LBO Modle Guide
What is a leveraged buyout, and why does it work? - ANSIn a leveraged buyout (LBO), a private
equity firm acquires a company using a combination of debt and equity (cash), operates it for
several years, possibly makes operational improvements, and then sells the company at the
end of the period to realize a return on investment.
During the period of ownership, the PE firm uses the company's cash flows to pay interest
expense from the debt and to pay off debt principal.
An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts
returns.
2. Using the company's cash flows to repay debt principal and pay debt interest also produces a
better return than keeping the cash flows.
3. The PE firm sells the company in the future, which allows it to regain the majority of the funds
spent to acquire it in the first place.
Why do PE firms use leverage when buying a company? - ANSThey use leverage to increase
their 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 high return on $2 billion of your own money and $3 billion borrowed from other
people than it is on $5 billion of your own money.
A secondary benefit is that the firm also has more capital available to purchase other companies
because they've used debt rather than their own funds.
Walk me through a basic LBO model. - ANS"In an LBO Model, Step 1 is making assumptions
about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you
might also assume something about the company's operations, such as Revenue Growth or
Margins, depending on how much information you have.
Step 2 is to create a Sources & Uses section, which shows how the transaction is financed and
what the capital is used for; it also tells you how much Investor Equity (cash) is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, allocate
the purchase price, and add in Goodwill & Other Intangibles on the Assets side to make
everything balance.
,In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow
Statement, and determine how much debt is paid off each year, based on the available Cash
Flow and the required Interest Payments.
Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an
EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the
firm."
What variables impact a leveraged buyout the most? - ANSPurchase and exit multiples (and
therefore purchase and exit prices) have the greatest impact, followed by the amount of
leverage (debt) used.
A lower purchase price equals a higher return, whereas a higher exit price results in a higher
return; generally, more leverage also results in higher returns (as long as the company can still
meet its debt obligations).
Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an
impact as well, but they are less significant than those first 3 variables.
How do you pick purchase multiples and exit multiples in an LBO model? - ANSThe same way
you do it anywhere else: you look at what comparable companies are trading at, and what
multiples similar LBO transactions have been completed at. As always, you show a range of
purchase and exit multiples using sensitivity tables.
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.
What is an "ideal" candidate for an LBO? - ANSIdeal candidates should:
• Have stable and predictable cash flows (so they can repay debt);
• Be undervalued relative to peers in the industry (lower purchase price);
• Be low-risk businesses (debt repayments);
• Not have much need for ongoing investments such as CapEx;
• Have an opportunity to cut costs and increase margins;
• Have a strong management team;
• Have a solid base of assets to use as collateral for debt.
The first point about stable cash flows is the most important one.
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? - ANSYou use it to value a company by setting a targeted
, IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the
PE firm could pay to achieve that IRR.
This is sometimes called a "floor valuation" because PE firms almost always pay less for a
company than strategic acquirers would.
Wait a minute, how is an LBO valuation different from a DCF valuation? Don't they both value
the company based on its cash flows? - ANSThe difference is that in a DCF you're saying,
"What could this company be worth, based on the present value of its near-future and far-future
cash flows?"
But in an LBO you're saying, "What can we pay for this company if we want to achieve an IRR
of, say, 25%, in 5 years?"
So both methodologies are similar, but with the LBO valuation you're constraining the values
based on the returns you're targeting.
Give me an example of a "real-life" LBO. - ANSThe most common example is taking out a
mortgage when you buy a house. We think it's better to think of it as, "Buying a house that you
rent out to other people" because that situation is more similar to buying a company that
generates cash flow.
Here's how the analogy works:
• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Rental Income from Tenants: Cash Flow to Pay Interest and Repay Debt
in an LBO
• Selling the House: Selling the Company or Taking It Public in an LBO
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? - ANSIt's a different scenario because:
1. The PE firm does not hold the company for the long-term - it sells it after a few years, so it is
less concerned with the higher "expense" of debt over cash and is more concerned about using
leverage to boost its returns by reducing the capital it contributes upfront.
2. In an LBO, the company is responsible for repaying the debt, so the company assumes much
of the risk. Whereas in a strategic acquisition, the buyer "owns" the debt, so it is more risky for
them.
Why would a private equity firm buy a company in a "risky" industry, such as technology? -
ANSAlthough technology is "riskier" than other markets, remember that there are mature, cash
What is a leveraged buyout, and why does it work? - ANSIn a leveraged buyout (LBO), a private
equity firm acquires a company using a combination of debt and equity (cash), operates it for
several years, possibly makes operational improvements, and then sells the company at the
end of the period to realize a return on investment.
During the period of ownership, the PE firm uses the company's cash flows to pay interest
expense from the debt and to pay off debt principal.
An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts
returns.
2. Using the company's cash flows to repay debt principal and pay debt interest also produces a
better return than keeping the cash flows.
3. The PE firm sells the company in the future, which allows it to regain the majority of the funds
spent to acquire it in the first place.
Why do PE firms use leverage when buying a company? - ANSThey use leverage to increase
their 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 high return on $2 billion of your own money and $3 billion borrowed from other
people than it is on $5 billion of your own money.
A secondary benefit is that the firm also has more capital available to purchase other companies
because they've used debt rather than their own funds.
Walk me through a basic LBO model. - ANS"In an LBO Model, Step 1 is making assumptions
about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you
might also assume something about the company's operations, such as Revenue Growth or
Margins, depending on how much information you have.
Step 2 is to create a Sources & Uses section, which shows how the transaction is financed and
what the capital is used for; it also tells you how much Investor Equity (cash) is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, allocate
the purchase price, and add in Goodwill & Other Intangibles on the Assets side to make
everything balance.
,In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow
Statement, and determine how much debt is paid off each year, based on the available Cash
Flow and the required Interest Payments.
Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an
EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the
firm."
What variables impact a leveraged buyout the most? - ANSPurchase and exit multiples (and
therefore purchase and exit prices) have the greatest impact, followed by the amount of
leverage (debt) used.
A lower purchase price equals a higher return, whereas a higher exit price results in a higher
return; generally, more leverage also results in higher returns (as long as the company can still
meet its debt obligations).
Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an
impact as well, but they are less significant than those first 3 variables.
How do you pick purchase multiples and exit multiples in an LBO model? - ANSThe same way
you do it anywhere else: you look at what comparable companies are trading at, and what
multiples similar LBO transactions have been completed at. As always, you show a range of
purchase and exit multiples using sensitivity tables.
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.
What is an "ideal" candidate for an LBO? - ANSIdeal candidates should:
• Have stable and predictable cash flows (so they can repay debt);
• Be undervalued relative to peers in the industry (lower purchase price);
• Be low-risk businesses (debt repayments);
• Not have much need for ongoing investments such as CapEx;
• Have an opportunity to cut costs and increase margins;
• Have a strong management team;
• Have a solid base of assets to use as collateral for debt.
The first point about stable cash flows is the most important one.
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? - ANSYou use it to value a company by setting a targeted
, IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the
PE firm could pay to achieve that IRR.
This is sometimes called a "floor valuation" because PE firms almost always pay less for a
company than strategic acquirers would.
Wait a minute, how is an LBO valuation different from a DCF valuation? Don't they both value
the company based on its cash flows? - ANSThe difference is that in a DCF you're saying,
"What could this company be worth, based on the present value of its near-future and far-future
cash flows?"
But in an LBO you're saying, "What can we pay for this company if we want to achieve an IRR
of, say, 25%, in 5 years?"
So both methodologies are similar, but with the LBO valuation you're constraining the values
based on the returns you're targeting.
Give me an example of a "real-life" LBO. - ANSThe most common example is taking out a
mortgage when you buy a house. We think it's better to think of it as, "Buying a house that you
rent out to other people" because that situation is more similar to buying a company that
generates cash flow.
Here's how the analogy works:
• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Rental Income from Tenants: Cash Flow to Pay Interest and Repay Debt
in an LBO
• Selling the House: Selling the Company or Taking It Public in an LBO
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? - ANSIt's a different scenario because:
1. The PE firm does not hold the company for the long-term - it sells it after a few years, so it is
less concerned with the higher "expense" of debt over cash and is more concerned about using
leverage to boost its returns by reducing the capital it contributes upfront.
2. In an LBO, the company is responsible for repaying the debt, so the company assumes much
of the risk. Whereas in a strategic acquisition, the buyer "owns" the debt, so it is more risky for
them.
Why would a private equity firm buy a company in a "risky" industry, such as technology? -
ANSAlthough technology is "riskier" than other markets, remember that there are mature, cash
