350 million and we get to 1 billion like that for our exit equity proceeds 1 billion divided by 400 million is a 2.5 X multiple we know that 2x multiple over 5 years is about 1/5 percent IRR and a 3x multiple over five years is about a twenty five percent IRR so we would approximate this one as around 20 percent in Excel you can enter this yourself and you can say negative four hundred zero zero zero zero and then one thousand and take the IRR like this and you get to exactly twenty percent so if you get this kind of question right they will throw something harder your light and ask you to back solve for one of the key assumptions here's an example you buy 100 a pizza business for a TEDx multiple and you believe you can sell it again in five years for 10x EBIT ah you use 5x debt to ebay to fund the deal and the company repays 50 percent of that debt over five years generating no extra cash how much epic growth do you need to realize a 20 percent IRR so once again we need the initial equity the equity proceeds and a number of years we know it's a five year holding period and the initial investor equity is pretty easy to get because we know how much debt we're using we know the eBay da we know the multiple in the beginning so the initial investor equity here is the 100 I beta times this 10x multiple and then 5x debt to eBay da means that about 50 percent of the price will be funded with equity so multiplying all those gives us 500 and then for the exit we know that 20% are over five years is around a two point five x multiple from the last question 2x is 15% 3x is 25% so two point five x is right in between those and that should give us around 20% this means that we need to get to 1.25 billion in equity proceeds to get this 20 percent IRR over five years now we know that the PE firm used five hundred of debt here in the beginning because five times 100 vb does five hundred of debt the company repays fifty percent of it which means that there is 250 left at the end which means that we need to sell this company for an exit enterprise value of one thousand five hundred if we do that we will end up with this 1250 and equity proceeds we know that we can sell the company at the end for ten xeb da so 1500 divided by ten is 150 and you can go into Excel and verify this one for yourself as well but that's how we might work backwards to get this figure now if you get that right then they might give you an even harder question which is how to approximate IRR in an IPO exit so a simple question here might be a PE firm requires a two hundred a bit company for an e^x multiple using 50% debt the company's eBay increases the two hundred forty four three years and it repays all the initial debt the PE firm takes it public and sells off at stake evenly over three years at a 10 X multiple what is the IRR so in this case the initial investor equity is easy because two hundred I beta times eight times 50 percent gives us eight hundred now the exit enterprise value is just the 240 times the 10x multiple which is 2,400 here we know the company repays all the initial debt so the exit equity proceeds are actually the same as the exit enterprise value in this case we're assuming no cash or anything like that now the tricky part here is figuring out how many years it takes to exit if the private equity firm sells off one-third in year three one-third and year four and then one-third and year five the average number of years to exit is 4 this is a triple our money scenario because we get back two thousand four hundred and we put in 800 in the beginning and we know that tripling our money over three years that burned a forty five percent IRR and tripling our money over five years is rent of twenty five percent IRR so we could use something in the middle that range can see the approximate IRR here is 35 percent this one is actually off a little bit if you go into Excel and do the math yourself if we put in 800 in the beginning and we get back 800 each year the IRR actually comes up to 32 percent for this scenario so we're a little bit off and that's because of the fact that it took us three years to completely exit our stake in this company nevertheless our approximation isn't that far off 35 percent is decently close to 32 percent and at least we know the rough range of the IRR in this deal so those are a few examples of LBO model interview questions let's do a recap in summary now the most important point on this topic is that you have to understand the intuition behind an LBO what makes for good at buyout candidates how to walk through a simple LBL model and so on and so forth with the math questions you can always approximate the IRR if you know the multiple and the number of years in the holding period what this means is that the three key variables are the initial investor equity the exit equity proceeds and the number of years if you have all those you can always come up with some kind of estimate for the internal rate of return if they give you a variation of this type of question and they ask you for something like the purchased multiple or the EBIT ah if you're targeting a certain IRR or targeting certain multiple you can always back into those assuming that you have all the other information the way to think about it is that it's just one equation with a single variable and if there's just one single unknown you can always solve that equation to get that unknown for more unusual scenarios like IPO exits or dividend recaps think about the average year in which you receive the equity proceeds and use that to do all your math and then finally remember that these tricks work well for standard situations such as selling a company after three years or five years or seven years but they stopped working as well if it's a very short holding period like one year or two years and also stopped working well for very long holding periods like 12 years or 15 years or cases where the exit takes a very long time such as 4 years 5 years 6 years so be aware of these tricks and use them as much as you can but also be aware of their limits and understand why they may not necessarily match up with the results you get in real life that's it for this tutorial hopefully now you know a little bit more about LBO modelling interview questions what to expect and how to do some of the math and quick and proclamations that might be expected of you in interviews you
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Channel: Mergers & Inquisitions / Breaking Into Wall Street
Views: 127,715
Rating: 4.9304123 out of 5
Keywords: lbo model interview questions, lbo model interviews, walk me through an lbo, private equity interview, private equity interviews, paper lbo, approximating irr, lbo models, interview prep, lbo model, investment banking interviews, lbo, leveraged buyouts, internal rate of return, irr, MoM multiple, Cash-on-Cash Multiple, private equity, mergers and inquisitions, breaking into wall street, investment banking, investment banking interview, job interview tips, interview tips
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Length: 18min 49sec (1129 seconds)
Published: Tue Nov 01 2016
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