Private equity interview questions
The types of questions asked in a private equity interview can be broken into four categories:
Behavioral Questions (“Fit”)
Technical LBO Questions
Investing Acumen Questions
Firm-Specific Industry Questions
Understanding the fundamental LBO concepts is essential to perform well on the LBO modeling and case study portions of the interview, as well as to showcase your judgment during investment rationale and deal discussions in the later stages of the recruiting process.
Generally, the standard technical questions are most applicable for interviewees from non-traditional backgrounds and are less common for more experienced candidates.
Q1 What is a leveraged buyout (LBO)?
An LBO is the acquisition of a company, either privately held or publicly traded, where a significant amount of the purchase price is funded using debt. The remaining portion is funded with equity contributed by the financial sponsor and in some cases, equity rolled over by the company’s existing management team.
Once the transaction closes, the acquired company will have undergone a recapitalization and transformed into a highly leveraged financial structure.
The sponsor will typically hold onto the investment between 5 to 7 years. Throughout the holding period, the acquired company will use the cash flows that it generates from its operations to service the required interest payments and pay down some of the debt principal.
The financial sponsor will usually target an IRR of approximately ~20-25%+ when considering an investment.
Q2 Walk me through the mechanics of building an LBO model.
Step 2: Sources and Uses → Next, the “Sources and Uses” section will lay out the proposed transaction structure. The “Uses” side will calculate the total amount of capital required to make the acquisition, whereas the “Sources” side will detail how the deal will be funded. Most importantly, the key question being answered is: What is the size of the equity check the financial sponsor must contribute?
Step 3: Financial Projection → Once the Sources & Uses table has been completed, the free cash flows (FCFs) of the company will be projected based on the operational assumptions (e.g. revenue growth rate, margins, interest rates on debt, tax rate). The FCFs generated are central to an LBO as it determines the amount of cash available for debt amortization and the interest expense due each year.
Step 4: Returns Calculation → In the final step, the exit assumptions of the investment are made (i.e. exit multiple, date of exit), and the total proceeds received by the private equity firm are used to calculate the IRR and cash-on-cash return, with a variety of sensitivity tables attached below.
Q3 What is the basic intuition underlying the usage of debt in an LBO?
The typical transaction structure in an LBO is financed using a high percentage of borrowed funds, with a relatively small equity contribution from the private equity sponsor. As the principal of the debt is paid down throughout the holding period, the sponsor will be able to realize greater returns upon exiting the investment.
The logic behind why it is beneficial for sponsors to contribute minimal equity is due to debt having a lower cost of capital than equity. One of the reasons the cost of debt is lower is because debt is higher up on the capital structure – as well as the interest expense associated with the debt being tax-deductible, which creates an advantageous “tax shield”. Thus, the increased leverage enables the firm to reach its returns threshold easier.
Simply put, the smaller the equity check the financial sponsor has to write towards the transaction, the higher the returns to the firm.
Private equity firms, therefore, attempt to maximize the amount of leverage while keeping the debt level manageable to avoid bankruptcy risk.
Another side benefit of using higher amounts of debt is that it leaves the firm with more unused capital (i.e. “dry powder”) that could be used to make other investments or to acquire add-ons for their portfolio companies.
Q4 What is the “Sources & Uses” section of an LBO model?
The “Sources & Uses” section outlines the amount of capital required to complete the transaction and how the proposed deal will be funded.
Uses Side → The “Uses” side answers, “What does the firm need to buy and how much will it cost?” The most significant usage of funds in an LBO is the buyout of equity from the targets’ existing shareholders. Other uses include transaction fees paid to M&A advisors, financing fees, and oftentimes the refinancing of existing debt (i.e. replacing the debt).
Sources Side → On the other hand, the “Sources” side answers: “Where is the funding coming from?” The most common sources of funds are various debt instruments, the equity contribution from the financial sponsor, excess cash on the balance sheet, and management rollover in some cases.