LBO Model Guide Made Simple

LBO Model Guide Made Simple




What is a leveraged buyout, and why does it work? - correct answersIn a leveraged buyout (LBO), a private
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equity firm acquires a company using a combination of debt and equity (cash), operates it for several years,
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possibly makes operational improvements, and then sells the company at the end of the period to realize a
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return on investment. s s




During the period of ownership, the PE firm uses the company's cash flows to pay interest expense from the
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debt and to pay off debt principal.
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An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
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1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns.
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2. Using the company's cash flows to repay debt principal and pay debt interest also produces a better return
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than keeping the cash flows.
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3. The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to
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acquire it in the first place. s s s s s




Why do PE firms use leverage when buying a company? - correct answersThey use leverage to increase their
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returns.

,Any debt raised for an LBO is not "your money" - so if you're paying $5 billion for a company, it's easier to earn a
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high return on $2 billion of your own money and $3 billion borrowed from other people than it is on $5 billion of
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your own money. s s




A secondary benefit is that the firm also has more capital available to purchase other companies because
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they've used debt rather than their own funds. s s s s s s s




Walk me through a basic LBO model. - correct answers"In an LBO Model, Step 1 is making assumptions about
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the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you might also assume
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something about the company's operations, such as Revenue Growth or Margins, depending on how much s s s s s s s s s s s s s s s




information you have. s s




Step 2 is to create a Sources & Uses section, which shows how the transaction is financed and what the capital is
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used for; it also tells you how much Investor Equity (cash) is required.
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Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, allocate the purchase
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price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
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In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and
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determine how much debt is paid off each year, based on the available Cash Flow and the required Interest s s s s s s s s s s s s s s s s s s s




Payments.



Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit
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Multiple, and calculate the return based on how much equity is returned to the firm." s s s s s s s s s s s s s s




What variables impact a leveraged buyout the most? - correct answersPurchase and exit multiples (and
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therefore purchase and exit prices) have the greatest impact, followed by the amount of leverage (debt) used.
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A lower purchase price equals a higher return, whereas a higher exit price results in a higher return; generally,
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more leverage also results in higher returns (as long as the company can still meet its debt obligations).
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Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an impact as well,
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but they are less significant than those first 3 variables.
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, How do you pick purchase multiples and exit multiples in an LBO model? - correct answersThe same way you
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do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO
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transactions have been completed at. As always, you show a range of purchase and exit multiples using s s s s s s s s s s s s s s s s s




sensitivity tables. s




Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but
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this is just for valuation purposes if you're using an LBO model to value the company.
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What is an "ideal" candidate for an LBO? - correct answersIdeal candidates should:
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• Have stable and predictable cash flows (so they can repay debt);
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• Be undervalued relative to peers in the industry (lower purchase price);
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• Be low-risk businesses (debt repayments);
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• Not have much need for ongoing investments such as CapEx;
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• Have an opportunity to cut costs and increase margins;
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• Have a strong management team;
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• Have a solid base of assets to use as collateral for debt.
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The first point about stable cash flows is the most important one.
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How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor
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valuation" for the company? - correct answersYou use it to value a company by setting a targeted IRR (for
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example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to
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achieve that IRR. s s




This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than
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strategic acquirers would. s s




Wait a minute, how is an LBO valuation different from a DCF valuation? Don't they both value the company
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based on its cash flows? - correct answersThe difference is that in a DCF you're saying, "What could this
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company be worth, based on the present value of its near-future and far-future cash flows?"
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