LBO Model Guide Made Simple
What is a leveraged buyout, and why does it work? - correct answersIn a leveraged buyout (LBO), a private
s s s s s s s s s s s s s s s s s s s
equity firm acquires a company using a combination of debt and equity (cash), operates it for several years,
s s s s s s s s s s s s s s s s s s
possibly makes operational improvements, and then sells the company at the end of the period to realize a
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s
debt and to pay off debt principal.
s s s s s s
An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
s s s s s s s s s s s s s s s s
1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns.
s s s s s s s s s s s s s s s s s
2. Using the company's cash flows to repay debt principal and pay debt interest also produces a better return
s s s s s s s s s s s s s s s s s s s
than keeping the cash flows.
s s s s
3. The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to
s s s s s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s s s s s s s
high return on $2 billion of your own money and $3 billion borrowed from other people than it is on $5 billion of
s s s s s s s s s s s s s s s s s s s s s s s
your own money. s s
A secondary benefit is that the firm also has more capital available to purchase other companies because
s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s
the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you might also assume
s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s s s
used for; it also tells you how much Investor Equity (cash) is required.
s s s s s s s s s s s s s
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, allocate the purchase
s s s s s s s s s s s s s s s s s s s
price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
s s s s s s s s s s s s s s s
In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and
s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s
therefore purchase and exit prices) have the greatest impact, followed by the amount of leverage (debt) used.
s s s s s s s s s s s s s s s s
A lower purchase price equals a higher return, whereas a higher exit price results in a higher return; generally,
s s s s s s s s s s s s s s s s s s s
more leverage also results in higher returns (as long as the company can still meet its debt obligations).
s s s s s s s s s s s s s s s s s
Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an impact as well,
s s s s s s s s s s s s s s s s s
but they are less significant than those first 3 variables.
s s s s s s s s s
, How do you pick purchase multiples and exit multiples in an LBO model? - correct answersThe same way you
s s s s s s s s s s s s s s s s s s s
do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s s
this is just for valuation purposes if you're using an LBO model to value the company.
s s s s s s s s s s s s s s s
What is an "ideal" candidate for an LBO? - correct answersIdeal candidates should:
s s s s s s s s s s s s
• Have stable and predictable cash flows (so they can repay debt);
s s s s s s s s s s s
• Be undervalued relative to peers in the industry (lower purchase price);
s s s s s s s s s s s
• Be low-risk businesses (debt repayments);
s s s s s
• Not have much need for ongoing investments such as CapEx;
s s s s s s s s s s
• Have an opportunity to cut costs and increase margins;
s s s s s s s s s
• Have a strong management team;
s s s s s
• Have a solid base of assets to use as collateral for debt.
s s s s s s s s s s s s
The first point about stable cash flows is the most important one.
s s s s s s s s s s s
How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor
s s s s s s s s s s s s s s s s s s s s s s
valuation" for the company? - correct answersYou use it to value a company by setting a targeted IRR (for
s s s s s s s s s s s s s s s s s s s
example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to
s s s s s s s s s s s s s s s s s s
achieve that IRR. s s
This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s
based on its cash flows? - correct answersThe difference is that in a DCF you're saying, "What could this
s s s s s s s s s s s s s s s s s s s
company be worth, based on the present value of its near-future and far-future cash flows?"
s s s s s s s s s s s s s s
What is a leveraged buyout, and why does it work? - correct answersIn a leveraged buyout (LBO), a private
s s s s s s s s s s s s s s s s s s s
equity firm acquires a company using a combination of debt and equity (cash), operates it for several years,
s s s s s s s s s s s s s s s s s s
possibly makes operational improvements, and then sells the company at the end of the period to realize a
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s
debt and to pay off debt principal.
s s s s s s
An LBO delivers higher returns than if the PE firm used 100% cash for the following reasons:
s s s s s s s s s s s s s s s s
1. By using debt, the PE firm reduces the up-front cash payment for the company, which boosts returns.
s s s s s s s s s s s s s s s s s
2. Using the company's cash flows to repay debt principal and pay debt interest also produces a better return
s s s s s s s s s s s s s s s s s s s
than keeping the cash flows.
s s s s
3. The PE firm sells the company in the future, which allows it to regain the majority of the funds spent to
s s s s s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s s s s s s s
high return on $2 billion of your own money and $3 billion borrowed from other people than it is on $5 billion of
s s s s s s s s s s s s s s s s s s s s s s s
your own money. s s
A secondary benefit is that the firm also has more capital available to purchase other companies because
s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s
the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you might also assume
s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s s s
used for; it also tells you how much Investor Equity (cash) is required.
s s s s s s s s s s s s s
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, allocate the purchase
s s s s s s s s s s s s s s s s s s s
price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
s s s s s s s s s s s s s s s
In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and
s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s
therefore purchase and exit prices) have the greatest impact, followed by the amount of leverage (debt) used.
s s s s s s s s s s s s s s s s
A lower purchase price equals a higher return, whereas a higher exit price results in a higher return; generally,
s s s s s s s s s s s s s s s s s s s
more leverage also results in higher returns (as long as the company can still meet its debt obligations).
s s s s s s s s s s s s s s s s s
Revenue growth, EBITDA margins, interest rates and principal repayment on Debt all make an impact as well,
s s s s s s s s s s s s s s s s s
but they are less significant than those first 3 variables.
s s s s s s s s s
, How do you pick purchase multiples and exit multiples in an LBO model? - correct answersThe same way you
s s s s s s s s s s s s s s s s s s s
do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s s
this is just for valuation purposes if you're using an LBO model to value the company.
s s s s s s s s s s s s s s s
What is an "ideal" candidate for an LBO? - correct answersIdeal candidates should:
s s s s s s s s s s s s
• Have stable and predictable cash flows (so they can repay debt);
s s s s s s s s s s s
• Be undervalued relative to peers in the industry (lower purchase price);
s s s s s s s s s s s
• Be low-risk businesses (debt repayments);
s s s s s
• Not have much need for ongoing investments such as CapEx;
s s s s s s s s s s
• Have an opportunity to cut costs and increase margins;
s s s s s s s s s
• Have a strong management team;
s s s s s
• Have a solid base of assets to use as collateral for debt.
s s s s s s s s s s s s
The first point about stable cash flows is the most important one.
s s s s s s s s s s s
How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor
s s s s s s s s s s s s s s s s s s s s s s
valuation" for the company? - correct answersYou use it to value a company by setting a targeted IRR (for
s s s s s s s s s s s s s s s s s s s
example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to
s s s s s s s s s s s s s s s s s s
achieve that IRR. s s
This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than
s s s s s s s s s s s s s s s s s s
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
s s s s s s s s s s s s s s s s s s s
based on its cash flows? - correct answersThe difference is that in a DCF you're saying, "What could this
s s s s s s s s s s s s s s s s s s s
company be worth, based on the present value of its near-future and far-future cash flows?"
s s s s s s s s s s s s s s
