• 118 02/17/2021

In an LBO model the sources and uses table is a convenient way to track the sources and uses of cash required to close a transaction. Building a sources and uses table can appear to be a process that is without a proper sequence, but there is definitely an order that can be followed. To understand it, let’s first explore concise definitions of the two terms. Think of sources and uses as follows:

Sources: The sources of cash required to consummate the transaction.
Uses: The cash used satisfy all claimants of the target company so that ownership can be transferred (enterprise value or purchase price) and to pay all of the fees associated with the transaction. Total uses will be equal to enterprise value plus all fees.

Under Uses we need to further define claimants and fees, because in both instances there will be two types.

Claimants will need to be divided between shareholders (target company equity holders / "Seller Proceeds" in the table below) and creditors (target company debt holders / "OldCo Debt" in the table below). Enterprise Value - OldCo Debt = Seller Proceeds. Another way to think about Seller Proceeds is that this is the sum required to purchase the target company's equity.
Fees will be divided between transaction expenses and financing fees.

With these definitions in mind, we can establish a sequence. The image below pulls data from the LBO Case Study to complete the sources and uses table. The steps are outlined below the image and a video at the bottom of this post walks through the process in detail.

SEQUENCE (All of the "video links" included in the outline are timestamps for the YouTube video available below.)

1. Establish Purchase Price (EBITDA x EBITDA Multiple) [Video Link]
2. Sources and Uses: Estimate Debt Available to Finance the Acquisition and Financing Fees (Note: Use Term Sheets if Available.) [Video Link]
3. Uses: Identify Debt Balances of the Target Company to be Paid Off (Satisfy Debt Holders) [Video Link]
4. Uses: Estimate Transaction Expenses [Video Link]
5. Uses: Calculate Total Capital Required to Close (Sum of Purchase Price and Fees)
6. Uses: Calculate Seller Proceeds (Cash Required to Purchase Target Company Equity) [Video Link]
7. Sources: Set Total Sources Equal to Total Uses
8. Sources: Calculate Equity Required to Close (Total Sources – Debt Available) [Video Link]
In the video available below I build a Sources and Uses table for the LBO Case Study as part of a live “Watch-Me-Build-It-Series.” As a visual for this sequence I have included timestamps below the video to make it easy to reference.

1. LBO Pro Forma Balance Sheet Adjustments (Template Available)
2. LBO Case Study (Case Study and Template Available)

Note: All of the information included in the sources and uses table pulls from the LBO Case Study linked above.

• 117 01/27/2021

This video is Part 4 of an introduction to private equity. In this video you will learn more about the individuals involved in the process of sourcing, structuring and closing transactions. The video provides an introduction to the independent sponsor (aka fundless sponsor), and explains certain advantages dealmakers have over their competition. The conclusion covers a brief comparison of the independent sponsor structure and the private equity fund structure.

After a short introduction, the video provides a little background on the independent sponsor (going back to 1984). Superficially, an independent sponsor is an individual that acquires companies and raises funds on a deal-by-deal basis without raising a committed pool of capital. Click on the image below to skip to this detail (all images are linked to the relevant part of the video).

THE DEALMAKERS

In this video three unique dealmakers are introduced. This video starts with Bradley Jacobs, who is well known for having completed 500 acquisitions. Per his one-page website:

Over the course of his career, Jacobs has led teams that integrated approximately 500 acquisitions and opened over 250 greenfield locations, raised over \$25 billion of debt and equity capital, including two IPOs, and created icons of business excellence across several industries.

Next the video covers a less conventional private equity participant, Hollywood actor Ryan Reynolds. Reynolds has an advantage few can match in his social media megaphone. For example, when he invested in Aviation Gin, sales reportedly doubled from \$20 million to \$40 million, and Jeffries estimated that the company sold 96,000 cases in 2019. Then in 2020 Diageo agreed to acquire Davos Brands LLC, a portfolio of brands including Aviation Gin, for \$610 million.

As one last example, Vista Equity Partners, which was founded by billionaire investor Robert Smith, has been included as well. Vista is known for turning software companies into profit machines. Per an article in the WSJ:

This video concludes with a brief comparison of the independent sponsor structure to the private equity fund structure. The reason an introduction to the independent sponsor is helpful to understanding private equity is that the independent sponsor model allows us to focus on a single initial transaction. In the videos that follow both of these structures will be dismantled and explained one component at a time, and by the conclusion of this course you should have a greater understanding of how these two private equity participants operate.

Introduction to Private Equity Series:

• 116 01/27/2021

This video is Part 3 of an introduction to private equity. In this video we will explore how to determine the appropriate amount of leverage for a target investment.

DEBT RATIO ANALYSIS

In a control private equity transaction, debt is commonly employed to acquire a business. This debt creates obligations of interest and principal payments that are due on a timely basis. If these payments are not made creditors can take action to recover the sums borrowed by the company.

For this reason much of the financial analysis involved in underwriting a transaction will focus on the company’s ability to make timely interest and principal payments. The degree to which a company’s performance can decline while maintaining its debt obligations is an indication of safety. For example, if a company can continue to meet its debt obligations even if revenue declines by as much as 25% it might make investors more confident.

To measure this flexibility, a company will be modeled under various scenarios with debt ratios for each projected period. This permits evaluating the business under a variety of different capital structures. On a most superficial basis, debt ratio analysis revolves around a comparison of liquidity or measure of profitability and the debt-related obligations of a company. The video linked in this newsletter starts by introducing the debt-to-EBITDA ratio.

FIXED CHARGE COVERAGE RATIO

As the video demonstrates, however, EBITDA is not a good proxy for cash flow and the total debt balance fails to communicate what is required in each period to remain in compliance. The Fixed Charge Coverage Ratio (FCCR) is introduced as a solution to these shortcomings.

The fixed charge coverage ratio is used to measure a company's ability to cover its "fixed charges" (largely debt-related payments but this can include additional obligations as you will see below) due in any given period. Below we will start with a simple visual and expand on this by including the definition a senior lender might use in a term sheet.

The Fixed Charge Coverage Ratio gets more precise by subtracting additional uses of cash from EBITDA to get to a closer approximation of cash flow for the period. The logic behind subtracting capital expenditures instead of depreciation and amortization (the “DA” in EBITDA) is that capital expenditures are a cash outflow whereas D&A are noncash items. After that, cash taxes are subtracted to arrive at a better approximation of cash flow. Interest expense is not subtracted, but it can be found in the denominator (interest expense is one of the "fixed charges").

To elaborate on the denominator, rather than reference gross debt, this calculation looks at the actual cash required to remain in compliance in each period. Since you are more closely comparing the cash available for debt payments to the debt payments required in each period, a lender typically requires that this ratio remain above a minimum threshold of 1.2x.

Example of what you might find in a senior debt term sheet:
"Fixed Charge Coverage Ratio - Borrower shall not permit the ratio of (a) EBITDA minus the sum of (i) capital expenditures (excluding financed or equity funded capital expenditures), (ii) taxes, (iii) distributions, divided by (b) the sum of (i) cash interest expense and (ii) scheduled principal payments on total funded debt (including capital lease payments) to be less than 1.25x."

Introduction to Private Equity Series:

Models are:

A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

*Answers a, b, c, d, e, f and g are all correct.