LBO Modeling Exam from Wall Street Prep
What is a leveraged buyout, and why does it work? - ANSWER In a leveraged
buyout (LBO), a PE 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 regain the majority of
funds spent to acquire it in the first place.
Why do PE firms use leverage when buying a company? - ANSWER They 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. - ANSWER 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 variable impact a leverage buyout the most? - ANSWER Purchase 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? - ANSWER
The 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? - ANSWER Ideal 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
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? - ANSWER You 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 cash flows? - ANSWER The 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?
What is a leveraged buyout, and why does it work? - ANSWER In a leveraged
buyout (LBO), a PE 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 regain the majority of
funds spent to acquire it in the first place.
Why do PE firms use leverage when buying a company? - ANSWER They 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. - ANSWER 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 variable impact a leverage buyout the most? - ANSWER Purchase 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? - ANSWER
The 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? - ANSWER Ideal 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
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? - ANSWER You 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 cash flows? - ANSWER The 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?
