The Cash-Free Debt-Free Basis in M&A Deals and Leveraged Buyouts: What It Means and How to Model It
In this tutorial, you’ll learn what a deal done on a cash-free debt-free basis means, how it works in the context of a leveraged buyout, and how LBO models that use this deal structure differ from ones that use a standard structure.
Cash-Free Debt-Free Basis Definition: In a cash-free debt-free deal, the Seller’s existing Cash and Debt both go to $0 when the deal closes and are replaced by new Debt and Cash (if applicable); the deal price is typically based on Purchase Enterprise Value.
Deals done on a cash-free debt-free basis are most common for private companies that get acquired by buyers such as private equity firms and large, public companies.
The short, simple explanation for these deals is the following:
Target’s Existing Cash and Debt: These both immediately go to $0 when the deal closes. In other words, the Target uses all its Cash to repay its Debt, and if there is still extra Cash, the Acquirer “gets it.” If some Debt remains after the Target has used all its Cash to repay as much Debt as it can, the Acquirer repays the remaining Debt.
Sources & Uses Schedule: The Uses side of this schedule is based on Purchase Enterprise Value rather than Purchase Equity Value and includes the normal transaction and financing fees. Enterprise Value adds Debt and subtracts Cash, which is what happens in a deal structured this way, so it’s a better fit than Equity Value.
Balance Sheet Adjustments: You must reflect the Debt repaid and Cash used, but no special adjustments or offsets are required because the new Investor Equity + new Debt in an LBO or the Cash/Debt/Stock in an M&A deal should balance these items.
Net Effect: Total Uses in the Sources and Uses schedule increases by the Target’s existing Debt and decreases by the Target’s existing Cash, which means the Sources side could change as well (in either direction).
To explain this concept in more detail, we first need to demonstrate what a “standard” transaction looks like.
The cash-free debt-free basis can apply to both M&A deals and leveraged buyouts, but we’ll use an LBO example because it’s easier to understand the differences with a single company:
A “Standard” Leveraged Buyout and How It Differs from One Done on a Cash-Free Debt-Free Basis
The main difference in a “standard” deal, such as the leveraged buyout of a public company, is that the Target’s existing Cash and Debt do not necessarily go to $0 upon deal close.
For example, the Target might retain some of its Cash because it needs a certain amount to keep running its business.
Or the Acquirer might assume the Target’s existing Debt rather than repaying it and replacing it with new Debt, if that is allowed by the lenders.
We’ll use an example of a Singaporean mobile app company with the following financial profile:
Revenue: $251 million
EBITDA: $40 million
Pre-Deal Cash Balance: $88 million
Pre-Deal Debt Balance: $50 million
Purchase TEV / EBITDA Multiple: 15x (it’s a private company)
Purchase Enterprise Value: $595 million
The Sources & Uses schedule for a “standard” leveraged buyout of this company might look like this:
The company’s Minimum Cash Balance is $20 million, so the Excess Cash on the Sources side is only $68 million.
The company uses this $68 million to repurchase some of its shares, which reduces the amount the private equity firm must pay, resulting in a lower number for Investor Equity.
The $50 million of Debt is “refinanced,” which means it is repaid and replaced with new Debt.
So, this existing balance goes to $0, but it’s immediately replaced with ~$198 million of new Term Loans and Subordinated Notes.
After building this schedule, we make the standard Balance Sheet adjustments: deducting the Cash used to fund the deal, writing up certain Assets, subtracting the refinanced Debt and adding the new Debt, and writing down and replacing the Common Shareholders’ Equity:
This Deal on a Cash-Free Debt-Free Basis
Now, suppose that the PE firm structures this deal based on a cash-free debt-free basis.
The Sources & Uses schedule would look like this:
The main difference is that the Investor Equity is $407 million, not $427 million, because with this structure, the company uses its ENTIRE Cash balance to fund the deal by repaying existing Debt and repurchasing outstanding shares.
Deals done on a cash-free debt-free basis don’t always work exactly like this, but we’ll return to this point after finishing this example.
Continuing, here’s the Balance Sheet after the deal closes:
So, the post-transaction Cash balance is now $0, but the Debt balance is the same because the old Debt gets repaid and replaced with new Debt.
You might now be asking yourself, “OK, so why is this structure such a big deal? What changes in the model?”
In the context of an LBO, the main difference is that the company can repay less Debt in the first year because its Beginning Cash Balance is below its minimum level:
The PE firm saves a bit of money upfront via the lower Investor Equity contribution, but the company has to borrow extra in Year 1.
This creates a tiny difference in the internal rate of return (IRR) and other metrics, such as the money-on-money multiple, but it’s so small that it’s not worth thinking about.
This deal structure makes a big difference only if the company has a massive Cash balance and it’s not planning to use any of it to fund a traditional deal – but it uses the entire Cash balance in a cash-free debt-free deal.
But this scenario is illogical because even in a standard deal, the PE firm would press the company to use at least some of its Cash balance to fund the transaction.
Why the Cash-Free Debt-Free Basis is Often Much Ado About Nothing
And here’s the punchline: even in a deal done on a cash-free debt-free basis, private equity firms may impose a Minimum Cash requirement on the company immediately AFTER the deal closes.
If that’s the case, there is no real difference with this deal structure.
For example, consider what this deal would look like on a cash-free debt-free basis if the PE firm also required the company to have $20 million in Cash upon deal close:
Under these terms, it’s effectively the same as a “standard” deal in which the company’s existing Debt is refinanced, and its Excess Cash is used for funding:
The deal terms are not necessarily set up this way, so there could still be minor differences with this structure.
But the overall impact of a cash-free debt-free basis tends to be low because:
1) Most companies do not have huge excess Cash balances that could fund acquisitions or leveraged buyouts of themselves.
2) Existing Debt in a leveraged buyout (and even in an M&A deal) is almost always “refinanced” or repaid and replaced with new Debt in all deal structures.
This deal structure is useful in private equity interviews and case studies as a way to simplify your assumptions and complete the model more quickly.