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LBO - Basic

16 important questions on LBO - Basic

What are the five steps in building an LBO model?

Entry valuation
Sources & Uses table
Financial Forecast
Exit valuation and returns
Sensitivity analyis

Extend on Step 1: Entry valuation

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.

Extend on step 3: Financial Forecast

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.

Extend on step 4: Exit valuation

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.

Extend on step 5: Sensitivity analysis

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?

To increase your returns.
Have more capital to purchase other companies
Tax deductible
Lower financing cost since it is finite
Keep the profits instead of giving to stakeholders

What variables impact an LBO model the most?

Purchase and exit multiples
The amount of leverage
Revenue Growth and EBITDA

How do you pick purchase multiples and exit multiples in an LBO model?

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.

What is an “ideal” candidate for an LBO?

Stable cashflow
Low risk business
Low CapEx
Opportunity for expense reductions to boost margins
A 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?

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.

Why are Goodwill & Other Intangibles created in an LBO?

Remember, 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.

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

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

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

What are reasonable leverage and coverage ratios?

This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions.
To figure out the numbers, you would look at “debt comps” showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently.
There are some general rules: for example, you would never lever a company at 50x EBITDA, and even during the bubble leverage rarely exceeded 5-10x EBITDA.

Why might you use bank debt rather than high-yield debt in an LBO?

If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt; they might also use bank debt if they are planning on major expansion or Capital Expenditures and don’t want to be restricted by incurrence covenants.

Why would a PE firm prefer high-yield debt instead?

If the PE firm intends to refinance the company at some point or they don’t believe their returns are too sensitive to interest payments, they might use high-yield debt. They might also use the high-yield option if they don’t have plans for major expansion or selling off the company’s assets.

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LBO - Basic

16 important questions on LBO - Basic

What are the five steps in building an LBO model?

Extend on Step 1: Entry valuation

Extend on step 3: Financial Forecast

Extend on step 4: Exit valuation

Extend on step 5: Sensitivity analysis

Why would you use leverage when buying a company?

What variables impact an LBO model the most?

How do you pick purchase multiples and exit multiples in an LBO model?

What is an “ideal” candidate for an LBO?

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?

Why are Goodwill & Other Intangibles created in an LBO?

Do you need to project all 3 statements in an LBO model? Are there any shortcuts?

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

What are reasonable leverage and coverage ratios?

Why might you use bank debt rather than high-yield debt in an LBO?

Why would a PE firm prefer high-yield debt instead?

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