My name's Jonathan.

Great to have you here. Hopefully you can hear me.

Hopefully you can see me. And hopefully you can also see my screen share as well.

Uh, it would be really useful, um, if you could jump onto the, um, webpage.

We're gonna talk about LBO today.

And, um, you don't have to have the files at your fingertips necessarily.

I mean, you can just watch what I'm doing on the screen, but it's probably advantageous if you do.

Um, down the bottom here of the webpage, on the bottom right, we've got a full file and we've got an empty file.

So I'm gonna click on the empty file and it should download.

So if we click on the empty file to download it, that would be good.

And I actually have that open already, so ideally, uh, you would have that downloaded.

Um, and, uh, we're gonna work through some questions together.

So when you open up the file, you land on the welcome sheet, but we wanna go to the workout sheet, so you can use your mouse to click on that or hold down control and tap page down a couple of times to get to it.

There are loads of workouts in here and we won't get through them, uh, all of them in an hour.

Uh, but there's a couple of workouts that I really would like to have a look at.

So we're gonna talk through those.

Before we do that, I'm gonna jump to the side.

So I'm gonna go over to the side, just find a bit of blank space.

And I just wanna have a really, a general discussion about, uh, leverage buyouts and, and how they work and, and what that means.

So if we set up a bit of a scenario here, um, I maybe I have experience in a certain industry, so I really understand how a certain industry works and what I'm gonna do.

I'm a financial sponsor, okay? I'm, um, private equity and I'm gonna set up a fund.

Now, it's not gonna be a mutual fund.

It's not gonna be a fund that's open to all retail investors and does things that are highly regulated.

Instead it's gonna be, um, uh, it's gonna be a private equity fund, open to credit, open to credited investors only.

Uh, and, um, and it's gonna be quite risky, okay? So let me tell you a little bit about what we're gonna do. We're hopefully gonna get you to invest in the fund and we're gonna take your money to buy a business.

So the idea is to go and buy a business today at entry, and then we're gonna hold it for about three years, and then we're gonna sell it for a return, hopefully for a return.

Now, how are we gonna make that happen? Well, I'm gonna buy a, buy a business in an industry that I really understand.

So I found a, a business that perhaps I think is undervalued in some way.

Um, and we, we we're gonna make the enterprise value worth more, okay? So from entry to X exit, the enterprise value is gonna gonna go up. And if you think about how we calculate the enterprise value, it's typically the product of the EBITDA and a multiple.

So what we're gonna do is grow the EBITDA.

And if you think, if imagine the multiple is constant from entry to exit, the thing that changes is the EBITDA goes up, then by virtue of that, the enterprise value is going to increase.

So you might say, well, when you say increase C ebitda, how are you gonna achieve that? I tell you what I'm probably not going to want to do.

I'm probably not gonna wanna grow the top line.

So if you grow the revenue, what that means is that as the businesses revenue grows, we have to invest in, um, an increase in operating working capital.

If it's a net asset, then that's a, that's a, a cash outflow.

We would have to invest in more property plant equipment. So lots of CapEx. So if we grow the EBITDA by growing the top line, then we need to invest a lot into the business and that that reduces our cash flows. We actually don't wanna do that.

And we'll talk about why in a minute.

What I'm gonna do is I'm gonna increase the EBITDA through headcount rationalization, which is a fairly sort of clinical way of saying sacking loads of people.

So we're gonna find a business that we understand, we believe that business to be undervalued.

We're gonna try and increase the value by making cost savings.

And to do this, um, I've got experience in the sector, so we're gonna use my experience, but also we wanna make this happen very, very quickly.

So usually the time horizon could be three years, could be longer, could be five or seven years, some uncertainty there. But let's talk in terms of three years.

So to make this happen really quickly, we're also gonna bring the management along for the ride.

So the incumbent management, we're gonna offer them some equity in the deal, and this could be like financially transformative for, for, for them, for their, for their lives to, to do this.

So we're gonna grow the EV but that's not all we're gonna do.

We're gonna find a company when we buy it, we're gonna put a load of debt into that company, only gonna buy it with a very, uh, small amount of, uh, equity.

Uh, just a question in chat. Yeah, it's being recorded.

Uh, and yeah, you will get that at the end. Okay? Uh, so we're gonna buy it with a, a load of debt and only a very small amount of equity.

Now, the idea is, if you think about the asset, the enterprise value between entry and exit, that's gonna get bigger.

And if we put a very thin slice of equity in and increase in the enterprise value, it's gonna bring about a large percentage increase in the, uh, in the equity value from entry to exit.

We're also gonna try and do not just grow the EV but we're gonna try and shrink the debt.

So we're gonna pay that debt down very aggressively.

And we can only do that if the business has very strong cash flows.

IE if it's got relatively modest growth.

'cause we don't wanna divert lots of those cash flows to CapEx and to increasing, uh, an OWC asset.

Okay? So that's me kind of just giving you a a, a narrative overview.

Let's actually chuck some numbers down.

Now we'll do some workouts in a minute, but before we do that, let's think about maybe what this should look like.

So I'm gonna write entry here, and I'm gonna say asset equals liability plus equity.

Let's make that bold and I'm gonna grab a few boxes here.

So let's grab a few boxes and make them green. And I'm gonna call this EV enterprise value.

And I'm gonna grab another box on the right hand side, we're gonna make this pretty simple, this example debt, and then we're gonna talk about equity and we'll chuck some numbers in here in a minute.

Let's add that up.

So what I'm trying to show you is that the, we've got the enterprise value and it's financed by debt and equity, and the majority of the financing sits with debt.

Now, let's think of some numbers.

So, uh, imagine the enterprise value is a thousand.

Imagine the debt is 600, then that would mean the equity must be the enterprise value minus the debt that has to be 400.

Okay? So, um, we're gonna say, I'm gonna say LTM ebitda.

So last 12 months EBITDA, historic ebitda, sometimes called trailing 12 months.

TTM EBITDA, I'm gonna make a number up, I'm gonna say a hundred.

So imagine that we have a hundred million of EBITDA.

Could we calculate the entry multiple from that? Well, yeah, the EV over LTM EBIT dark would be equal to a thousand divided by a hundred, okay? Um, now what I wanna do is think about the, uh, the debt.

So let's look at the, the debt to LTM EBITDA.

What multiple of debt do we have at entry? So I'm gonna take 600 and divide it by a hundred.

Really easy numbers.

So we've got six times debt to ebitda.

So is that number reasonable? Well, I'd ask you to think about yourselves as individuals.

Certainly in the uk if I take out a mortgage, I could borrow at about four or five times my salary.

Okay? So if you think about my borrowing as a multiple of my salary, about four or five times my salary, it's probably similar for you, whichever market you are in.

Now, from a company's perspective, companies borrow at different multiples of their EBITDA, okay? Obviously talking about salary doesn't make sense for a company.

So we're gonna talk about EBITDA.

So they, they borrow at different multiples of EBITDA.

If we're doing a a, a leverage transaction, an LBO, then guidance indicates that, um, about six times debt to EBITDA would, would be like a high watermark.

Now, that's only guidance and reality is that financial institutions could lend more if they want to.

So I think we typically would see like maybe seven, seven and a half times debt to EBITDA in these transactions.

But it does depend on the deal.

It does depend on the nature of the business and the industry that they're in.

Let's say here that their debt to EBITDA is six.

In fact, I could have that as an input, right? I could hard code in a six, all hj, I could say, well, you know, it's gonna be six times.

And if that's true, then we're gonna take six times the EBITDA and it'll be six.

Okay? Um, now if you think about an LBO, just the words leverage buyout, the suggestion there is that we're going to buy the business with a big chunk of debt.

If we have a business that has high growth and very high returns, those kinds of businesses trade on higher multiples.

So all other things held equal.

If it's high growth and high returns, then it'll trade on a higher multiple. Imagine I've got a company that's trading on EV to EBITDA of like 30 times.

Your debt is gonna cap out at about maybe six times.

So most of that business, if you're gonna acquire it, would need to be financed by equity.

If debt to, if EV to EBITDA was 30, debt to EBITDA is not gonna get much above six, then that means most of the acquisition is funded by equity.

Now, that can be still an exciting target.

We can make good returns in it, but in the traditional sense, it doesn't really, um, lend itself to an LBO, right? Because you can't buy it mostly with leverage and benefit from that leverage effect.

Let's think, uh, let's grab the, let's grab all of these numbers.

We're gonna copy them and I'm gonna go over here and I'm gonna paste them.

So we've got an entry, some entry numbers.

Let's just change this a bit. I'm gonna write exit, okay? And we're gonna knock out some of the numbers here and, and kind of rebuild this.

So we've um, we've bought the business at year zero and we've got a holding period.

So the holding period in years, let's just put the normal sell style there.

So holding period in years is three.

So that's just an assumption, right? Let's assume that we're gonna hold the business for three years.

Now what's gonna happen in that three year period? I said to you that we're gonna try and uplift the EBITDA number.

So let's look at EBITDA, compound annual growth rate.

So the annual growth in ebitda, let's just say 5%, okay? H oh hj. Um, that's an assumption. There we go.

So the EBITDA compound annual growth rate, we're gonna assume we'll be 5% and that means at the end of year three, the EBITDA would be equal to a hundred.

That's what it was in year zero. And we did the deal multiplied by open bracket, one plus 5% close bracket raised to the power of IE compounded up over three years.

We get to 115 point, uh, eight.

Now what about the, um, EV to EBITDA multiple? What might that be? Well, if we buy the business at 10 times EV EBITDA, then I think we should assume that we're gonna sell it at 10 times.

Now, let's think about that.

The, the EV EBITDA, the multiple you buy the business on might go up over those three years, or it might even go down over those three years.

And I think it would be useful to explore maybe the different scenarios therein to see how that might affect our returns.

But if we're looking at our base case, um, our base case for an investment, I wouldn't build an investment case, assuming that the multiple is gonna expand.

If multiple expands, we're gonna make more money.

But if you think about the multiple, the multiple is really a like a macro number, right? So the market really determines what that is.

What you can do, what I can do if we buy this business is we can directly control the ebitda.

We could be super aggressive with the EBITDA and really strip out loads of costs.

We can control that, but we cannot control the multiple.

We are at the mercy of the market.

I'm not saying it won't move, and I'm not saying we shouldn't explore the possibilities of it moving, but our kind of base case investment case should really be based on the multiple remaining constant.

So that's what we're going to do. Okay? Now I can calculate the EV, right? So the, if I've got the EBITDA number in year three and I've got the enterprise value multiple for year, for year three, then I've got the EV.

And perhaps it would be a good idea for me just to move this down and let's just move this down and just visually show that this EV has got bigger, right? So the entry, the EV was a thousand and X is 1, 1 5, 7 0.6.

Now we're also gonna try and work hard to pay down the debt.

So I'm gonna say debt pay down.

And just to make life really easy for us, I'm gonna just chuck a number in. So let's have an assumption.

Let's assume that the debt pay down is a hundred.

I think it would be interesting for us to explore that in more detail in some of the workouts, but we won't do that.

Now let's just accept, let's a hundred.

Now that means that the exit debt is gonna be equal to 600, which is what we started with, minus the hundred down assumption.

That means it'll be 500.

If the EV goes up and the debt goes down, then consequently the equity value will increase.

If the EV is 1, 1 5, 7 0.6 and the debt is now 500, then it's gone up to 6 5, 7 0.6.

So what we could do is we could look in absolute terms of the return we've made. So what's the value creation here? We've, our fund has invested 400 in year zero and at year three it's come out with 6, 5, 7 0.6.

Now if we lay that out in an equation below, we could say something like, the exit equity is equal to the entry equity.

Well, clearly they're not the same.

So what do we need to do? We're gonna multiply it by open bracket one plus some return.

I think I'm gonna call that the internal rate of return.

The IRR raise to the power of the number of years.

So just to make it clear, let me grab my stylus.

Um, the exit equity is 6 5 7 0.6.

Yeah, 6 5 7 0.6.

The entry equity is 400.

We're gonna multiply that by one. Plus the IRR, I actually don't know what the IRR is.

We're gonna raise that to the power of the number of years.

And the year count is three.

Now what I wanna solve for is the IRR.

So if we rearrange that formula, I could take the exit, maybe I'm gonna open a bracket.

Actually I could take the exit equity and I could divide it by the entry equity.

So move the entry equity to the other side of the equals sign.

So I can divide by the entry equity, close the bracket, and that would leave me with one plus IRR raised to the power of n.

I want to take that to the power of N over to the other side, which means that I'm gonna raise it to the power of open bracket one over N.

And that leaves me with one plus IRR.

I'd like to move the one to the other side of the equation.

So I'm gonna subtract one from that and that leaves me with the IRR.

We could probably calculate that, right? So if I write here IRR and we show our formulas, I could say something like equals open bracket.

And exactly as we've got above, I can go and grab the exit equity and divide it by the entry equity.

So 6, 5, 7 0.6 over 400.

It's just what I'm showing here in this formula.

Close the bracket, raise it to the power of open a bracket one over, it looks like one over the number of years.

So let's go and find the number of years that's three.

Close the bracket minus one.

Now if I say alt H and p, we get 18% as an IRR.

Is that good or bad? I mean, that sounds really good, right? If you think that's an annual return, if you put your money in a bank account, you might get a 3% return.

And I'm saying in this deal you can get 18%, but there's risk here.

So this return needs to be fairly high.

We, if we invest in the company, we don't know if we're gonna be able to exit in three years.

It could be five or it could be seven or it could be even longer than that.

We don't know whether or not we're gonna be able to uplift the EBITDA as we expect.

We don't know whether or not we're gonna generate enough cash flows to aggressively pay down the debt as we expect.

We don't know what multiple we might exit the transaction on. So there are a lot of variables here. There are a lot of uncertainties, uh, and we need to factor that in.

So in terms of return, somewhere between about 15 to 25% compound annual growth rate, IRR, um, annualized return is what we're looking for.

I don't have to calculate it like this.

I can get Excel to do some heavy lifting for me.

So I could go, let's just go below, I could say year.

And I'm gonna put a zero in there and say, because that plus one, and I could copy this out to the right and I could say cash flow and there are cash flow in year zero as the fund, we are investing 400 million to buy this business.

I'm gonna multiply that by minus one.

There are cash flows that occur for the company throughout the forecast period, which they use to pay off the debt, but the investors are not extracting anything from the business.

So the investors don't have any cashflow in year one or any cashflow in year two.

But at the end of year three, they sell the business for 6 5, 7 0.6.

So what we could do is we could say IR and we can get Excel to do a bit of heavy lifting for us.

So I could say equals IRR 'cause there's a function called I rrr returns, the internal retain rate of return of a series of cash flows.

I could hit tab to complete the name of the function and insert the bracket and then I can just go and grab these numbers.

So all Excel wants to some values, I close the bracket, I get, oh, hp I get my 18%.

So what I'm trying to say is that we could do the calculation manually ourselves if we understand the maths sitting behind it.

Alternatively, we can get Excel to do the heavy lifting for us and we should come to the same number.

Okay, I hope that makes sense. That's my kind of overview.

What I'd now like to do is formalize what we're doing.

So I'm gonna go back into the workouts.

If we go to the left, and we're gonna really just follow on from what we've done.

So we've got here, uh, oh, can I show how I ca, poly says, can I show how I calculate the exit EV Uh, yeah, absolutely Polly. So if I say formula text value in, if we're using comparables, if we're using multiples is always gonna be the product of the EBITDA for the period you're interested in and the multiple for the period you're interested in.

So the product of those two, so what I'm saying, um, Polly, is if we know that we buy the business for a thousand, yeah, the operational business is a thousand and we know that the EBITDA is a hundred, then the multiple would be 10.

Okay? One divided the, the, the other is 10.

We are gonna assume that that multiple is applicable at exit as well.

So the market might go up and down, but we're not gonna model that in 'cause it's outside of our control.

We don't wanna, we don't wanna trick ourselves into thinking we're gonna get, gonna get an incredible return just 'cause the market's, the the market's gonna move in our favor.

So we're gonna assume that's gonna remain the same.

So how do I get, so the question was how do I get the X exit EV? What I wanna do is basically reverse engineer that multiple.

So the multiple is EV over EBITDA gives you 10.

So if I multiply that multiple by 10 by by multiple the multiple by EBITDA apologies, then I get the EV.

So it's the product of the two.

Um, I hope that's okay and that makes sense.

Assume we're good. Great. Okay.

So what we're gonna do is we're gonna go, um, to the, uh, we're gonna go to workout one.

Nothing new, no new information, okay? Here at all, everything we've looked at where we're just gonna practice now.

So we have got different scenarios here.

So we've got scenario one, scenario two, scenario three and scenario four.

And if we just take a sort of cursory look, let's say entry versus exit case one.

In exit case one, we assume that we've been able to improve the ebitda, we're gonna give that a tick, okay? Because that's really what our expectation is when we're doing an LB.

We also assume here that the multiple is gonna remain constant.

It may or may not do that.

And I am interested in looking at different scenarios, but as a kind of baseline for my investment case, then I'd say that is a good assumption to make.

Now the next line item is super disappointing because in the LBO our intention is to find a business that's got really strong cash flows and use its cash flows to pay down its debt.

And it hasn't done that. Okay? I mean that is like not great.

So we're looking at a scenario where we're not able to generate any debt pay down.

We have got other scenarios and I won't talk through all each of them, but we are exploring things like multiples changing different levels of EBITDA and different levels of debt pay down.

So we're, it's useful.

I think it's useful and it's reasonable to look at these scenarios.

Now, given what, um, Polly just asked, she said, well how did we get to the EV? Our next line item here is the enterprise value.

I want the enterprise value at entry.

I also want the enterprise value in the various exit cases.

So at entry, the enterprise value is the product of EBITDA and the, um, EBITDA multiple.

So we're gonna go in at uh, 2,100.

Now this is the enterprise value.

So if I do the same color coding that we had previously in that diagram, this is the box I had in green previously.

Quick check over here.

So this is that green box at entry and four different exit scenarios.

Okay? So I'm just gonna kind keep going with that formula.

I'm gonna copy it out to the right, I'm gonna copy it all the way out to the right.

So the enterprise value is always gonna be the product of the EBITDA and the appropriate multiple for that year.

What about the debt? Well, I, I wish we could go a bit further here and do a bit more on debt.

But actually to make this example simple, we've just been given the debt.

So they have bought the business, um, using 1500 of debt.

And in case one, they haven't paid me down.

But in case two they do pay down a bit of debt and in case three, they're super aggressive, their cash flows perhaps are much stronger than they expected them to be across their forecast period.

And they really pay that debt down to keep our color coding in play.

I'm gonna color this in blue because we'd use blue in the diagram over here to figure out our entry debt and our exit debt.

Okay? Maybe just out of interest, we'll look at the multiple.

So if I take the debt and divide it by the EBITDA, we can see the multiple of debt to EBITDA.

This is not an unusual concept.

I might say to you, what is your mortgage? And I might ask you, if you divide your mortgage by your salary, by your annual salary, what multiple of borrowing have you got on your home? So this is the same for a company.

We're saying what is their debt? We don't have a salary.

So we use ebitda.

We're saying what multiple of EBITDA are they borrowing at now At entry, they're borrowing at five.

Bear in mind the exit case one, they don't pay any of that debt down.

Nevertheless, the multiple still does go down because the EBITDA increases.

So hopefully as we go forward across the forecast, they are paying down that debt and increasing their ebitda and we've got some various debt to EBITDA multiples.

Let's look at equity. So for the equity, and let's show the formulas here.

I'm gonna, I'm gonna color the equity in this sort of peachy color that we used before because what I wanna do is I wanna draw an association with the diagrams that we're drawing, the entry equity and the exit equity.

Take the EV, subtract the debt and get to equity.

So let's do that for all of these.

Let's take the enterprise value and let's subtract the debt from that.

And that gets you to the equity value.

So if I'm setting up a, I'm saying to buy this business, the fund needs to put money in to buy the business and you'd say, yeah, the business is worth 2100.

No, we don't need to invest that amount because to buy the business which has got a value of 2100, it's an asset, right? Yeah. The enterprise value is an asset. It's like buying a house, which is an asset.

We don't need to put in equity of 2100 'cause we're gonna borrow, it's a bit like taking out a mortgage.

Yep. So if we're gonna borrow 1500, we only need to put in 600.

That's an entry. And then we've got various exit scenarios.

I'm just gonna copy that out to the right.

So only one of these will end up being applicable for us, but we're just exploring different possibilities now, um, what I'd quite like to do now is calculate the IRR.

So how do we do that? Well, if I go to the right over here we had this formula, these two formulas that we were using, let's copy these and just chuck these down here.

So these are the formulas that we were using previously to calculate the IRR.

If you look at the one at the bottom, which is the rearrangement, it's the exit equity over the entra to raise the power of one over the number of years minus one.

I'm gonna do that. So I'm gonna go into exit case one.

Gonna calculate the IRR equals I'm exactly following this formula.

Open bracket exit equity divided by entry equity.

As we copy this out to the right, I always want it to look at that entry equity of 600.

So I'm gonna press F four to lock that reference close bracket.

I'm gonna raise it to the power of open bracket one over the number of years.

I don't need to lock this because in each exit case we've got its own individual year count.

Um, they happen to all be the same, but I guess they didn't have to be close bracket.

And then I'm gonna subtract one from that.

Now all h and PI get an IRR of 60 13.6%, which isn't brilliant.

I wonder if it could be better than that or if it could be worse than that.

If we copy it out to the right, then actually our best case scenario is, uh, exiting.

Uh, under case three we get a 32% IRR pretty incredible, but is worth us being aware that we might lose money.

And that's why private equity are offering higher returns of say 15 to 25%. Ideally because there is risk here that you might actually be invested in something maybe for seven years.

So you sink money into something, you can't touch that money for seven years.

In seven years time you get it back and it's worth less.

So it's possible, uh, it's, it's possible to lose money.

Let's, let's look at the value created in absolute terms.

So the, the value created in absolute terms is equal to, in the first case 880 minus 600.

I'm gonna lock that 600 and copy that out to the right.

So we've got 2 8600, 780, that's our best outcome.

And then possibly we might lose $60 million.

What I'd quite like to do is maybe think a little bit more about that value creation and break it down.

I'm gonna move these formulas out the way they're now in the way.

So let's just chuck those over there.

Okay, so uh, in absolute terms, in the first case, we've created value creation of two 80.

And if you think about the diagrams we've been drawing that value creation can come from the enterprise value increasing.

And there are two reasons why the enterprise value might increase.

So if you kind of like come off with that one, you might have bigger EBIT D and the other reason could be that you've got a bigger multiple.

So they're the two reasons that drive an increase in EV.

The other reason that you might have created value is because, or, or destroyed value.

I mean we may even say um, because you've paid down the debt, okay? So that debt paid down. So that's what we're gonna explore.

The debt repayment probably the easiest one to think about.

So if I say equals I go up to exit, uh, I go up to the entry number, I'm gonna press F four on that and I'm gonna subtract the debt and exit case one.

So if the debt is going down, we're creating value. Yep. Thinking about the diagram now, slightly annoying, but we actually have a zero in there for the first exit case.

But if I copy it out to the right, you can actually see what's going on.

So our sort of best case scenarios that you might pay down 500 million of debt, a third of the debt in three years, what about the EBITDA improvement? Because if EBITDA gets bigger, and I'm gonna remind you that in the example we made up that EBITDA did get bigger over that three year period, okay? So if we have an increase in EBITDA, then that'll create value as well.

I'm gonna say because I'm actually gonna open a bracket and I'm gonna get the exit EBITDA three 40 and I'm gonna subtract the entry EBITDA 300, actually wanna, in different scenarios, I wanna compare whatever the respective EBITDA is at exit to always the entry ebitda.

So I'm gonna lock that using F four.

Now, if I hit enter, and we just think about this, the EBITDA has gone up by 40, but it hasn't created 40 of value, right? If you go back to our example that we created here, how much has the enterprise value gone up by? So 1, 1 5, 7 0.6 minus a thousand.

The enterprise value in our example, I'm just gonna do some rough workings here, has gone up by 1 5 7 0.6.

How much did the EBITDA go up by 115.8 minus a hundred? Really easy numbers.

15.8, the increase in the EBITDA is not the same as the increase in the enterprise value.

And that is because every dollar of EBITDA is multiplied up to create value.

So if you took the 1 5, 7 0.6 is divided by the 15.8, you would get 10.

Well, I know that number.

That's the, the multiple, that's the EV EBITDA multiple.

So we're saying for every dollar of extra ebitda and we've got, we've got, we've got 15.8 million of them, but for every dollar of EBITDA you create $10 of extra value.

So if you've got 15.8 million of extra ebitda, then you've got like 15.8 or 150, uh, sorry, 158 or we'll remove some of the rounding 157.6 of extra value.

So let's go back, um, here.

So what I'm missing from this, I'm gonna press F two on that and I'm gonna multiply F two again and I'm gonna grab the entry multiple, okay? If I copy that out to the right and show you my formulas, then we're creating, uh, in the first scenario, no value from DebtPay. We haven't paid any down, but we are creating value, um, from EBITDA improvement.

What about the multiple expansion? It's a similar idea.

Open bracket. If we look at the exit multiple in case one and we subtract the entry multiple, which I'm inclined to lock with F four 'cause we always wanna compare to that, then there's nothing happening.

If I copy this out to the right, then we can see, uh, that in the second case the multiples gone up by one.

Now that doesn't mean we created one of value. That would be silly, right? Not one of value.

You know, the value creation must be the product of the EBITDA and the change in multiple.

So I'm gonna go back to that formula, I'm gonna press F two multiplied by F two again and I'm gonna go and pick up the exit EBITDA number.

It's still zero, but if we copy this out to the right, we can see it's 300 and zero and minus 340.

Now the question is, does this work? If I add up those three value creation lines, they need to be the same. These two yellow rows need to be the same. And they are.

So you could look up, say exit case four and say, oh my goodness, we've got a, you know, we, we were losing money. Under what circumstances might we lose money? Well, you might improve that ebitda and I guess that's a good thing, but if the multiple moves against you, we've gotta a fall in the multiple.

Even if you do improve the ebitda, which is probable for this deal, you will lose money.

So we we're exploring that. Perhaps that's not the, the kind of base scenario that we are building our investment case on, but it is nevertheless a scenario that we need to be mindful of.

It is possible to lose money on the deal. Okay? I'd love to do a little bit more on this.

I think we've got 20 minutes, we've got time just to squeeze in.

Um, another example, I'll tell you what I'm not very happy with.

I'm not terribly happy in the example that we've done with just having these debt numbers given to us.

So I think it might be nice to look mechanically at how you might arrive at those numbers.

I think it's actually pretty interesting to do that.

Now I'm gonna go down, I'm gonna scroll down not to work out two, three or four, but I'm gonna scroll down to work out five.

Now it is a little bit more complicated workout five.

So what we have, and I'll read through the narrative in a minute, is, um, we've got some cash flows.

We've got a cash flow statement here and we're gonna figure out how much cash the business has and then we're gonna have, uh, some debt schedules a bit further down. We've got some debt schedules.

So we've got a term loan a, a term loan B and a mezzanine loan.

So we're gonna see, given a certain amount of cash, we're gonna see how aggressively we can pay down that debt because that stimulates a return for us.

Okay? We're probably being a bit ambitious trying to squeeze this in, but I think it's a, it's a really good one to have a look at.

So I definitely wanna do that.

We'll read through the question. P co is considering acquiring X xco extracts and the forecast figures are given below, that's great.

Pecos provide you you with the source of funds it would use.

So the sources of funds are given here.

If we had a day to spend together, then what I would do is we'd explore companies and look at their forecast cash flows and we'd see how much debt we could load onto them and you know, we'd be doing a load of credit analysis on them and we'd arrive at these numbers and then we'd build an LBO model.

But we're not doing that in 60 minutes.

So we've been given these numbers, okay? So we'll assume this is the maximum amount they could potentially borrow.

Goes on to say P code would like to know how much of the acquisition debt could be paid down over the intended ownership period.

That is absolutely the key point.

How much could be paid down over the ownership period, how much debt could be paid down? You have to know that if you don't know what the exit debt is, you do not, you cannot get to the exit equity and you can't calculate the IRR. So we're gonna try and figure that out.

It says calculate the ending balance of term loan A, B and the mezzanine loan at the end of year three.

Let's just have a think about these loans.

So a term loan here we've got A and B, their loans from the bank.

Be familiar with that as a concept and uh, we pay interest in cash.

Yeah, so if I looked at the accounting equation here, I'd say asset equals liability plus equity.

And uh, every period we pay interest, uh, cash goes down and our retained earnings goes down and we'd call that interest expense.

Now we've got, below this, we've got mezzanine debt.

So if you think about the word mezzanine, let's think about real estate.

So if you're go into a fancy office building, you've got a really nice reception on the ground floor, you've got a floor above you, but in between the two you sometimes have a large balcony and that balcony is called the mezzanine floor.

So mezzanine in English language means something in between.

If it's mezzanine, it's in between.

And mezzanine finance is in between debt and equity.

So the, the term loans will be provided by financial institutions like banks and the mezzanine finance will be provided by um, probably a hedge fund.

And so what we're gonna say to the hedge fund is we wanna borrow some money, um, and they say, okay, uh, in terms of seniority, we're gonna have the mezzanine debt as relatively junior.

So it's okay, well that's reflected in a higher rate.

And uh, I'll also say that I've allocated a lot of cash flows to pay down term loan A and B.

So I can only really afford to pay the mezzanine loan when we exit the investment.

And so what I wanna do is I wanna make the interest pick now pick stands for payment in kind so we're not paying the interest in cash.

It will accumulate into the loan, it will roll up into the loan and we'll pay it at the end.

Now I did say it was mezzanine was like in between debt and equity.

So the other thing we'll do is we'll say to the mezzanine investor the hedge fund, at the end of the, uh, at the end of this deal, the LBO will pay back the principle, we'll pay back the interest.

I'm also gonna give you a certain percentage of the equity.

So it's mezzanine because on redemption they get the principle and the interest and they get some equity in the deal as well.

Um, now if you just think about the pick interest, if you've got pick interest, it cannot be a reduction in cash and you pay that interest, it's impossible because we're not paying it in cash.

I said to you, it accrues up into the loan.

So actually it increases the Mez.

So the way that the pick interest works, it's always expense.

So that's doesn't really matter if you're paying it or not, it's expensed, but rather than be paid in cash, it rolls up into the loan.

Now, um, so let's keep reading.

It says assume there are no other mandated payments. So everything we've got available to us, we're gonna, we're gonna push through debt repayment.

Assume all cash flows available for debt repayment. Were directed towards paying debt via sweep and assume interest is calculated on beginning debt balances.

Now I wouldn't usually do that, right? So I would assume that interest is calculated on an average balance, but we're doing this in a workout.

If I calculate interest on an average balance, then it's gonna create circularity and that will screw up all the other stuff in the workout.

So really just for simplicity in this particular file, we're going to base interest on beginning balances, right? Let's scroll down and let's try and get this done.

So first thing we wanna figure out how, what the cash is available for debt service.

We've got ebitda, it's not cash flow.

So from EBITDA we're gonna knock off the taxes, knock off the, I would say that's an increase in operating working capital.

If operating working capital is an asset and that asset gets bigger than cash goes down, so it's a cash outflow of 5 million.

And then CapEx, which is us buying more pp and E.

So we've got these cash flows available to us.

Let's just show the formula there.

And um, what I'm gonna do is finish building this cash flow schedule.

I'm gonna kind of finish it.

So the next uh, if you look at that line it says cashflow available for debt service.

So debt service is quite broad so the cash you've got available to service the debt would be used to pay the interest and also to repay any of the principle.

Well think about interest first 'cause there's a contractual obligation to deal with that.

Now I am not actually ready to calculate the interest yet, but we'll come back to this and fill it in and the numbers will will kind of flow through.

So what I'm gonna do if you'll permit me is I'm just gonna go down to the cashflow available for debt repayment.

I'm gonna grab the cash available for debt service.

I'm then I'm gonna grab what will become our interest cash payments, we don't have that yet.

So it looks like at the moment we've got cash available.

Having paid the interest for debt repayment of a hundred million, I'm now gonna think about the repayment of this debt, but I'm not really ready to do that either.

So if you don't mind, I'm gonna color that in yellow and we'll come back to these numbers.

Now we're gonna look at net cash flow.

Now I really need the net cash flow number to be zero, okay? If we are directing all of our cash flows to pay down debt, certainly in the first few years you wouldn't have any remaining cash flow 'cause everything's being diverted towards debt repayment at the moment.

We've got some numbers in here, but it's only 'cause we haven't populated those yellow cells yet.

You'll also notice that the beginning cash balance in year zero is zero.

And that's because when we do an LBO, we look at the company and any debt that the company's got on its balance sheet before we acquire it, we pay that off using their cash.

So we take the ca all the cash off their balance sheet to pay down that debt and then we refinance any remaining debt. So it's pretty typical that the business will uh, uh, will, will, we'll start with zero cash.

Now it might have a very small amount of cash for operational uh purposes.

So for fluctuations in o WC at the moment equals we've got beginning cash of zero, we've got net cash flow of a hundred.

So we actually do have an increase in cash position but that will disappear when we complete this.

Okay, let's scroll down then.

So if we look at term loan a bearing in mind that column C is year zero, we've got the ending balance numbers here.

Do we know when we do the deal at year zero? Do we know what the term loan a balance is? Well I think we do. If we scroll up to our sources of funds, we are being told they're gonna borrow 500 million.

I'm gonna hit enter on that.

Now that means that the beginning balance is 500 million.

Let's just show some formulas here.

Can they pay any of that 500 million off in year one? Well if you look at the cashflow available for debt repayment, it appears to be a hundred and the beginning cash beginning beginning debt is 500.

So they would, of that 500, they're gonna pay 100 off.

I'm gonna use a formula for that.

I'm gonna say equals excel. Choose the minimum open bracket of the cash available for debt repayment and the beginning balance, I'm gonna close the bracket.

Ideally I'd like this to come through as a negative number so I'm gonna multiply it by minus one.

So we think they're gonna repay a hundred million all equals equals they'll have 400 million by the end.

Can we calculate the interest on that equals Yes we can.

If you look at the sources of funds above, let's go and have a look.

We've been given the interest rate.

The interest rate is 5% term loan B and the meds have got a higher interest rate because they're more risky.

Okay? You might say well I'd rather pay the meds off first, uh, or term loan B off first because it's got a higher rate, you're not allowed to, that's the point.

It's got a higher rate because it has to wait.

You have to pay term A off first and that makes it less risky, which is why it's got the lower rate.

I'm gonna grab that 5%, I'm gonna lock that using F four and I'm gonna multiply it by the beginning balance of 500, okay, because I got told to do this in beginning balances.

I've got 25 Now what I'd like to do now is I'd like to take the interest of 25 up to my schedule.

So we're gonna have a go at filling out these yellow cells now.

So I'm gonna say equals um, in interest for uh, term A, I'm gonna go and grab that 25.

I'd quite like that to display negatively.

So I'm gonna multiply that by minus one.

I'll just copy this out to the right, although we, we've got some value errors and that's okay, just we have to copy the schedule out in a minute.

Okay? Also we've got the repayment for term loan A and I think I'd like to chuck that repayment up there as well.

So I'm gonna go to the repayment, I'm gonna say it calls.

I'm gonna go and grab that repayment number again, I will copy this out to the right.

We might get a few, you know, funny numbers in there, but it's just 'cause we haven't completed the forecast yet.

Just focus on that first year. Okay? So now we're gonna do term loan B.

And if we look at the ending balance you might say, Hey, do you know what the ending balance for term loan B is? Well, yeah, in year zero when we do the deal it's 200 million and that must be the beginning balance as well in the first year.

There we go. Okay, so um, what about the repayment? Well I'm gonna say equals I'm gonna use a min function again.

I'm gonna arrow up for the cash available for debt repayment of 75.

And I'm just gonna pause, I'm gonna say Jonathan, and they pay off 75 million of term loan B.

No, but it looks like they've got 75 million of cash.

No because they've used that 75 million to pay down term loan A.

So I'm gonna add in that repayment of term loan A, they actually have no cash available in this first year to start paying term loan B.

They won't be able to pay term loan B down until they've settled term loan A, but I'm gonna compare um, D 115 plus D 117, which is zero.

Yeah, which gens up being zero.

I'm gonna compare that to the beginning balance.

Close bracket multiplied by minus one, the ending balance is still gonna be 200.

I can calculate the interest here.

I could say equals I can go and grab the interest rate from above, which is 6%.

I will lock that using F four and I'm gonna multiply it by the beginning balance.

I've got 12. Now let's go and zoom out very slightly.

Let's feed these numbers into our model above.

I'd like the interest to go into the interest line and the repayment such that it is to go into the repayment line.

Okay, so interest on term loan B equals.

Now if I go and grab that 12 and multiply it by minus one, when we insert that interest of 12, the cash available for a debt repayment is gonna go down to 63, which means that the cash, the repayment of term loan A is gonna go down to 63.

So these numbers are shifting, they're adjusting, which means that we actually have more term loan A than we think.

It won't affect the interest 'cause the interest is based on the beginning balance. So it won't create a circularity for us.

Let's hit enter and chuck that in.

I am gonna copy this out to the right and then put that down.

And I'm gonna do the same for the repayment.

I'm gonna say it equal. I'm gonna go and grab the repayment. It happens to be zero. Okay? And then I'm gonna copy that out to the right as well and show that.

Now I could probably, 'cause we've got a load of hash values in there, I can probably copy the whole thing out to the right. And now we haven't quite finished.

But what I would like to show you is that by doing that, can you see that the cash balance is now zero? So that really has to be the case because every last dime of cash they've got, they're gonna direct towards the repayment of their debt.

So you would not expect them to have any cash available unless they get to the point where they pay all their debt down to zero.

Okay? We haven't quite finished because below we've got the mezzanine, which is kind of a bit weird because it looks like we've done everything we need to do on the cashflow statement.

And that is because the mezzanine loan's interest is payment in kind, it's pick.

So there's no cash cash implication there.

Remember we said that above.

I'm gonna grab that annotation above.

Let's move that down.

Let's move that down here.

Okay, so just remind ourselves of the accounting here.

So the interest on the mezzanine is not cash and also there's no repayment of the mezzanine until the end of the deal.

So I'm gonna ask really the same question.

I'm gonna say, hey, do we know in year zero when we do the deal what the mezzanine balance is? Well we borrowed a hundred million and so that becomes a hundred million at the beginning.

Do you know what the interest is? Well the end, it was expensive, right? 'cause it's risky for the lender here.

So the interest rate was 10%, F four multiplied by the beginning balance.

Check that out. The interest is increasing the ending balance and that is consistent with what I've drawn here in the accounting equation, but it's going up.

Okay, we're gonna copy that out to the right now we have really done the question.

We are finished, but we've still got seven minutes to go and there's a little bit of extra stuff I wanna do on this to give you some context.

The entire point of doing this model was to get the ending balance for the debt.

So let me put that into context for you.

If we, if we maybe finish this session almost where we started it.

So I'm gonna do a diagram at the top. I'm gonna say entry.

I'm gonna say asset equals liability plus equity.

And this won't be to scale. This is just gonna be a sketch.

I don't think you're gonna mind that too much.

So I'm gonna have an enterprise value.

I'll use the same color coding that we used before.

Uh, box for debt and a box for equity.

So I'm gonna say EV, debt and equity and we're gonna have uh, some entry numbers and we're also going to have some exit numbers, some entry and exit numbers.

Now, um, what do we know at entry? Do we know the entry equity? Well if you look at the sources of funds, we are being told in no uncertain terms that the private equity fund is gonna invest 300 million of equity.

Do we know the debt? We are being told outright in the source of funds and entry, they're gonna raise 800 debt.

If you know the equity and the debt, then you know the, you know the enterprise value.

Yes. What I'd like to do is I would like to calculate the EV over LTM last 12 months.

EBITDA, I'd like to calculate that.

Now I could take the EV divided by, I don't have, look at that. It's blank. I don't have the LTM EBITDA.

Now one of my colleagues wrote this file and if you look at how she built it, the EBITDA in year one is 150.

Look at the formula bar here.

If I go to the right, she's assumed that EBITDA for year two is gonna grow at half a percent.

Yep. And for year three is gonna grow at half a percent.

I'm gonna be clear, I don't know the EBITDA for year zero, but if I say equals and grab the 150, I don't think it would be unreasonable for me to divide it by 1.05 for me to discount it.

So this is an assumption on my part 'cause I don't know that that number's the case.

But if we assume that the, a reasonable EBITDA number in year zero would be 142.9, then we can calculate the EV and divided by that ebitda.

And we come to 7.7. So it was, it was bought on 7.7.

If we think about exit, okay, so what's the EV what's the EV over EBITDA multiple that we might use at exit.

Remember what we said previously? We might look at scenarios that assume that the multiple is gonna expand and contract, but our kind of base case, uh, investment, uh, uh, analysis would assume that the multiple would remain the same.

Could you calculate the EV and exit? We'd need two things. You'd need to know the multiple.

Got that. And you'd need to know the exit EBITDA in year three. We'll assume we're exit in year three. We do know that.

So if you look here, my colleague built the model, she's given us the exit ebitda. It's 165.4.

So the product of the exit multiple, which I assume is the same as the entry multiple.

And the exit EBITDA gives me the exit.

EV can we get to the exit equity so we can calculate the IRR? My goodness. To do that, we would need to know what the exit debt was.

Now the whole point of this exercise was for us to get from our cash sweep, the exit debt.

So I, I said to you earlier, I thought the, the examples we were looking at earlier were just that little bit too straightforward with the debt. And let's go a little bit deeper into a debt calculation.

So our entry debt was 800, our exit debt was 619.

Can we calculate the equity? Well, enterprise value minus debt gives me the equity number.

Can I calculate the IRR? If we go back up, we've got like three minutes left, but we're gonna do it, I know we're gonna do this.

If we go back up to the first workout, like copy that formula, let's go back down and paste that down here.

You'll remember that the IRR formula, the one at the bottom there.

So if we said let's calculate the IRR and show a formula there, the IRR is equal to open bracket.

I'm just doing what we've got here.

The exit equity divided by the entry equity closed bracket raised to the power of one over the number of years. We're assuming we're gonna exit in year three, close bracket minus one.

And we've got 20, 29 0.7%.

Okay. Is our IRR.

So what I really wanted to do is give you a lot of mechanics and give you the context of how that all fits together.

We do have about 120 seconds left, so let's try and make use of that time, shall we? Um, does anyone have any questions? Anything you'd like to ask? I'll, I'm not gonna pause for two minutes.

Don't, we're not gonna sit in silence staring at each other for two minutes.

I'm gonna pause momentarily just to see if anyone asks anything.

Okay, good. Thanks very much.

Okay guys, well look, thanks so much for being dialed in. It's really nice having you in the room. We actually had some massive numbers on this one, so, um, really, really great.

Uh, hope you enjoyed it. You know, I hope it was fun, uh, and I hope it was interesting and you learned something useful and I really look forward to seeing you guys in a future session.

Thanks very much.