What is “LBO Valuation”?
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.
Key Learning Points
- A leveraged buyout or LBO is an acquisition of an underperforming company funded using significant amounts of debt
- The investors (acquires) aim to increase the returns to equity holders and repay debt from the company’s operational cash flows
- Target companies usually have key characteristics which make them an attractive investment for investors including stable cash flows, potential for operational improvements or reduced costs and a clear exit strategy
- There are multiple steps that need to be undertaken to indicate whether a company is a potential LBO candidate
- A key assumption is that the investor is able to sell the business in order to understand what they could pay today
Characteristics of Target Companies
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
Valuation Key Steps
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
Valuing an LBO
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.
|From the model|
|Assumption based on expected performance within industry|
|Exit enterprise value||
|Calculate = exit EBITDA * exit multiple|
|Exit net debt||
|From the model|
|Exit equity valuation||
|Calculate = exit enterprise value – remaining net debt|
|IRR implied entry equity valuation||
|Calculate = exit equity valuation / (1+ IRR)n|
|Available debt financing, entry||
|IRR implied Enterprise Value (maximum EV)||
|Calculate = available financing + IRR implied equity valuation|
|Target’s refinanced (existing) net debt||
|From target Balance Sheet|
|Target’s implied equity purchase price||
|Calculate = IRR implied enterprise value – refinanced debt|