Building the Cash Flow Sweep:

The world of private equity revolves around the strategy of employing leverage to enhance returns, which is why the debt schedule with a cash flow sweep is critical to any LBO model. A better understanding of this critical piece of modeling can also illuminate several principles of finance. To explain why, let’s first explore the purpose of a cash flow sweep.

The Purpose of the Cash Flow Sweep:

The cash flow sweep calculates the amount of cash generated in any accounting period for the purpose of paying down the outstanding debt obligations of the company on an accelerated schedule. These payments must be made in order of seniority and in accordance with credit agreements and intercreditor agreements.  

From the definition above, it follows that evaluating the mechanics of a cash flow sweep will center on three essential concepts:

1. How a Company Generates Cash: Calculating the amount of cash available for debt repayment requires an understanding of the cash flow statement. (Author’s opinion: One of the most important technical skill sets to develop early as an investor is an understanding of how every transaction affects cash.)
2. The Significance of Seniority in Capital Structure: The cash flow sweep must carefully prioritize repayment of debt according to seniority. While it might be appealing to prioritize repayment of the most expensive debt tranches, the credit documents will direct excess cash flow to the most senior (and generally least expensive) credit first. 
3. How Capital Structure Impacts Returns: We have explored in previous lessons how debt enhances returns, but the toggle on a cash flow sweep will demonstrate that returns are enhanced by the amount of interest payments avoided with accelerated debt repayment as well. 

Beyond being a requirement in any LBO model building exercise, understanding a cash flow sweep will provide a better understanding of finance. As we work through the mechanics, revisit the three points listed above as often as you can. The more context you have for why you are building this schedule the easier it will be to do it from memory in the future.

In this lesson we will cover the following:

1. The optimal sequence to follow when building a debt schedule with a cash flow sweep.
2. The mechanics of the cash flow sweep.
3. The line of credit (a.k.a. the “revolver”).