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A leveraged buyout (an LBO) is an acquisition by a financial sponsor, financed using significant amounts of debt. Leverage is used to increase the returns to equity holders, and debt is repaid from the company’s operational cash flows. Private equity funds expect to exit the investment within the medium term to monetize their returns. An LBO transaction is evaluated by calculating an internal rate of return (IRR). The IRR compares the equity investment upon exit versus the amount invested at entry and calculates an annualized return on the investment.

Investment strategies of sponsor funds can differ significantly, but target companies usually have:

  • Stable cash flows and low fixed costs
  • Potential for operational improvements
  • An attractive valuation upon entry and present a clear exit strategy

Valuing a company as if it were a target for an LBO can provide valuable insight into the business and give an indication of whether the company is a potential LBO candidate.

In order to perform an LBO valuation, the following is required (as a minimum):

  • An operating model, forecasting EBIT and EBITDA
  • A debt repayment model forecasting how debt will develop from acquisition to exit
  • An assumption of when and at what multiple the LBO investor can exit
  • An assumption about how much debt a buyer could raise to fund the transaction

Once the above has been established the following steps are taken to perform an LBO valuation:

  • The expected EV at exit is established using the forecast (exit) EBITDA level from the operating model times the expected EV/EBITDA multiple at exit (the exit multiple).
  • The expected exit net debt is deducted from the EV to get to the expected exit equity valuation.
  • The expected equity value at exit is then discounted back to the deal date using the buyers minimum IRR requirement. This, in turn, gives the maximum equity investment by the buyer (entry equity valuation).
  • Since the buyer will change the financing structure of the company in the LBO, we then have to add the post-transaction debt (available debt financing, entry) to get the maximum EV a buyer would pay at the deal date. Maximum equity and maximum debt give maximum EV.
  • Once the maximum EV is established, we finally walk the EV to Equity bridge using the pre-deal (ie existing) debt and arrive at the maximum amount a buyer could pay for the equity of the business.

This might seem like a roundabout way of valuing a company, and it is! We have to assume where we can sell the business, in order to figure out what we could pay today.

lbo valuation

Click below to download our FREE Excel workout to have a go at an LBO valuation yourself:

Enroll in our online course Leveraged Buy Out to learn more

Have you read “What Happens When You Include Synergies in a DCF” yet?