LOS o: Explain the role of cash sweep in an LBO transaction.

Q1. A cash sweep in an LBO transaction is the:

A)   excess cash used to pay down debt.

B)   excess profit paid out to the general partner.

C)   excess profit paid out to the limited partners.

Q2. Which of the following correctly identifies how an increase in the cash sweep affects the cash balance in an LBO and how it affects equityholders’ claim on the LBO investment’s assets, respectively?

               Cash balance          Equityholders’ claim on assets

A)       No effect                         Increases

B)      Decreases                        Increases

C)       No effect                         No effect

Q3. If the cash balance in an LBO is set constant by contract, and the LBO pays out all of its net income in dividends, how does a cash sweep affect equityholders’ claim on assets? Equity holders’ claim on assets:

A)   remains unchanged.

B)   decreases.

C)   increases.

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Q1. A cash sweep in an LBO transaction is the:

A)   excess cash used to pay down debt.

B)   excess profit paid out to the general partner.

C)   excess profit paid out to the limited partners.

Correct answer is A)

A cash sweep refers to the excess cash from an LBO that is used to pay down debt. Typically senior debt is paid down first, followed by junior debt based on seniority.

Q2. Which of the following correctly identifies how an increase in the cash sweep affects the cash balance in an LBO and how it affects equityholders’ claim on the LBO investment’s assets, respectively?

               Cash balance          Equityholders’ claim on assets

A)       No effect                         Increases

B)      Decreases                        Increases

C)       No effect                         No effect

Correct answer is A)

Cash sweep is the excess cash flow from an LBO that is used to pay down debt (in order of seniority). Since the LBO’s cash balance is set by contract, a cash sweep would have no effect on the cash balance.

An increase in the cash sweep reduces debt and thus increases the equity investors’ claim on an LBO investment’s assets.

Q3. If the cash balance in an LBO is set constant by contract, and the LBO pays out all of its net income in dividends, how does a cash sweep affect equityholders’ claim on assets? Equity holders’ claim on assets:

A)   remains unchanged.

B)   decreases.

C)   increases.

Correct answer is C)

Since the cash balance is set constant by contract, the cash sweep is used to pay down the LBO’s debt. Thus, debt falls. In the unusual scenario when the entire net income is used to pay dividends, the equity component remains unchanged. A reduced debt balance coupled with unchanged equity means that equity increases relative to debt and equity holders’ claim on assets also increases.

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