Basic LBO Model Questions and Explained Answers

Basic LBO Model Questions and
Explained Answers




Walk me through a basic LBO model - correct answers"An LBO, or leveraged buyout, is when a financial
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sponsor acquires a company using a significant amount of debt, with the goal of improving operations, paying
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down debt, and eventually selling the company for a profit. Here's how I'd build a basic LBO model:
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Step 1: Begin by making assumptions on the purchase price, new debt/equity split, cost of debt, and, if
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available, operational drivers like revenue growth and margins.
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Step 2: Build the Sources & Uses table to show where the funding comes from (sources) and what it's spent on
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(uses), which tells you the equity investors must contribute.
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Step 3: Adjust the target's balance sheet for the new debt and equity, and add goodwill and other intangibles
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so that the balance sheet still balances.
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Step 4: Project the income statement, balance sheet, and cash flow statement, and calculate how much
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principal debt is repaid each year based on free cash flow after interest, taxes, capex and changes in net
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working capital. v




Step 5: Make exit assumptions, usually an EBITDA multiple after several years, and calculate returns to
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investors — typically the Internal Rate of Return (IRR) or the Multiple on Invested Capital (MOIC) — based on
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the equity value at exit.
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, Why would you use leverage when buying a company? - correct answersYou use leverage in an LBO to boost
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the private equity firm's returns. Debt reduces the amount of equity you have to invest upfront, so the same
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absolute profit translates into a higher return on your invested capital. A secondary benefit is that it preserves
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more of the firm's equity capital for other deals.
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What variables impact an LBO model the most? - correct answersThe variables with the biggest impact on LBO
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returns are the purchase multiple and the exit multiple, because small changes in valuation directly affect the
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equity value at entry and exit. v v v v v




After that, the amount of leverage used has a major impact, since it magnifies equity returns.
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Finally, operational drivers like revenue growth, EBITDA margins, and cash flow conversion also matter, but
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they usually have a smaller effect than the entry and exit multiples or the capital structure.
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How do you pick purchase multiples and exit multiples in an LBO model? - correct answersYou pick purchase
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and exit multiples the same way you would in any valuation — by looking at trading multiples for comparable
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public companies and transaction multiples from similar LBO deals. In the model, you usually show a
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sensitivity table with a range of purchase and exit multiples. v v v v v v v v v




Sometimes, if you're valuing a business with an IRR target in mind, you work backwards from that target to find v v v v v v v v v v v v v v v v v v v v




the implied exit multiple — but that's more for valuation purposes than actual deal execution.
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What is an "ideal" candidate for an LBO? - correct answersThe ideal LBO candidate has stable and predictable
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cash flows — that's the most important factor, because it ensures the company can service debt. Other
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desirable traits are a low-risk business model, limited ongoing capex requirements, opportunities for margin
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improvement through cost cuts, a strong management team, and tangible assets that can be used as v v v v v v v v v v v v v v v v




collateral for debt. These factors reduce risk and increase the likelihood of strong returns.
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How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor
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valuation" for the company? - correct answersYou can use an LBO model to value a company by setting a target
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IRR — say 25% — and back-solving for the maximum purchase price the PE firm could pay to meet that return.
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