LBO Model: Sources & Uses

okay hello and welcome to another tutorial video this time we're going to be going over the leveraged buyout model again and specifically focusing focusing on these sources and uses schedule and just to give you an idea of what we're talking about here I'm going to bring up examples from a few different lvl models in our courses where we have the sources and uses schedule here's an example for the three billion dollar leveraged buyout of j.crew and then we have another example here for a hypothetical leveraged buyout of Best Buy and we also have similar looking sources in use of schedule there and then a third example is for the dell leverage about silver lakes 24 billion dollar leveraged buyout of dell we again have a sources and uses schedule right here so it's a very common feature in LB o models and something that you're going to need to understand if you want to really understand the leveraged buyout model in depth and the reason why it matters so much is that your sources your funding for the deal has to equal your uses how you're spending the net the money it's sort of like how the asset side of a balance sheet has to equal the liabilities equity side or like in math how two sides of an equation must balance or in physics how energy and momentum can be neither created nor destroyed so if you've studied physics before of course you know about the conservation of momentum the conservation of energy and basically it says that with any change that you have in the natural environment between objects moving together or something like that energy is going to stay the same you cannot create energy and same with momentum mass times velocity it can't be created it can't be destroyed so it always has to remain in balance for regardless of what goes on outside and it's sort of the same thing with the sources and uses schedule money in this case we're not talking about energy or momentum or math but money can be neither created nor destroyed now as I say here sort of tongue-in-cheek yes central banks of course have been known to print money irresponsibly rampantly to devalue currency so that is one exception about companies and private equity firms can neither create nor destroy money and that's we're dealing with here so that's why it matters and to illustrate these poins going through this what I have up here is extracts from some of those models that I just showed you a simplified sources in use the schedule for j.crew and then a more complex one for Best Buy and then an even more complex one for the leveraged buyout of Dell and so what we're going to do here is once we go through a few more points and what to watch out for on why sourcing uses matter I'm going to tell you what goes into the schedule how you build the sources and you schedule a few more complex items and then we'll go through at the end what to do next if you want additional practice with this topic so as I say up here the point that the source and uses schedule the sources must balance the uses that's all well and good but the real point of the sources that use the schedule is that it determines how much cash the private equity firm has to contribute toward a deal and that in turn determines the internal rate of return on the deal so if the P firm puts in less cash well it's easier to get a high return if the PE firm puts in more cash it's more difficult to get a high return so they could sell the company for the same amount but if they paid less for it up front they're going to get a higher return if they paid more for it up front they're going to get a lower return so that's why it's so important we're saying okay here's how much it costs to buy this company with all the expenses included here's how much debt we have to fund it here's how much and other sources of funding we have and then you say but taking into account all that we still need to put in something ourselves to close the gap to make sure for example that when we buy a company and we have to pay three billion dollars for the equity and we have say 1.6 billion of debt well we need to plug that gap somehow and the way you do that is with investor equity so this is the real point of a sources in you schedule yes both sides have to balance but it's really all about calculating this number figuring out the private equity firms own contribution and then one final point here is that the schedule often explains why shareholders dislike buyouts and how and why they can often get a bad deal from these types of leveraged buyout transactions and we'll go through an example of that toward the end with again the Dell deal using that as an example so step two here we've been over why the sourcing use of schedule matters and why it's so important for a leveraged buyout model and the real point of it step two we want to go into what goes into a sources and use the schedule and how do you build one and I think it's easiest here to start with user side so in other words what you have to spend money on when you buy a company and there are basically three main categories here number one is the equity purchase price of the company so you have to buy all the company's outstanding shares to acquire a company or if it's private you just pay a lump sum for the company and then you also have to pay fees to a lot of people bankers lawyers lenders a lot of others advising you on the deal or providing financing so there are fees and then a third major category here is if debt gets repaid so if the company already has existing debt that gets repaid this also counts as a use why does it count as a use because if you're spending money to pay off that debt you need to put in more of your own cash or you need to raise more debt to pay it off so those are the three main categories here now let's go down and take a look at the use of schedule four j.crew using this as an example so the equity purchase price here was around three billion dollars then we have around twenty five million of fees and then the third major category they had about twenty four million of debt to where somebody gets repaid so we can add up our uses of funds down here and really those are the main categories even in more complex schedules they're usually just variations of these and different categories within these now let's move to the sources side next note the made items here as I say are the debt that you raise to buy the company and then the investor equity so all types of debt you can have one tranche of debt or two or ten or 15 and then the investor equity what you have to put in personally to fund the deal there are all different types of debt here you have term loans you could have a revolver you can have senior note subordinate notes mezzanine I'm not going to get into the details of these because it's not what this tutorial is about but I've arranged these in order of roughly the least risky to the riskiest form of debt and then the important part here is that when you calculate the investor equity the final category you have to take your total uses and then subtract the total sources so far so everything above the investor equity line item and you have to follow this process that I outlined here so you have to calculate the purchase price of the company add in the fees and the debt that's being paid off on the sources side add the debt that using the fund the deal and any other sources of funding and then when you calculate investor equity you have to set it equal to total uses minus sources so far and then add up total sources at the bottom so let's see an example of this in action for Jaykar again that we've already added up our uses funds here we know it costs about just over three billion dollars to buy this company and about twenty four million to repay their debt now the source is a fun so we've calculated elsewhere the amount of debt that we're using about 1 billion dollars of term loans and then about 600 million of a riskier higher interest subordinated note now what do we do next well next up here is for the investor equity we want to take our total uses and then subtract our sources so far so this plugs the gap the investor equity here is always going to plug the gap and that's why it's so important and that tells us that the PE firm has to contribute about 1.4 to 1.5 billion dollars of its own cash to do this deal how is this important why does this really matter well take a look at a few things here we could look at this and say okay what if the purchase price went up what if went up to 3.5 billion well now the P firm asked to contribute 1.9 billion what if we funded it with say a billion dollars of term loan a instead well now the P firm only has to contribute 900 million or a billion dollars of its own money so it directly impacts how much cash they're putting in and it's going to very directly impact the private equity firms returns on this deal as well and that's why the schedule is so important so we're done with this second part of this second step here what goes into the schedule and how do you build the sources and use the schedule and now let's go to the second half of this which is a few more complex items that go into the sources and use the schedule and I'm going to start with the uses side because that's a little bit more straightforward but really the main addition here the other addition that you could see is a line item called assumed existing debt and how this works is that if the company already has debt on its balance sheet and as an example let me just show you the model for Best Buy over here so you can see exactly what I mean I'm going to go down to their balance sheet and you can see here they actually already have an existing draw and revolver and not only that they have about 1.9 billion worth of existing long-term debt right here so they already have these forms of debt and the question and any buyout deal like this is what do you do with it do you have to repay it can you keep it on the company's balance sheet now obviously most of the time it helps the PE firm if they can keep the debt around because it means they don't have to pay anything to repay it so it's usually in their interest to do it but they cannot always do that let's take a look at the uses side for Best Buy just to see what happens here so equity value about 8.5 billion for the steel assume existing debt take a look at this were streaming it stays on the balance sheet so it appears under both uses and other sources and it has no net impact on the cash that is required to do this deal and that's the key takeaway here when you're assuming existing debt you're not paying off it appears under both sides of sources and uses and it has no impact on the cash required now under this we still have some of the similar items such as fees here we have the equity value of the company so those are all the same we have refinancing existing debt but this is the new item I want to show you quickly let's add up the total uses here so I can show you what happens in this case we have about ten point five billion and then under sources of funds so we have debt here on top and it's a little bit different but it's still basically the same thing just different types of debt we're using a few more different types in this case we have assumed existing debt I just went over that on them and then we have two new interesting items here excess cash used and Founder rollover what does this mean excess cash used if a company has a large cash balance that is far above what it needs to operate it can actually use some of the cash to fund the deal itself so instead of the PE firm actually putting its own cash forward or raising debt to fund the deal the company itself can take some of that cash and say you know what we're going to use this cash to buy some of our own shares and help get this deal done and once we do that the P firm will not have to buy as many shares which is why it counts as a source of funds because it reduces the amount of shares that the private equity firm has to pay thereby reducing the purchase price and the cash they contribute so that's one new item now this item can be very controversial many shareholders really just like this because they look at this and say well okay you can do that but what about if you just issue us a dividend and then we keep holding your shares because then we can capture upside if your share price goes up and we get a dividend why are you favoring the new investors in your company the new PE firm that's going to buy you guys out so this can be a controversial item and then this other item here found a rollover so in this case the founder of Best Buy owned 20% of the company and in this scenario if you have a founder or management team that is keeping a certain percent of the company what's going to happen is that it counts as a soar of funds why because if they're keeping 20% the private equity firm only needs to acquire 80% of the company not a hundred percent thereby reducing the investor equity that's required to do the deal so these are both funding sources because again it reduces the amount the private equity firm has to pay and that's a simple check you can do for any of these items if it increases how much they have to pay like repaying debt that's going to go on the user side if it decreases the amount then it's going to go in the sources side and if has no net impact it's going to appear on both sides like assume existing debt right here so I have the explanation in words over here so sources side assume debt excess cash use founder management rollover and we've already been over all that so what I wanted to now is just flesh out the schedule and show you exactly what happens for this best buy scenario so invest your equity we've already completed the first few steps our process we end up our uses of funds over here invest your equity let's take our total uses and then subtract our sources so far and then add up everything there the bottom so 10.5 billion and these match and we've done this correctly and then let's go down to this last schedule here for Dell and I just want to show you this very quickly because there is one new item here that's interesting uses of funds we sell the equity purchase price we still have repaying existing debt we selves assuming existing debt if we want to do that and this again appears on both sides of these sources and uses schedule as it should and then of course we still have all of our fees here at the bottom so the user side is pretty standard not too much there that's different let's add that up the deal price here was announced as 24 billion because the equity purchase price at the share price that silver like offered was corresponding to a value in about that range now under sources of funds we still have basically all different types of debt here at the top the revolver here is not drawn in the beginning so this is zero so if you're not drawing on that revolver initially there's going to be zero the rest these are drawn initially so these all have dollar amounts assuming system get excess cash you've been over and then founder roll over equity we went over that for Best Buy and then one new item here is the cash contribution for equity so what is this item mean this item means that Michael Dell in this case the founder the company said you know what I own a certain percent right now I'm going to keep that stake I'm going to maintain this and roll it over but it to that I actually want to put in some of my cash and acquire more of this company for myself so you can actually change the ownership percentage in a deal like this and that's another very important use case for sourcing uses it is a more advanced item but it does come up and it's important to go over what's the net impact of this well if he puts in seven hundred fifty million more think about it this way the new ownership is going to consist of him these two items and then Silverlake now these other items up here these do not factor into the ownership because these are all other people's money raising debt doesn't give the lenders any ownership of the company's equity so this has no impact all that has an impact is these last three items here and so what does it do well let's take a look at it for ourselves invest your equity let's take our total uses and then subtract our sources so far so 1.2 billion for Silverlake let's add up our total sources down here what is the overall impact of this well the overall impact is that Michael Dell will now own let's just do the math right here about 70% of the company now if we didn't put in that cash contribution he would only owned about 65% the company silver like we'd have to contribute a lot more and that is the impact of a cash contribution to up a management team or founders stake in a business like this so that's sources and uses and as I say here this is something that can really infuriate shareholders and actually I'm going to bring up the Dell I'll be a model to show you what happens take a look at this Michael Dell owned 15% before but then after the deal takes place he owns 78% of the company can you imagine how mad shareholders would get at this because he didn't really do a great job of leading it yes he owned a percentage of it but the share price had fallen a lot of company wasn't doing well and then because of this deal he opted his ownership percentage astronomically going from 15% to 78% and this is why people like Carl I can for example protested so much when the deal took place and of course the moral of the story is that if you understand the sources and use a schedule and you understand that the equity here represents ownership and the company's new equity and that everything else above it does not then you understand how this works and the dynamics of why these deals can off be a bad deal for shareholders so that's it for our tutorial to sum up what we did here we started off with wise sources and uses schedule that schedule matters what goes into it and how you build one start with the user side calculate everything there then go to the source side look at debt investor equity is the plug just equal to total uses minus sources so far and then we looked at a few more complex items like the assumption of debt excess cash rollovers and additional cash contributions what next find a deal you're interested in find a deal you've read about and use press releases company filings to construct your own sources and use a schedule maybe you won't be able to do it exactly but you come up with a rough estimate of it and then be prepared for these questions and interviews they're very common in private equity interviews but sometimes even in investment bank interviews you're going to have to know about it and of course if you get a case study on this you get a modeling test you're definitely going to have to know it for these interviews and then finally if you read about shareholders or activists investors getting angry like the car like an example you'll know exactly why so that's it for our tutorial on sources and uses hope you got a lot out of this one and that you understand the concept more effectively now you

Channel: Mergers & Inquisitions / Breaking Into Wall Street

Views: 83,713

Keywords: sources & uses, management rollover, founder rollover, excess cash, dell lbo, dell leveraged buyout, lbo, LBO Valuation Model, leveraged buyout, lbo model, leveraged buyout model, private equity, deal ownership, debt assumed, debt refinanced, michael dell, carl icahn, lbo modeling test, private equity modeling test, private equity case study, term loans, subordinated notes, Mergers And Inquisitions, Wall Street Prep, WSTSS, EduPristine, breaking into wall street

Id: w-SQ4rOe3LE

Length: 17min 20sec (1040 seconds)

Published: Tue Jan 28 2014