What is an “LBO Model”?
An LBO model is a financial tool designed to evaluate a leveraged buyout (LBO). This is a financial transaction involving an acquisition of a business by a financial sponsor (typically private equity) and financed using substantial amounts of debt, hence the term ‘leveraged’.
Leverage is used to increase the returns to equity holders and is repaid from the company’s operational cash flows (although please note that the ability to generate cash flows and repay debt is key). Operational improvements are integral to improve the cash flows.
Private equity funds generally target exiting the investment within a five-year horizon to monetize their returns (i.e., the investment horizon is usually 3-5 years, followed by sale). An LBO transaction is evaluated by calculating an internal rate of return (IRR).
Key Learning Points
- The underlying aim of the LBO model is to evaluate the transaction and earn the highest feasible risk-adjusted IRR
- There are two types of LBO models – Q&D models and fully integrated models
- Q&D models consist of three main components – model inputs, cash sweep and model outputs
LBO Model – Aim and Types
The underlying aim of the LBO model is to enable investors to adequately assess the potential transaction and earn the highest possible risk-adjusted IRR.
There are two types of LBO Models. The first type is referred to as a Q&D model, which values a business by estimating the maximum bid price a sponsor would be willing to pay in an auction. This type of model does not require a construction of a pro forma balance sheet or a goodwill calculation. The second type of model is a fully integrated model, which is more complicated.
LBO Modelling Steps – (Q&D Models)
Stated below are the steps to complete a simple LBO model.
First step and component – model inputs: this includes assumptions pertaining to acquisition, financing, exit, interest rate, fees (that will have to be paid) and other assumptions including sources and uses of funds table. The sources of funds include debt and equity, and uses of funds including buying the company.
If it is a public company, you might want to include the current share price. Further, also include the premium that is going to be paid above it and calculate the market value of equity and the acquisition equity value. Then we include interest rate assumptions on any debt that is going to be put on the deal. Exit assumptions include the exit year and an exit EBITDA multiple.
Second step and component – the cash sweep: in an LBO, the endeavor is to reduce debt as soon as possible. The analyst needs to create an operating forecast – an income statement, some balance sheet items and a cash flow statement. From this one can perform a cash sweep, which is essentially targeting all the future potential cash available to pay down the debt. This would then create a debt schedule, so that there is a record of the level of debt in each year.
Third step and component – model outputs: this includes credit ratios (to ensure that the debt level never breaks any required thresholds). It also involves calculating equity IRRs for various groups of shareholders, performing sensitivity tables (for example, if the exit year would vary then what would happen to the IRRs) and a levered valuation.
LBO – Model (Assumptions and Valuation)
Given below is an example of some of the main assumptions needed for LBO analysis.
The first thing to do in our LBO model is to set up assumptions. The current share price of our target company is $26.67. We know that a 20% premium is going to be paid initially.
Therefore, the acquisition price is $32 and so this is the offer price per share. In our example, the company has 3 types of options – we have Tranche 1 stock options, Performance Stock Units (PSU) and Serviced-based Stock Units. Taking all this information, we find that the total dilution impact is 0.9. Therefore, the net new shares from options is 0.9. The diluted shares outstanding (sum of the basic shares plus net new shares) is $68.52.
Next, we come to the acquisition valuation. The acquisition equity value ($2,193) is calculated by multiplying the acquisition share price by the number of diluted shares outstanding. The acquisition enterprise value ($2,100.6) is arrived at by adding the acquisition equity value, net debt (which in this case in net cash) and other debt-equivalent liabilities. The historical (LTM) EBITDA i.e. last 12 months EBITDA is $123 (get this from the income statement).
The historical (LTM) EBITDA multiple at entry is 17.1x, which we assume is the same as the exit EBITDA multiple. This is why this number is very important.