LBO Model Questions and Answers
1. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-First, the
Liabilities & Equities side is adjusted - the new debt is added on, and the
Shareholders' Equity is "wiped out" and replaced by however much equity the
private equity firm is contributing.
On the Assets side, Cash is adjusted for any cash used to finance the transaction,
and then Goodwill & Other Intangibles are used as a "plug" to make the Balance
Sheet balance.
Depending on the transaction, there could be other effects as well - such as
capitalized financing fees added to the Assets side.
2. Give an example of a "real-life" LBO. - ANS-The most common analogy is taking out
a mortgage when you buy a house.
• Down Payment: Investor Equity
• Mortgage: Debt
• Mortgage Interest Payments: Debt Interest
• Mortgage Repayments: Debt Principal Repayments
• Selling the House: Selling the Company / Taking It Public
3. How could a private equity firm boost its return in an LBO? - ANS-1. Lower the
Purchase Price in the model.
2. Raise the Exit Multiple / Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company's growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees, consolidating
buildings, etc.).
Note: These are all "theoretical" and refer to the model rather than reality - in
practice it's hard to actually implement these.
4. How Do You Determine the Cash / Stock / Debt Mix in an M&A Deal? - ANS-Generally,
it's cheapest to fund a transaction with cash, then debt, then equity.
Cash is the cheapest, since interest rates on cash are lower than interest rates on
debt, and tend to be low in general. The next cheapest is Debt, since it is still
cheaper than equity and since interest paid on debt is tax-deductible. Stock is the
most expensive since the Cost of Equity tends to exceed the Cost of Debt.
CASH
Look at the company's minimum cash balance to keep operating, and use the
excess cash above that to fund the deal.
, How to Determine: Company disclosures or look back at historical cash balances
and estimate based on that (what was its lowest cash balance in past years?).
DEBT
Calculate key leverage ratios for the combined company, such as:
Total Debt / EBITDA
Net Debt / EBITDA
EBITDA / Interest Expense
See what amount of debt makes these look "reasonable", in line with historical
figures and also figures for comparable companies.
STOCK
Often used as a last resort because:
A) It tends to be the most expensive method for most companies.
B) Most acquirers don't like giving up ownership and diluting existing
shareholders.
Exceptions:
1. Buyer has an exceptionally high P/E (Amazon) - stock might be the cheapest!
2. Buyer wants to do a tax-free deal (Google / YouTube) and it's much bigger
anyway, so won't make a difference.
3. Companies are similarly sized - stock might always be necessary because
cash/debt are implausible (mergers of equals).
The greater the confidence that the acquirer will be able to realize benefits of an
acquisition, the more they will want to pay for stocks in cash. Under similar
circumstances, the target would want to be paid in stock.
When an acquirer's shares are considered overvalued, the acquirer may prefer to
pay for the acquisition with an exchange of stock-for-stock. If the acquire
5. How do you pick purchase multiples and exit multiples in an LBO model? - ANS-You
look at the range of multiples for similar LBO transactions of comparable
companies, and choose the multiples appropriate for your situation.
Sometimes you set purchase and exit multiples based on a specific IRR target that
you're trying to achieve - but this is just for valuation purposes if you're using an
LBO model to value the company.
6. How do you use an LBO model to value a company, and why do we sometimes say that
it sets the "floor valuation" for the company? - ANS-You use it to value a company by
setting a targeted IRR (e.g., 25%) and then back-solving to determine what
purchase price the PE firm could pay to achieve that IRR.
1. Can you explain how the Balance Sheet is adjusted in an LBO model? - ANS-First, the
Liabilities & Equities side is adjusted - the new debt is added on, and the
Shareholders' Equity is "wiped out" and replaced by however much equity the
private equity firm is contributing.
On the Assets side, Cash is adjusted for any cash used to finance the transaction,
and then Goodwill & Other Intangibles are used as a "plug" to make the Balance
Sheet balance.
Depending on the transaction, there could be other effects as well - such as
capitalized financing fees added to the Assets side.
2. Give an example of a "real-life" LBO. - ANS-The most common analogy is taking out
a mortgage when you buy a house.
• Down Payment: Investor Equity
• Mortgage: Debt
• Mortgage Interest Payments: Debt Interest
• Mortgage Repayments: Debt Principal Repayments
• Selling the House: Selling the Company / Taking It Public
3. How could a private equity firm boost its return in an LBO? - ANS-1. Lower the
Purchase Price in the model.
2. Raise the Exit Multiple / Exit Price.
3. Increase the Leverage (debt) used.
4. Increase the company's growth rate (organically or via acquisitions).
5. Increase margins by reducing expenses (cutting employees, consolidating
buildings, etc.).
Note: These are all "theoretical" and refer to the model rather than reality - in
practice it's hard to actually implement these.
4. How Do You Determine the Cash / Stock / Debt Mix in an M&A Deal? - ANS-Generally,
it's cheapest to fund a transaction with cash, then debt, then equity.
Cash is the cheapest, since interest rates on cash are lower than interest rates on
debt, and tend to be low in general. The next cheapest is Debt, since it is still
cheaper than equity and since interest paid on debt is tax-deductible. Stock is the
most expensive since the Cost of Equity tends to exceed the Cost of Debt.
CASH
Look at the company's minimum cash balance to keep operating, and use the
excess cash above that to fund the deal.
, How to Determine: Company disclosures or look back at historical cash balances
and estimate based on that (what was its lowest cash balance in past years?).
DEBT
Calculate key leverage ratios for the combined company, such as:
Total Debt / EBITDA
Net Debt / EBITDA
EBITDA / Interest Expense
See what amount of debt makes these look "reasonable", in line with historical
figures and also figures for comparable companies.
STOCK
Often used as a last resort because:
A) It tends to be the most expensive method for most companies.
B) Most acquirers don't like giving up ownership and diluting existing
shareholders.
Exceptions:
1. Buyer has an exceptionally high P/E (Amazon) - stock might be the cheapest!
2. Buyer wants to do a tax-free deal (Google / YouTube) and it's much bigger
anyway, so won't make a difference.
3. Companies are similarly sized - stock might always be necessary because
cash/debt are implausible (mergers of equals).
The greater the confidence that the acquirer will be able to realize benefits of an
acquisition, the more they will want to pay for stocks in cash. Under similar
circumstances, the target would want to be paid in stock.
When an acquirer's shares are considered overvalued, the acquirer may prefer to
pay for the acquisition with an exchange of stock-for-stock. If the acquire
5. How do you pick purchase multiples and exit multiples in an LBO model? - ANS-You
look at the range of multiples for similar LBO transactions of comparable
companies, and choose the multiples appropriate for your situation.
Sometimes you set purchase and exit multiples based on a specific IRR target that
you're trying to achieve - but this is just for valuation purposes if you're using an
LBO model to value the company.
6. How do you use an LBO model to value a company, and why do we sometimes say that
it sets the "floor valuation" for the company? - ANS-You use it to value a company by
setting a targeted IRR (e.g., 25%) and then back-solving to determine what
purchase price the PE firm could pay to achieve that IRR.
