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WALL STREET PREP: PRIVATE EQUITY
EXAM QUESTIONS WITH VERIFIED CORRECT ANSWERS
“What is an LBO? - CORRECT ANSWER In a leveraged buyout,
- PE firm acquires a company using D + E
- Operates it for a several years with operating improvements
- sells it at the end of the period to realize a return on that investment"
"Walk me through the mechanics of an LBO model. - CORRECT ANSWER 1) Assumptions
2) S&U
- Adjust Balance Sheet - Debt and Equity - Goodwill
- Project 3 statements
- Project FCF
- Debt and Interest Schedule
- Exit Calc (MOic and IRR)
- Sensitivity Tables"
"How do you model in PIK notes? - CORRECT ANSWER
https://www.wallstreetoasis.com/forums/interview-question-pik-accounting"
"Walk me through the calculation of Free Cash Flow. - CORRECT ANSWER EBITDA
Less: Interest Less: Taxes Less: CapEx Less: Change in NWC"
"Why would a private equity firm use a convertible preferred note? - CORRECT ANSWER
Access to upside in the equity of the company. Low-risk debt investment until the company proves to be successful, then becomes an equity investment. Has the best of both worlds."
"What is the difference between senior and subordinated notes? - CORRECT ANSWER 1)
Seniority - senior debt gets paid first in a bankruptcy
- Covenants - (bank - covenants)"
"What are the key considerations to structuring a carve-out transaction? - CORRECT
ANSWER "
"How would you decide what amount of leverage to use in building a company's capital
structure? - CORRECT ANSWER Current capital structure and types of debt
EBITDA and ability to handle interest expense
Size of the company Industry (stable or cyclical) Current credit rating State of the credit markets" "Assume that your company sold an asset for a loss of $10 million (it had originally been bought
for $20 million). Walk me through the impact of this transaction on the financial statements. -
CORRECT ANSWER https://www.wallstreetoasis.com/forums/gainloss-on-sale-of-asset
Record $10 loss on I/S, NI down $6. CFO add back $10 loss, CFI up by $10, CF up $14. Cash up $14, Asset down $20, Equity down $6." "Your company sells a yearly subscription for $120. Walk me through the impact that this sale has
on the financial statements. - CORRECT ANSWER "
"Buy a business at 8.0x EBITDA, sell in 5 years at 8.0x EBITDA. IRR 20%. Banks will lend up to 4x
Debt/ EBITDA, and half will be repaid in 5 years. EBITDA Expansion? - CORRECT ANSWER
Assume 10m EBITDA. 40m Debt to start, 20m Debt to end. 20% IRR in 5 years is approx. 2.5x MoM, so exit equity is 100m. Total EV is 120m. 120/8 = 15m. 50% expansion over 5 years."
"Why do you want to pursue a career in private equity? - CORRECT ANSWER I want to be in
private equity because I enjoy learning about businesses and working with management. The opportunity to use the operational knowledge I've gained while working at Disney with financial analysis to identify attractive investments and add value to portfolio companies is something that interests me. I really enjoy the process of understanding what makes a business stand out and identifying strategic initiatives that can increase the overall performance of the company. Learn the complete deal process and holistic soft skills in effect becoming a more well-rounded investor"
"What is the most recent book you have read? - CORRECT ANSWER Da Vinci by Walter
Isaacson. It's a biography of Da Vinci life and I found it fascinating." "What happened when you worked in a team and one member wasn't contributing
appropriately? How did you respond? - CORRECT ANSWER During a recent project, one co-
worker who was senior to me regularly failed to complete his assigned tasks and frequently said he would not be doing some of his tasks. I told him privately over coffee that this resulted in other people on the team picking up his work, in addition to their own, which felt unfair. I asked if there was a reason for this issue and he said that he felt slighted by management for not getting a promotion and he was going to be leaving the company so he didn't feel it was necessary to
Provide a few reasons why you're interested in firm/PE, and what in particular sparked your interest. Networked across the entertainment industry, unique experience from operational point of view"
"How are Call Protection and "Prepayment" different? Don't they refer to the same concept? -
CORRECT ANSWER Call Protection refers to paying off the ENTIRE debt balance‚ whereas
"Prepayment" refers to repaying PART of the principal early‚ before the official maturity date."
"What are some examples of incurrence covenants? Maintenance covenants? - CORRECT
ANSWER Incurrence Covenants:
- Company cannot take on more than $2B of total debt.
- Proceeds from any asset sales must be earmarked to repay debt.
- Company cannot make acquisitions of over $200M in size.
- Company cannot spend more than $100M on CapEx each year. Maintenance Covenants:
- Total Debt / EBITDA cannot exceed 3.0x; Senior Debt / EBITDA cannot exceeds 2.0x
- (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0x
- EBITDA / Interest Expense cannot fall below 5.0x
- EBITDA / Cash Interest Expense cannot fall below 3.0x
- (EBITDA - CapEx) / Interest Expense cannot fall below 2.0x" "Why would you use PIK (Payment In Kind) debt rather than other types of debt‚ and how does it
affect the debt schedules and the other statements? - CORRECT ANSWER • Unlike "normal"
debt‚ a PIK loan does not require the borrower to make cash interest payments - instead‚ the interest accrues to the loan principal‚ which keeps going up over time. A PIK "toggle" allows the company to choose whether to pay the interest in cash or have it accrue to principal.
- PIK is riskier than other forms of debt and carries with it a higher interest rate than traditional Bank Debt or High-Yield Debt.
- Adding it to the debt schedules is similar to adding High-Yield Debt w/ a bullet maturity - except instead of assuming cash interest payments‚ you assume that the interest accrues to the principal.
- You include this interest on the Income Statement‚ but you need to add back any PIK interest on the Cash Flow Statement‚ b/c it's a non-cash expense." "How does Preferred Stock fit into these different financing methods? Isn't it a type of Debt as
well? - CORRECT ANSWER • Preferred Stock is similar to Debt and it would match the
"Mezzanine" column in the table (on p. 43) most closely.
- Just like w/ Mezzanine‚ Preferred stock has the lowest seniority in the capital structure and tends to have higher interest rates than other types of Debt."
"How do you treat Noncontrolling Interests (AKA minority interests) and Investments in Equity
Interests (AKA Associate Companies) in an LBO model? - CORRECT ANSWER • Normally you
leave these alone and assume that nothing happens - so they show up in BOTH the Sources AND Uses columns when you make assumptions in the beginning.
- You could assume that the PE firm acquires one or both of these‚ in which case they would ONLY show up in the Uses column - similar to refinancing existing Debt."
"Walk me through how you adjust the Balance Sheet in an LBO model. - CORRECT ANSWER •
This is very similar to what you see in a merger model - you calculate Goodwill‚ Other Intangible Assets‚ and the rest of the Write-Ups in the same way‚ and then the B/S adjustments (e.g. subtracting Cash‚ adding in Capitalized Financing Fees‚ writing up Assets‚ wiping out Goodwill‚ adjusting the DTAs/DTLs‚ adding in new debt‚ etc.) are almost all the same.
- In an LBO model you assume that the existing Shareholders' Equity is wiped out and replaced by the value of the cash the PE firm contributes to buy the company; you may also add in Preferred Stock‚ Management Rollover‚ or Rollover from Option Holders to this number as well depending on your assumptions.
- In an LBO model you'll usually add more tranches of debt compared to what you would see in a merger model.
- In an LBO model‚ you're not combining two companies' Balance Sheets."
"Why are Capitalized Financing Fees an Asset? - CORRECT ANSWER There are a couple ways
to think about this:
- It's just like Prepaid Expenses items on the Assets side: paid for in cash up-front and then recognized as an expense over many years. Since the company has already paid for it in cash‚ its not going to cost them anything more in future periods.
- An Asset represents potential future income or potential future savings; Capitalized Financing Fees have already been paid in cash‚ so when the expense is recognized on the Income Statement over several years it reduces the company's taxes (similar to Prepaid Expenses)." "Can you walk me through how a Debt Schedule works in an LBO model when you have multiple tranches of Debt? For example‚ what happens when you have Existing Debt‚ a Revolver‚ Term
Loans‚ and Senior Notes? - CORRECT ANSWER First off‚ note that you MUST make all
mandatory debt repayments on each tranche of debt before anything else. So there is no real "order" there - you simply have to repay what is required. The "order" applies only when you have extra cash flow beyond what is needed to meet these mandatory repayments:
- REVOLVER: You borrow additional funds here and add them to the balance if you don't have enough cash flow to meet the mandatory debt repayments each year; you use any extra cash flow each year to repay this Revolver first‚ before any other debt.
"What is the intuition underlying the usage of debt in an LBO? - CORRECT ANSWER High
percentage of borrowed funds with small initial equity investment. As debt principal is paid down the sponsor will realize greater gains on exit. Therefore firms try to maximize leverage while keeping the debt level manageable to avoid bankruptcy risk. Want more debt because it is cheaper and interest expense is tax deductible which creates a tax shield."
"What are the main levers in an LBO that drive returns? - CORRECT ANSWER 1. Debt
Paydown: deleveraging the value of PE firms equity value grows over time as debt is paid down.
- EBITDA growth: operational improvements to business margin profile
- Multiple Expansion: higher exit multiple than entry through imporved investor sentiment, better economic conditions."
"What attributes make a business an ideal LBO candidate? - CORRECT ANSWER 1. Strong
Cash Flow Generation: predictable FCF generation with high margins
- Recurring Revenue: little risk associate with cash flows
- Economic Moat: differentiating factor
- Favorable unit economics: high margins, well-managed cost structure
- Strong committed management team
- Undervalued company with strong value-added opportunities."
"In the context of an LBO what is a tax shield? - CORRECT ANSWER Reduction of taxable
income from the highly levered capital structure. Interest payments on debt are tax deductible"
"Why not only finance with senior debt? - CORRECT ANSWER Senior lenders will only lend
up to a certain point usually 2x 3x EBTIDA"
"How do financial sponsors exit an investment? - CORRECT ANSWER Sale to a strategic
buyer Secondary buyout IPO"
"Downside of an IPO exit. - CORRECT ANSWER Not imideiate, time consuming and shares
could be locked-up"
"What is rollover equity and why do private equity firms perceive it as a positive sign. -
CORRECT ANSWER When management will rollover some or all of its equity into the new
company. This is an additional source of funds which reduces the amount of funds needed to be raised by the financial sponsor"
"How can value be created during a consolidation play? - CORRECT ANSWER Increased
pricing power: customers will pay more for a stronger brand and complementary product or service Improved cost structure: consolidated company can benefit from economies of scale and cost savings."
"Common IRR estimates - CORRECT ANSWER 2x initial in 3 years = 25%
2x initial in 5 years = 15% 2.5x initial in 3 years = 35% 2.5x initial in 5 years = 20% 3x initial in 3 years = 45% 3x initial in 5 years = 25%"
"The rule of 72 - CORRECT ANSWER states that in order to find out how long it would take an
investment to double you take the annual return over 72"
"Blackstone, Carlyle and Hellman & Friedman invest in Medline - CORRECT ANSWER
Countries largest privately help manufacturer and distributor of healthcare supplies with 2020 revenue of $17.5 billion. Company will still be led by the Mills family (largest shareholders) but will use the funds to expand its product offerings, accelerate international expansion and continue to make new infrastructure investments to strengthen its global supple chain."
"Blackstone buys out Australias Crown Resorts - CORRECT ANSWER 6.3 Billion buyout of
casino firm. Cheap because of COVID setbacks. Blackstone will try to overcome some regulatory setbacks put in place by the australian govenment."
"Corporate Capital Structure - CORRECT ANSWER Senior Debt
Mezzanine Debt Convertible equity/ convertible debt Preferred Equity Common Equity"
"How do you assess credit risk? - CORRECT ANSWER Leverage Ratios (never exceed 4x)
(debt / equity - under 2x) Interest-coverage ratios (greater than 1 - maintenance - above 3x) Fixed Charge Coverage Ratio Look at the industry, growth. Credit - protection against bankruptcy Industry and Company perspective"
- Exit Multiple
- Amount of Leverage
- EBITDA expansion"
"How do you calculate amortization of intangible assets? - CORRECT ANSWER If it's
Goodwill, test annually for impairment. Other intangibles you can estimate a useful life and amortize it over its lifetime. Typically companies will do a FMV of their intangible assets and determine the useful life of the assets. For example, for a patent, it is usually good for 15 years so you may straightline the amortization over the 15 year period."
"What are the uses of excess cash flow? - CORRECT ANSWER Dividend, pay back debt, share
repurchase, capex, M&A If the borrower has excess cash and the terms of the debt provide for early repayment at the borrower's option, the borrower may use excess cash to periodically repay debt ahead of schedule. This is called "cash sweep.""
"What makes for a good management team? - CORRECT ANSWER (1) Solid MGMT team with
experience (2) A team that has weathered storms (3) Been through an acquisition before"
"What 3 questions would you ask a CEO of a company you were looking to invest in? - CORRECT
ANSWER Growth: What do you expect the company's performance to look like in the short and
long-term? Risk: What are the threats and risks to the business and what steps are you taking to mitigate them? Moat: What is the competitive advantage of your business and is it sustainable?" "You have two companies with different EV/EBITDA multiples in different industries. What are
some reasons why their EBITDA multiples might be different? - CORRECT ANSWER One
company is an acquisition target Company is in M&A process Companies have different EBITDA margins One company has controlling market share (position of company in market) One company has been hit by bad news or scandal recently Growth potential of the industry" "Company A has depreciation that is overstated by $10 million. Walk me through the impact of
this overstatement on the financial statements. - CORRECT ANSWER Income Statement -
Increase in expense by $10 to represent the increase in depreciation. Pre-tax income is down by $10. After tax (assuming a 40% tax rate), net income will be down $6. Statement of Cash Flows - Net Income flows onto the statement of cash flows as down $6. Then depreciation is added back due to the fact that it is a non-cash expense. -$6 + $10 = cash up $
Balance Sheet - Cash is up by $4 on the assets side but PPE is down by $10 as depreciation is making that less valuable. Assets are down by $6. On the SE and Liabilities side, net income flows into retained earnings, making it down $6." "Tax depreciation is $20 million over 10 years, while financial statement depreciation for the asset is $10 million over 10 years. Walk me through the impact of these differences on the
financial statements, assuming a tax rate of 40%. - CORRECT ANSWER Income statement
same as $1 depreciation each year, CFO add back depreciation and additional $0.4 deferred taxes. Create DTL on liabilities worth 40% * $1 = $0.4." "Assume that your company bought an asset for $10 million, of which $7 million was financed
through debt. Walk me through the impact of this transaction on the financial statements. -
CORRECT ANSWER I/S = NOTHING
C/F = CFI = down by 10, CFF = up by 7M B/S = Cash -3, PP&E= up by 10, L = up by 7"
"What is the difference between gross revenue and net revenue? - CORRECT ANSWER Net
Revenue - gross revenue net of discounts and returns Adjusts for price reductions, price adjustments and refunds" "The New York City subway currently costs $2.50 to ride one way. Pretend that tomorrow, the cost is going to increase to $3.00. Assuming you can lock in the $2.50 rate in the future by paying for the future rides now, how many coins would you purchase? What are the key considerations
to make? - CORRECT ANSWER Tomorrow, the $3 you spend is approximately going to = $
today (discount is only one day) However, 10 , 50, 100 years from now, $3 is worth MUCH less than the $2.50 today. At some point in the future $3 = $2.50 today Plan to buy as many tickets up to that date log 1.2 / log 1.1 = 2 years you would have to estimate potential customer demand...can other customers pre-purchase tickets, how many people use the subway on a daily basis, do the tickets expire, population growth/decline in the city, etc.? Are you constrained by financial resources? Are there modes of transportation that compete with the subway? Regulations to be aware of? Technological changes?" "What is the angle (in degrees) formed by the minute and hour hands on a clock when the time is
3:15? - CORRECT ANSWER 7.5 degrees"
"What characteristics do you think are needed to be successful in private equity? - CORRECT
ANSWER Self-starter with an ability to manage multiple workstreams. Having a good
investment acumen -- being able to identify the various risks and rewards associated with different investments and being able to take a position on the future of an industry or market."
- Each type of debt is arranged in order of rising interest rates - so Revolver has the lower interest rates‚ Term Loan A is slightly higher‚ B is slightly higher‚ Senior Notes are higher than Term Loan B and so on.
- "Seniority" refers to the order of claims on a company's assets in a bankruptcy - the Senior Secured holders are first in line‚ followed by Senior Unsecured‚ Senior Subordinated‚ and then Equity Investors.
- "Floating" or "Fixed" Interest Rates: A "floating" interest rate is tied to LIBOR. For"
"What about "Excess Cash"? Why do you sometimes see that in a Sources & Uses table? -
CORRECT ANSWER • This represents the scenario where the company itself uses its excess
cash (i.e. if it only requires $10M in cash but has $50M on its B/S‚ $40M is the excess cash) to fund the transaction. This always shows up in the Sources column.
- It's just like how you subtract Cash when calculating Enterprise Value: an acquirer would "receive" that Cash upon buying the company.
- You do not always see this item - it's more common when the company has a huge amount of excess cash and has no real reason for having it." "Can you give a complete list of items that you might see in the Sources & Uses section and explain
the less common ones? - CORRECT ANSWER • SOURCES: Debt and Preferred Stock (All
Types)‚ Investor Equity (PE firm's cash)‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Management Rollover
- USES: Equity Value of Company‚ Advisory and Legal Fees‚ Capitalized Financing Fees‚ Debt Assumed‚ Noncontrolling Interests Assumed‚ Debt Refinanced‚ Noncontrolling Interests Purchased.
- Debt and Debt-like items such as existing Preferred Stock and Noncontrolling Interests can always be either assumed (remain on the B/S) or refinanced/purchased (paid off and disappear).
- The "management rollover" refers to the option to let the management team reinvest their shares and options into the deal. For example‚ if the team currently owns 5% of the company‚ the PE firm might say‚ "We'll acquire 95% of the shares‚ and then let you keep the 5% you own to incentivize you to perform well over these next few years and reap the rewards.""
"How would you adjust the Income Statement in an LBO model? - CORRECT ANSWER The
most common adjustments:
- Cost Savings - Often you assume the PE firm cuts costs by laying off employees‚ which could affect COGS‚ Operating Expenses‚ or both.
- New Depreciation Expense - This comes from any PP&E Write-Ups in the transaction.
- New Amortization Expense - This includes both the amortization from written-up intangibles and from capitalized financing fees.
- Interest Expense on LBO Debt - You need to include both Cash and PIK interest here.
- Sponsor Management Fees - Sometimes PE firms charge a "management fee" to a company to account for the time they spend managing it. NOTES:
- Cost Savings and new D&A hit the Operating Income line; Int. Expense and Sponsor Management Fees affect Pre-Tax Income.
- Common and Preferred Stock Dividends (e.g. from a Dividend Recap‚ or just a normal preferred stock issuance) are not on this list b/c theoretically‚ Dividends should always be listed on the SCF.
- In many cases‚ however‚ they will actually be shown on the I/S in an LBO and will impact the Net Income line item only (no tax impact - they get subtracted after you've calculated Pre-Tax Income * (1 - Tax Rate)). Just be aware of this b/c you will see it from time to time‚ and remember that neither one is tax-deductible."
"Explain how a Revolver is used in an LBO model. - CORRECT ANSWER • You use a Revolver
when the cash required for Mandatory Debt Repayments exceeds the cash flow you have available to repay them.
- REVOLVER BORROWING = MAX(0‚ Total Mandatory Debt Repayment - Cash Flow Available to Repay Debt)
- The Revolver starts off "undrawn‚" meaning that you don't borrow money and don't accrue a balance unless you need it - similar to how credit cards work.
- You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments.
- Within the debt repayments themselves‚ you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans."
"Walk me through how you calculate optional debt repayments in an LBO model. - CORRECT
ANSWER • First‚ note that you ONLY look at optional repayments for Revolvers and Term
Loans - High-Yield Debt doesn't have a prepayment option‚ so effectively it's always $0.
- You start by checking how much cash flow is available based on your Beg. Cash Balance‚ Min. Cash Balance‚ Cash Flow Available for Debt Repayment from the Cash Flow Statement‚ and how much you've spent on Mandatory Debt Repayments so far.
- Then‚ if you've used your Revolver at all‚ you pay off the maximum amount that you can with the cash flow you have available.
- Next‚ for Term Loan A you assume that you pay off the maximum possible amount‚ taking into account the fact that you have less cash flow from having paid down the Revolver. You also need to take into account the fact that you might have paid off some of Term Loan A's principal as part of the Mandatory Repayments.
- Finally‚ you do the same thing for Term Loan B‚ subtracting from the "cash flow available for debt repayment" what you've already used for the Revolver and Term Loan A.
- Just like with Term Loan A‚ you need to take into account any Mandatory Repayments you've made so that you don't pay off more than the entire Term Loan B balance.
- The formulas here get very messy and depend on how your model is set up‚ but this is the basic idea for optional debt repayments."
"What types of industries attract more deal flow from financial buyers? - CORRECT ANSWER
Non-cyclical/ low growth Potential synergies Favorable industry trends"
"What are some risks to look out for when assessing potential investment opportunities? -
CORRECT ANSWER 1. Industry Cyclicality: firms look for stability and predictability
- Customer Concetration: no customer should account for more than 5-10% of total revenue as its too risky
- Customer/employee churn rates. High for both create instability
- Past institutional ownership: past PE ownership would use same strategies to cut costs."