LBO Model - Basic 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. Can you explain how to adjust the Balance Sheet in a LBO model? - ANS-The
adjustments are similar to those in an M&A deal, but in an LBO, you don't
"combine" the Seller's Balance Sheet with the Buyer's since the "Buyer" is an
empty shel corporation.
You still write down the company's Shareholder's Equity and replace it with the
investor equity the PE firm is contributing, you still create Goodwill, and you
might adjust Deferred Tax-related items as well.
3. Do PE firms prefer companies in an industry where one firm has a 5% market share and
the rest have 1-5% or a firm in an industry where 3 companies have 80% of the market
share? - ANS-PE firms prefer one with a 5% market share.
PE firms typically looks to pursue bolt on acquisitions to make the company they
acquire bigger and more valuable, which is easier in a fragmented market.
4. Do you need to project all 3 statements in an LBO model? Are there any shortcuts? -
ANS-Yes, there are shortcuts and you don't necessarily need to project all 3
statements.
For example, you do not need to create a full Balance Sheet - bankers sometimes
skip this if they are in a rush. You do need some form of Income Statement,
something to track how the Debt balances change and some type of Cash Flow
Statement to show how much cash is available to repay debt.
But a full-blown Balance Sheet is not strictly required, because you can just make
assumptions on the Net Change in Working Capital rather than looking at each
item individually.
, 5. Give an example of a "real life" LBO. - ANS-The most common example is taking out
a mortgage when you buy a house. 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
Selling the House: Selling the Company / Taking It Public in an LBO
6. 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 that these are all "theoretical" and refer to the model rather than reality - in
practice it's hard to actually implement these.
7. How do you pick purchase multiples and exit multiples in an LBO model? - ANS-The
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.
8. How do you project Free Cash Flow and Cash Flow Available for Debt Repayment in an
LBO model? - ANS-Start with Net Income, add back D&A, factor in Change in
Working Capital, and subtract CapEx.
Cash flow available is similar to FCF, but also adds the Beginning Cash Balance
and Subtracts its Minimum Cash Balance and other obligations such as
repayments of assumed Debt.
9. 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 target IRR (for examples, 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.
10. How is "Free Cash Flow" in an LBO model different from the FCF in a DCF? - ANS-The
purpose is quite different since FCF in an LBO model determines a company's
ability to repay Debt, NOT the implied value of the company.
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. Can you explain how to adjust the Balance Sheet in a LBO model? - ANS-The
adjustments are similar to those in an M&A deal, but in an LBO, you don't
"combine" the Seller's Balance Sheet with the Buyer's since the "Buyer" is an
empty shel corporation.
You still write down the company's Shareholder's Equity and replace it with the
investor equity the PE firm is contributing, you still create Goodwill, and you
might adjust Deferred Tax-related items as well.
3. Do PE firms prefer companies in an industry where one firm has a 5% market share and
the rest have 1-5% or a firm in an industry where 3 companies have 80% of the market
share? - ANS-PE firms prefer one with a 5% market share.
PE firms typically looks to pursue bolt on acquisitions to make the company they
acquire bigger and more valuable, which is easier in a fragmented market.
4. Do you need to project all 3 statements in an LBO model? Are there any shortcuts? -
ANS-Yes, there are shortcuts and you don't necessarily need to project all 3
statements.
For example, you do not need to create a full Balance Sheet - bankers sometimes
skip this if they are in a rush. You do need some form of Income Statement,
something to track how the Debt balances change and some type of Cash Flow
Statement to show how much cash is available to repay debt.
But a full-blown Balance Sheet is not strictly required, because you can just make
assumptions on the Net Change in Working Capital rather than looking at each
item individually.
, 5. Give an example of a "real life" LBO. - ANS-The most common example is taking out
a mortgage when you buy a house. 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
Selling the House: Selling the Company / Taking It Public in an LBO
6. 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 that these are all "theoretical" and refer to the model rather than reality - in
practice it's hard to actually implement these.
7. How do you pick purchase multiples and exit multiples in an LBO model? - ANS-The
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.
8. How do you project Free Cash Flow and Cash Flow Available for Debt Repayment in an
LBO model? - ANS-Start with Net Income, add back D&A, factor in Change in
Working Capital, and subtract CapEx.
Cash flow available is similar to FCF, but also adds the Beginning Cash Balance
and Subtracts its Minimum Cash Balance and other obligations such as
repayments of assumed Debt.
9. 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 target IRR (for examples, 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.
10. How is "Free Cash Flow" in an LBO model different from the FCF in a DCF? - ANS-The
purpose is quite different since FCF in an LBO model determines a company's
ability to repay Debt, NOT the implied value of the company.
