Advanced LBO Interview Questions for Finance

In a typical LBO, the three most important types of debt are senior secured term loans (Term Loan A and B), high-yield bonds (or mezzanine debt), and revolving credit facilities. 

1. Senior Secured Loans (Term Loan A / Term Loan B):

• Term Loan A (TLA): Usually amortizing (paid down gradually), with lower interest rates and shorter maturities. Often provided by banks.
• Term Loan B (TLB): Common in LBOs, non-amortizing or lightly amortizing, with longer maturities and higher interest rates than TLA. Widely syndicated to institutional investors.
• Risk/Return: Senior in the capital structure, backed by collateral. Lowest cost of capital but most restrictive in terms of covenants.

2. High-Yield Bonds / Mezzanine Debt:

• Subordinated to senior loans and often unsecured or lightly secured.
• Comes with higher interest rates (fixed or PIK – payment-in-kind) to compensate for higher risk.
• Mezzanine debt can include equity kickers like warrants to boost returns for lenders.
• Risk/Return: Higher cost of capital and more flexible terms, but riskier due to subordination.

3. Revolving Credit Facility (Revolver):

• Functions like a corporate credit card—used for working capital needs, seasonal liquidity gaps, or contingency funding.
• Typically undrawn at close but available throughout the holding period.
• Backed by short-term assets like receivables or inventory.
• Risk/Return: Low interest when drawn, low utilization cost otherwise. Essential for liquidity but not a long-term financing source.

The optimal debt structure in an LBO depends on factors such as the target’s cash flow profile, industry characteristics, interest rate environment, and the sponsor’s strategic objectives.

1. Cash flow stability: Companies with predictable and steady cash flows can support higher leverage and amortizing debt like Term Loan A. In contrast, businesses with more volatile earnings may require longer-tenor, low-amortization instruments such as Term Loan B or high-yield bonds to preserve liquidity.
2. Business and industry risk: In cyclical or capital-intensive sectors, flexible structures with fewer covenants and bullet maturities are often preferred. Mature or asset-heavy businesses may accommodate more senior secured debt.
3. Interest rate outlook: In a rising rate environment, fixed-rate instruments (e.g., high-yield bonds) can help manage interest expense predictability. When rates are low or falling, floating-rate debt may offer cost advantages.
4. Sponsor strategy and exit horizon: The planned holding period and exit route influence structure. Prepayment flexibility, call protection, and the impact on exit valuation are all relevant. For example, a near-term IPO might require a capital structure that aligns with public market expectations.
5. Market conditions: Prevailing credit market conditions affect the availability and pricing of different debt tranches. A practical structure balances cost of capital, covenant flexibility, and execution risk.

PIK debt is typically used when the company has limited cash flow in the early years post-acquisition but expects stronger performance later. 

Unlike traditional debt, PIK interest accrues to the loan principal rather than being paid in cash, reducing short-term liquidity pressure. Due to its higher risk, PIK debt carries a higher interest rate and is generally subordinate to senior tranches.

In the financial model, PIK debt is treated similarly to bullet maturity debt:

• On the income statement, the interest expense is recorded as usual.
• On the cash flow statement, the PIK interest is added back in the operating activities section, since it’s a non-cash item.
• On the debt schedule, the principal increases over time as the accrued interest compounds, leading to a higher repayment amount at maturity.

Optional repayments typically apply only to revolving credit facilities and term loans (Term Loan A and Term Loan B). High-yield debt and other subordinated instruments usually cannot be prepaid, so they’re excluded from this part of the model.

To calculate optional repayments:

1) Start by determining the cash available.

2) Apply optional repayments in order:

1. Revolver: Pay down any drawn amount first, using as much of the available cash as possible.
2. Term Loan A: Apply remaining cash, considering any prior mandatory amortization.
3. Term Loan B: Use any leftover cash, again adjusting for mandatory repayments.

Throughout this process, the model ensures:

• No tranche is overpaid
• Cash is allocated in priority order
• Repayments are limited by the remaining outstanding balance on each instrument

While the exact formulas vary by model, this structure ensures that excess cash is used efficiently without violating debt terms.

In an LBO model, several adjustments are made to the income statement to reflect the new ownership structure, transaction effects, and financing:

Common adjustments include:

• Cost savings: Often modeled as reduced COGS or operating expenses based on efficiency improvements or layoffs.
• New depreciation expense: Arises from PP&E write-ups during purchase price allocation.
• New amortization expense: Includes amortization of both written-up intangible assets and capitalized financing fees.
• Interest expense: Includes both cash and PIK interest on the new LBO debt.
• Sponsor management fees: If applicable, these are added as a recurring expense.
• Preferred stock dividends: Modeled if preferred equity is part of the capital structure.
• Dividend recapitalizations: Treated as a reduction to net income if the company pays out a dividend to the PE sponsor.

Placement on the income statement:

• Cost savings, depreciation, and amortization affect Operating Income (EBIT)
• Interest and sponsor fees reduce Pre-Tax Income
• Preferred and common stock dividends are subtracted from Net Income if included in the model

At the close of an LBO transaction, several adjustments are made to reflect the new ownership and capital structure:

• Cash is subtracted from the balance sheet, as it’s typically used to fund part of the purchase price.
• New debt is added, often across multiple tranches (e.g., revolver, Term Loan A/B, high-yield bonds).
• Financing and transaction fees are capitalized and amortized over time.
• Existing goodwill is removed, and new goodwill and intangibles are created based on the purchase price allocation.
• Deferred tax assets/liabilities are adjusted to reflect any write-ups or write-downs.
• Shareholders' equity is reset to reflect the sponsor’s equity contribution and any management rollover or preferred equity.

Asset write-ups and write-downs in an LBO model affect both the balance sheet and the creation of deferred tax items:

• Asset write-ups (e.g., to PP&E or intangibles) increase the book value of assets and usually create deferred tax liabilities (DTLs) due to timing differences between book and tax depreciation.
• Asset write-downs reduce the book value and may create deferred tax assets (DTAs).
• Goodwill is calculated as the excess purchase price over the fair value of net identifiable assets, after accounting for write-ups/down.

These adjustments ensure the balance sheet reflects fair market values post-acquisition and directly influence future depreciation, amortization, and tax treatment in the model.

A management option pool introduces equity dilution at exit, reducing the private equity firm's ownership percentage and proceeds. In the model, this is reflected by:

• Using the Treasury Stock Method to calculate diluted shares at exit
• Allocating a portion of the equity value to management based on their vested options

While it lowers the sponsor’s return on paper, the pool is intended to boost company performance, potentially leading to a higher exit valuation that offsets the dilution.

In an LBO model, the Revolver acts as a short-term credit facility to cover cash shortfalls, particularly when mandatory debt repayments exceed available cash flow.

• The revolver starts undrawn and is only tapped when needed. 

• Any revolver draw is added to the cash available before calculating the rest of the debt repayments.
• In later years, if there’s excess cash flow, the model assumes the company repays any outstanding revolver balance first, before making optional repayments on Term Loans.

This setup ensures the company can meet its obligations even during periods of low cash generation.

When modeling a revolver in an LBO, several key assumptions are required:

• Maximum revolver capacity: The total amount the company is allowed to borrow under the facility.
• Interest rate: Typically a floating rate (e.g., SOFR or LIBOR + spread), applied only to the drawn amount.
• Commitment fee: A small annual fee charged on the undrawn portion of the revolver.
• Repayment priority: Assumption that any excess cash is used to repay revolver borrowings before other optional debt repayments.
• Availability conditions: Some models also assume limits tied to working capital or lender restrictions, though this is more advanced.

These inputs ensure the revolver functions as a flexible backstop for short-term liquidity without distorting long-term financing assumptions.

The sponsor’s return is typically measured using MOIC (Multiple on Invested Capital) and IRR (Internal Rate of Return), both based on the equity invested at entry and the proceeds received at exit.

1) Determine equity invested at the time of acquisition (purchase price minus debt).

2) At exit, subtract any remaining debt from the enterprise value to calculate equity value.

3) Adjust for any dilution (e.g. from management option pools) to find the sponsor’s share of proceeds.

4) Use these figures to calculate:

• MOIC = Exit Equity Proceeds / Initial Equity Investment
• IRR = the annualized return based on timing of cash flows

Key return drivers are:

• EBITDA growth
• Multiple expansion (entry vs. exit)
• Deleveraging (debt reduction over time)
• Holding period
• Dilution from equity incentives

The strongest returns typically result from a balanced combination of operational improvement and efficient use of leverage, rather than relying on just multiple expansion.