LBO Model - Basic Flashcards
Walk me through a basic LBO model.
Step 1: Make assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables. You can also make assumptions about financials, such as Revenue Growth, Margins etc.
Step 2: Create a ‘Sources and Uses of Cash’ section, which shows the sources of cash from financing and uses of capital that has been raised. This also shows how much Investor Equity is required.
Step 3: Adjust the company’s Balance Sheet for the new Debt and Equity figures, and also add in Goodwill and Other Intangibles on the Assets side to balance the BS.
Step 4: Project out the 3 statements and prepare debt schedules to determine how much debt is paid off per year, based on the available cash flow and required Interest Payments.
Step 5: Make assumptions about the EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.
Why would you use leverage when buying a company?
Increasing the amount of debt will increase return on equity, as equity investment is funded with your own money but debt investment is not.
Borrowing money also means the PE firm has more capital available for other/larger acquisitions.
What variables impact an LBO the most?
Purchase and exit multiples have the biggest impact.
Leverage (as a multiple of EBITDA, for example) also has a significant impact, followed by things like revenue growth and EBITDA margins.
How do you pick purchase and exit multiples in an LBO?
The same way as in all valuations - by seeing what comparable public companies are trading / what multiples similar LBO transactions have had.
As normal, you would use a range of multiples in sensitivity tables.
If you have a specific IRR target you are trying to hit, then you will set purchase and exit multiples accordingly.
What is an ideal candidate for an LBO?
- Stable and predictable cash flows (most important)
- Low-risk business
- Low capex investment required
- Opportunities for value creation
- Strong management team
- Good base of assets to use as collateral for the debt
How do you use an LBO model to value a company, and why is it often a “floor” valuation?
You use it by setting a targeted IRR (e.g. 25%), then back-solving in Excel to determine the purchase price a PE would pay to achieve that IRR.
This is a “floor” valuation, as PE is more concerned with IRR than strategic acquirers and are therefore more sensitive to purchase price.
Give an example of a real-life LBO.
A common real-life LBO analogy is a mortgage:
- Down-payment = Investor Equity in an LBO
- Mortgage = Debt in an LBO
- Mortgage Interest = Debt Interest in an LBO
- Mortgage Repayments = Debt Principal Repayments in an LBO
- Fixing up and selling the house = Creating value in the company and selling / taking it public
How is the balance sheet adjusted in an LBO?
Liabilities + Equity: New debt is added to Liabilities, and Shareholders’ Equity is replaced with the contributed capital from the PE sponsor.
Assets: Cash is adjusted for any cash used to finance the transaction, then Goodwill and Other Intangibles are used as a plug to make the BS balance.
There could also be capitalized financing fees added to the Assets side in some deals.
Why are Goodwill and Other Intangibles created in an LBO?
In the case that the PE firm pays a premium over the fair value of the business, the difference is booked to Goodwill and Other Intangibles.
Strategic acquirers will usually pay for a target in cash - why would a PE prefer to use debt?
- The PE usually intends to sell after a few years, so it is less concerned with the cash vs. debt expense difference, and more concerned with using leverage to boost its returns (by reducing the amount of its own capital it has to contribute).
- In an LBO, the debt is owned by the company, so the company assumes the risk of default. In a strategic acquisition, the buyer owns the debt (and therefore the risk).
Do you need to project all 3 statements in an LBO model?
Not necessarily - you can use an assumption for the Net Change in Working Capital rather than calculating the change in each Working Capital item.
You do need debt schedules, an income statement and a cash flow statement to show how much cash is available to repay debt.
How would you determine how much debt can be raised in an LBO and how many tranches there would be?
Look at comparable LBOs and see the debt terms / number of tranches.
You would look at companies in a similar size range and industry.
When analyzing how much debt a company can take on, and under what terms, what are reasonable leverage and coverage ratios?
This is completely dependent on the company, industry, and coverage ratios for comparable LBOs.
General rule: leverage should rarely exceed 5-10x EBITDA, and should never exceed 50x EBITDA.
What is the difference between bank debt and high-yield debt?
Most important differences:
- High-yield debt has higher interest rates than bank debt
- High-yield debt usually has fixed interest rates, whereas bank debt interest is usually floating
- High-yield debt has incurrence covenants, whereas bank debt has maintenance covenants. (Incurrence covenants prevent, maintenance covenants require)
High-yield debt usually has bullet maturity, whereas bank debt principal is usually paid off over time.
In a sizeable transaction, a PE firm uses both types of debt.
Why might you use bank debt rather than high-yield debt?
Bank debt has lower interest rates than high-yield, so a PE firm would choose bank debt if it is concerned about the company’s ability to generate cash to cover interest.
The PE firm might also choose bank debt if they plan on major NWC changes or Capex, which might not be possible with restrictive incurrence covenants on high-yield debt.
