LBO Analysis Flashcards
What is a leveraged buyout and why does it work?
In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells the company at the end of the period to realize a return on its investment. During the period of ownership, the PE firm uses the company’s cash flows to pay for the interest expense on the Debt and to repay Debt principal. It works because leverage amplifies returns: If the deal performs well, the PE firm will realize higher returns than if it had bought the company with 100% Equity. But leverage also presents risks because it means the returns will be even worse if the deal does not perform well.
Why do PE firms use leverage when buying companies?
To amplify their returns. Leverage does NOT “increase returns”: Using leverage – borrowing money from others – to fund a deal simplify makes positive returns even more positive and negative returns even more negative. All PE firms aim for positive returns above a certain IRR, and using leverage makes it easier to get there… if the deal goes well. A secondary benefit is that the PE firm has more capital available to buy other companies since it won’t use up all its funds on acquiring one company.
Walk me through a basic LBO model.
“In an LBO model, in Step 1, you make assumptions for the Purchase Price, Debt and Equity, Interest Rate on Debt, and other variables such as the company’s revenue growth and margins. In Step 2, you create a Sources & Uses schedule to show exactly how much how much in Investor Equity the PE firm contributes; you also create a Purchase Price Allocation Schedule to calculate the Goodwill. In Step 3, you adjust the company’s Balance Sheet for the new Debt and Equity figures, allocate the purchase price, and add Goodwill & Other Intangibles to the Assets side to make everything balance. In Step 4, you project the company’s Income Statement, Balance Sheet, and Cash Flow Statement, and determine how much Debt it repays each year based on its Free Cash Flow. Finally, in Step 5, you make assumptions about the exit, usually assuming an EBITDA Exit Multiple, and you calculate the IRR and Money-on-Money multiple based on the proceeds the PE firm earns at the end.”
Can you explain the legal structure behind a leveraged buyout and how it benefits the private equity firm?
In a leveraged buyout, the PE firm forms a “holding company,” which it owns, and then this “holding company” acquires the real company. The banks and other lenders that provide the Debt lend to this Holding Company so that the Debt is at the “HoldCo” level. Managers and executives at the acquired company that retain ownership after the deal closes also have shares in this Holding Company. This structure is important because it means that the private equity firm is NOT “on the hook” for the Debt it uses in the deal: It’s up to the Target Company to repay it. Not only does the PE firm borrow other peoples’ money to do the deal, but it doesn’t even borrow the money directly – the company borrows the money so the PE firm can do the deal.
What assumptions impact a leveraged buyout the most?
The Purchase and Exit assumptions, usually based on EBITDA multiples, make the biggest impact on a leveraged buyout. A lower Purchase Multiple results in higher returns, and a higher Exit Multiple results in higher returns. After that, the % Debt Used makes the biggest impact. If the deal performs well, more leverage will make it perform even better, and vice versa if it does not perform well. Revenue growth, EBITDA margins, interest rates and principal repayments on Debt all make an impact as well, but less so than the other assumptions.
How do you select the purchase multiples and exit multiples in an LBO model?
For public companies, typically you assume a share-price premium and check the implied purchase multiple against the valuation methodologies to make sure it’s reasonable. For example, you might assume a 30% premium to the company’s share price of $10.00, which implies an EV / EBITDA multiple of 10x. For private companies, you determine the purchase multiple by looking at comparable companies, precedent transactions, and the DCF analysis. The exit multiple is typically similar to the purchase multiple but could go higher or lower depending on the company’s FCF growth and ROIC by the end. You always use a range of purchase and exit multiples to analyze the transaction via sensitivity tables.
What is an “ideal” candidate for an LBO?
Almost any deal can work at the right price. Assuming the price is right – i.e., the company is relatively undervalued compared with its peers – an ideal LBO candidate should also: • Have stable and predictable cash flows (so it can repay Debt); • Not have much need for ongoing investments such as CapEx; • Be in a fast-growing and highly fragmented industry (so the company can make add-on acquisitions); • Have opportunities to cut costs and increase margins; • Have a strong management team; • Have a solid base of assets to use as collateral for Debt; • Have a realistic path to an exit, with returns driven by EBITDA growth and Debt paydown rather than multiple expansion. The first point about stable cash flows is the most important one after price.
How do you use an LBO model to value a company, and why does it set the “floor valuation” for the company?
You use it to value a company by setting a targeted IRR, such as 25%, and then using Goal Seek in Excel to determine the purchase price that the PE firm could pay to achieve that IRR. For example, if the exit multiple is 11x, which translates into $1,000 in Equity Proceeds for the PE firm, Goal Seek in Excel might tell you that the firm could pay $328 in Investor Equity to achieve a 25% IRR over 5 years. At a 50% Debt / Equity split, that translates into a Purchase Enterprise Value of $656. This method produces a “floor valuation” because it tell you the maximum amount a PE firm could pay to realize a certain IRR. Other methodologies are not constrained in the same way.
Wait a minute, how is an LBO valuation different from a DCF valuation? don’t they both value a company based on its cash flows?
They are both based on cash flows, but in a DCF you’re saying, “What could this company be worth, based on the Present Value of its cash flows?” But in an LBO, you’re saying, “What could we pay for this company if we want to achieve an IRR of, say, 25%, in 5 years?” Both methodologies are similar, but with the LBO valuation, you’re constraining the values based on the returns you’re targeting.
How is a leveraged buyout different from a normal M&A deal?
In an LBO, you assume the company is sold after 3-5 years (and sometimes a bit more than that). As a result, you focus on the IRR and MoM multiple as the key metrics. Also, PE firms can use only Debt and Equity (Equity means “Cash” in this context) to fund deals, whereas normal companies in M&A deals can use Cash, Debt, and Stock. Synergies and EPS accretion/dilution matter a lot in M&A deals, but not at all in LBOs. You determine the Purchase Price in similar ways, but in an LBO, you’ll often “back into” the Purchase Price based on the price required to achieve a targeted IRR.
A strategic acquirer usually prefers to pay for another company with 100% Cash - if that’s the case, why would a PE firm want to use Debt in an LBO?
It’s a different scenario in an LBO because: 1) The PE firm plans to sell the company in a few years – so it’s less concerned with the expense of Debt and more concerned with using leverage to amplify its returns by reducing the capital it contributes upfront. 2) In an LBO, the company is responsible for repaying the Debt, so the acquired company assumes most of the risk. In a standard M&A deal, the Buyer or “Combined Entity” carry the Debt, so there’s far more risk for the acquirer.
How could a private equity firm boost its returns in an LBO?
The main returns drivers are Multiple Expansion, EBITDA Growth, and Debt Paydown and Cash Generation, so a PE firm could improve its returns by improving any of those. In practice, this means: • Multiple Expansion – Reduce the Purchase Multiple and/or increase the Exit Multiple.
• EBITDA Growth – Increase the company’s revenue growth rate or boost its margins by cutting expenses.
• Debt Paydown and Cash Generation – Increase the Leverage (Debt) used in the deal, or improve the company’s cash flow by cutting CapEx and Working Capital requirements. Since the PE firm has the most control over the last factor, the easiest way to boost returns is to use more Debt (assuming the deal doesn’t blow up and destroy the universe).
How do you calculate the internal rate of return (IRR) in an LBO model, and what does it mean?
The IRR in an LBO is “the effective annual compounded interest rate”: For example, if you invest $100 in the beginning and get back $200 after 5 years, what interest rate would turn that $100 into $200 by the end? You calculate the IRR by making the Investor Equity (Cash) that a PE firm contributes a negative, and then using positives for Dividends to the PE firm and the Net Proceeds to the PE firm at the end. Then, you apply the IRR function in Excel to all the numbers, making sure that you’ve entered “0” for any periods where there’s no cash received or spent. If there are no Dividends or other distributions in between purchase and exit: IRR = (Exit Proceeds / Investor Equity) ^ (1 / # Years) – 1
How can you quickly approximate the IRR in an LBO? Are there any rules of thumb?
Yes. If you double your money, you can divide 100% by the # of years and multiply by ~75% to account for the compounding, and that gives you the approximate IRR. If you triple your money, you can divide 200% by the # of years and multiply by ~65%, since there’s a greater compounding effect there. The key numbers include:
• Double Your Money in 3 Years = ~25% IRR
• Double Your Money in 5 Years = ~15% IRR
• Triple Your Money in 3 Years = ~45% IRR
• Triple Your Money in 5 Years = ~25% IRR Technically, it’s 44% instead of the 45% IRR, and the first ~25% should be 26%, but the mental math is easier with these figures.
A PE firm acquires a $100 million EBITDA company for a 10x purchase multiple and funds the deal with 60% Debt. The company’s EBITDA grows to $150 million by Year 5, but the exit multiple drops to 9x. The company repays $250 million of Debt in this time and generates no extra Cash. What’s the IRR?
Initially, the PE firm uses 40% Equity, which means $100 million * 10x * 40% = $400 million. The Exit Enterprise Value = $150 million * 9x = $1,350 million (Mental Math: $150 million * 10x = $1.5 billion, and subtract $150 million). The initial Debt amount was $600 million, and the company repaid $250 million, so $350 million of Debt remains upon exit. The Equity Proceeds to the PE firm are $1,350 million – $350 million = $1 billion. $1 billion / $400 million = 2.5x, which is in between 2x and 3x over 5 years; since 2x over 5 years is 15% and 3x is 25%, this IRR is approximately 20%.
