Today we are going to discuss a few staples of LBO modeling that give new analysts trouble. Knowing how to model revolvers, minimum cash balances and cash sweeps are also important to get right in any private equity case study or interview. They are also important in general in making financial models balance.
Revolvers in Leveraged Buy Outs
A revolving credit facility or revolving loan (the “revolver”) is an important product offered by corporate and commercial banks, as it is the cornerstone of most banking relationships.
For the layman, the revolver can be compared to a credit card with ticking interest the moment that it is drawn. The borrower also pays the lender or the bank an upfront fee for lending to them (similar to an annual fee for the credit card, but the tenor for the revolver may be up to 5 years. The borrower will also typically pay an undrawn fee (or commitment fee) to the lender based on the unutilized amount of the facility (or the entire facility) for setting aside funds for the use of the borrower on demand.
For large corporates, revolvers are for liquidity. They may not necessarily be for drawing down in normal circumstances but may be used for general corporate purposes if cash flow timing means that there is a large use of cash in a period. Usually, they will be for backstopping cheaper financing such as commercial paper. Unsecured bank revolvers are relatively expensive compared to commercial paper or secured facilities and will often be completely unutilized throughout its lifespan.
For private equity, however, the sponsor wants to put on as much leverage as possible and as long as the bank debt is cheaper after-tax than its cost of equity, the sponsor will want revolver capacity as it will bump up their return on equity (the IRR).
Note: Revolver does not show up as “debt” unless it is drawn down. Revolver capacity is liquidity – not debt. Having revolver capacity is actually positive from a credit perspective because it increases liquidity.
Revolving Credit Facility Modeling Example
Sellsidehandbook has a $10,000,000 revolver with SunTrust Bank.
Sellsidehandbook may draw on the revolver from time to time to meet cash flow needs. If the outstanding drawn amount for the month is $3 million, sellsidehandbook will pay an interest rate applicable to that $3 million. Depending on what is contracted, sellsidehandbook may pay a commitment fee on the whole facility or just the unutilized portion. The concept of a revolver is easy – however, modeling the revolver is relatively complex.
The capacity is $10 million. As this is a new revolver, the current outstanding balance is zero.
To set up the revolver, organize your model in this order:
Cash Flow from Operations
Cash Flow from Investing
Free Cash Flow
Net Debt Repayments
Net Equity Issuance/Repurchases (includes preferred shares and hybrids)
Dividends (includes preferred dividends)
Free Cash Flow after Capital Payments
Cash Available for Revolver
Required Draw (Repayment)
the historical ending outstanding (zero) is the beginning outstanding balance. The available will be the capacity of the revolver.
The most important figure for modeling the revolver is the amount to draw or repay.
Free cash flow for the purposes of the revolver is operating cash flow plus investing cash flows. Usually, operating cash flows will be positive from running the business while investing cash flows will be negative due to capital expenditures. For the revolver to balance the model, it must come after all other capital payments.
As such, after free cash flow, an analyst must look at the net amount of capital payments. Repaying debt, repurchasing stock or paying a dividend will require cash. Issuing debt or issuing shares will increase cash. In an LBO, there will be no share issuance or repayment because the company is private.
If the net amount is negative because the company is spending more money than it is earning in the period, the company will pay the difference using available cash. If available cash is not enough to plug the free cash flow deficit after capital payments, the company must draw on its revolver.
Assume that the company has run a deficit for a few years and now generates strong positive free cash flow. It will naturally pay down the revolver. So now, the payment will be the minimum of the outstanding balance of the revolver – as the company will not pay back more than what it owes, and free cash flow minus capital payments.
A simple formula in Excel for the draw is:
Draw (Repayment) =-MIN(FCF – Capital Payments, Outstanding Balance on Revolver)
If FCF is positive, all free cash flow is used to pay down outstanding draws until the balance is zero. If FCF is negative, the deficit is funded by the revolver. Easy peasy.
Modelling Minimum Cash Balance
In many LBOs, there may be a requirement in certain credit agreements for the company to maintain a minimum cash balance. This is also important in industry operating models outside of LBOs. A prominent example is the airline industry, which keeps large cash balances as a cushion against cyclicality in economy and fuel.
A very simple fix is to just subtract the minimum cash allowed from cash available.
Modelling a Cash Sweep
Since private equity transactions involve large amounts of leverage, there is credit risk that banks want off their books as soon as possible. As such, banks may demand that all free cash flow is “swept” to pay down outstanding revolver draws immediately until the revolver is paid off completely.
This is already somewhat built into the revolver formula outlined above – however, cash sweep implies the tranche of debt in question gets priority over all other capital payments. This means no paying down other debt or dividends before their debt. The formula is the same except it will be free cash flow less available cash (which factors in the minimum cash).