M&I 400 LBO Model (Basic & Advanced)
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 you finance the transaction and
what you use the capital for; this also tells you how much Investor Equity is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also
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."
Why would you use leverage when buying a company? - ANSTo boost returns.
Remember, any debt you use in 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 elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.
A secondary benefit is that the firm also has more capital available to purchase other companies
because they've used leverage.
What variables impact an LBO model the most? - ANSPurchase and exit multiples have the
biggest impact on the returns of a model. After that, the amount of leverage (debt) used also
has a significant impact, followed by operational characteristics such as revenue growth and
EBITDA margins.
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 had. As always, you also 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? - ANS"Ideal" candidates have stable and predictable
cash flows, low-risk businesses, not much need for ongoing investments such as Capital
Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong
management team also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
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.
Give an example of a "real-life" LBO. - ANSThe most common example is taking out a mortgage
when you buy a house. Here's how the analogy works:
1. Down Payment: Investor Equity in an LBO
2. Mortgage: Debt in an LBO
3. Mortgage Interest Payments: Debt Interest in an LBO
4. Mortgage Repayments: Debt Principal Repayments in an LBO
5. Selling the House: Selling the Company / Taking It Public in an LBO
Can you explain how the Balance Sheet is adjusted in an LBO model? - ANSFirst, 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.
Why are Goodwill & Other Intangibles created in an LBO? - ANSRemember, these both
represent the premium paid to the "fair market value" of the company. In an LBO, they act as a
"plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to
the Assets side.
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 you finance the transaction and
what you use the capital for; this also tells you how much Investor Equity is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also
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."
Why would you use leverage when buying a company? - ANSTo boost returns.
Remember, any debt you use in 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 elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.
A secondary benefit is that the firm also has more capital available to purchase other companies
because they've used leverage.
What variables impact an LBO model the most? - ANSPurchase and exit multiples have the
biggest impact on the returns of a model. After that, the amount of leverage (debt) used also
has a significant impact, followed by operational characteristics such as revenue growth and
EBITDA margins.
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 had. As always, you also 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? - ANS"Ideal" candidates have stable and predictable
cash flows, low-risk businesses, not much need for ongoing investments such as Capital
Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong
management team also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
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.
Give an example of a "real-life" LBO. - ANSThe most common example is taking out a mortgage
when you buy a house. Here's how the analogy works:
1. Down Payment: Investor Equity in an LBO
2. Mortgage: Debt in an LBO
3. Mortgage Interest Payments: Debt Interest in an LBO
4. Mortgage Repayments: Debt Principal Repayments in an LBO
5. Selling the House: Selling the Company / Taking It Public in an LBO
Can you explain how the Balance Sheet is adjusted in an LBO model? - ANSFirst, 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.
Why are Goodwill & Other Intangibles created in an LBO? - ANSRemember, these both
represent the premium paid to the "fair market value" of the company. In an LBO, they act as a
"plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to
the Assets side.
