This post is a continuation of our prior two articles on paper LBOs:
A couple of our readers asked how to come up with reasonable debt financing assumptions if none are provided.
In our experience, this rarely occurs. The point of a paper LBO is to assess your understanding of basic LBO mechanics, not credit markets. Furthermore, many private equity firms have dedicated capital markets professionals, who provide guidance on financing assumptions and liaise with banks. To be frank, your interviewer probably wasn’t a capital markets banker and likely has a surface-level understanding of debt financing.
That being said, the question can come up. As we started writing an addendum to our paper LBO guide, we realized this question deserves its own post. So here goes:
Asking you to come up with debt financing assumptions tests the following:
- Do you have a basic understanding of credit markets?
- Do you have a sense for reasonable LBO financing limits? (If you’ve done a few sellside M&A pitches, you should)
- Are you familiar with basic credit ratios?
- Do you understand what attributes make an attractive credit?
Before composing a response, let’s review each of these topics.
A market is where buyers and sellers meet to exchange goods and services.
Capital markets are a market, like any other. There are many different providers of capital, who have unique return requirements and risk thresholds. Credit markets are a subset of the broader capital markets.
Private equity firms frequently access the credit markets in order to raise debt financing for portfolio companies and new investments. Many of the larger private equity firms even have debt financing arms.
Our Intermediate LBO Guide has more detail on LBO financing and includes links to debt primers.
Many of the attributes that make a good equity investment make a good credit investment:
- Predictable, recurring revenues & cash flows
- High margins
- Performs well during recession
- Diversified customer base / low customer concentration
- Low - negative working capital cycle
- Must-have product
- Strong management team
- Barriers to entry
- Non-cyclical industry
- Valuable collateral or fixed assets with resale value
- Large equity cushion (will get wiped out before debt in bankruptcy)
- Prior credit history (how quickly has the company delevered, etc.)
To further develop your intuition around capital structure, check out our first principles guide.
There are two main types of credit ratios:
- Leverage ratios - compare the amount of debt and the company’s cash flow (EBITDA).
- Interest coverage ratios - compare the company’s cash flow (EBITDA) and the interest expense burden.
The two main leverage ratios are:
- Total Debt / EBITDA
- Net Debt / EBITDA
The main interest coverage ratios are:
- EBITDA / Interest Expense
- EBITDA - CapEx / Interest Expense (this is especially important for capital-intensive industries)
Why use EBITDA vs. unlevered free cash flow?
We use EBITDA for credit metrics by convention. It’s just something that the credit markets have come to accept and expect. In practice, the EBITDA used would be heavily adjusted, as defined in the credit agreements. Also, while EBITDA and unlevered operating cash flow should be relatively close, unlevered free cash flow includes the impact of CapEx, whereas EBITDA does not.
Rarely does an LBO exceed 6.0x leverage (total debt / EBITDA). You occasionally see deals with 7.0x leverage, but that’s aggressive.
As a rule of thumb, the interest coverage ratio should be > 2.0x. Obviously, the higher the interest coverage ratio, the better.
Finally, any private equity investment should include a minimum 20% equity. Typically, equity is 20 - 40% of total capital.
Note: The above commentary around equity percentage is a generalization. This generalization holds for generic LBO deals. More growth-oriented investments can have a much higher equity percentage, because the returns are less dependent on capital structure (the asset’s ROA is higher).
Now that we’ve reviewed the topics that this question tests, we can begin to formulate a response.
First, I think it’s worth asking the interviewer for more information. It shows you’re approaching the problem the right way. After all, investing and the diligence process are all about asking questions and updating your view with new information. Ask for more information about the company and the industry, as these details inform the company’s creditworthiness.
- What industry is the company in? What does it do?
Of course, the interviewer might cut you off and say you have to work with the information already provided. If so, proceed to step 2 (below).
If the interviewer is playing along, and you’re unfamiliar with the industry, you should try to learn more:
- Is it capital-intensive?
- Is it a cyclical industry?
If you’re already familiar with the industry, you should signal you understand some of the credit factors. For example, you might say, “Airlines are highly cyclical, so I’m going to be cautious and assume a less aggressive debt package.”
Next, you should state your assumptions, so the interviewer can see how you’re thinking about the problem. This also gives the interviewer a chance to correct your assumptions and provide more information.
You can summarize what you know so far. For example:
- Well, so far I know it’s a specialty manufacturing company based in the U.S.
- I’m going to assume it has a diversified customer base and is relatively recession-resistant.
- Also, I’ll assume it has ample fixed assets that will serve as collateral.
- Based on the provided financials, it has a 25% EBITDA margin and is not too capital-intensive.
Going back to our Paper LBO Example, you were only given 2021 cash flow, not EBITDA, so you might say, “For the purposes of calculating credit ratios, I’ll assume that 2020 EBITDA = 2021 Unlevered FCF.”
Next, you need to figure out the various limits on how much debt the company can raise.
Let’s continue using our Paper LBO Example. We’re assuming 2020 EBITDA = 2021 Unlevered FCF (150).
6.0x total leverage equals 900 of debt. Remember the transaction value was 1,100, so that’s too high.
75% debt equals 825 of debt. That leaves 275 of equity.
In order to calculate interest coverage ratios, we need to know the interest rates of various debt tranches, so we’ll save this constraint as a confirmatory check for the end.
Combining the leverage and equity constraints, you might say: “800 total debt results in 27% equity and 5.3x total leverage, which seems reasonable.”
If there are credit concerns, you might settle on a lower total debt figure.
Contrary to our Paper LBO Example, private equity deals usually involve multiple tranches of debt. Again, for more detail on the various types of debt, you can check out the debt primers referenced in our Intermediate LBO Guide.
Here, given you don’t have much information, and this is a highly illustrative example, I think it’s best to play it safe. A classic financing scenario for LBOs is ~50% senior secured bank debt and ~50% notes (or bonds). The senior secured debt has priority and is secured against the company’s collateral, so it has a much lower interest cost. The notes have a higher interest cost, because they are junior to the bank debt.
You might say, “I’ll assume the company raises 3.0x of senior secured bank debt and finances the rest with notes. So the company raises 450 of senior secured bank debt and 350 of notes. Let’s assume the interest rate for the bank debt is Libor + 350 bps, and the interest rate for the notes is 8.000%.”
If your interviewer presses you and says that notes aren’t an option, you could finance the remainder with mezzanine debt (more expensive junior debt). An illustrative interest rate for the mezzanine debt is 10%.
You might add “Last, I want to check the interest coverage ratios to confirm this structure holds water. Assuming LIBOR equals 0.500%, the annual interest expense for the bank debt will be 18 (450 x 4%). The annual interest expense for the notes will be 28 (350 x 8%), so the total interest expense will be 46. Therefore, the PF interest coverage ratio is 3.26x. EBITDA - CapEx / Interest = 2.50x. That looks reasonable.”
At this point, your interviewer should stop asking you capital markets questions unless you’re interviewing at a firm that is extremely focused on capital structure.
If you’re preparing for private equity interviews, you should practice paper LBOs weekly. Once you get the hang of them, one problem a week should keep you fresh. Mix up the capital structure assumptions, so that you’re seeing something slightly different each time.
Also, check out some of our other tutorials (all free):