McCarthy95
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How to Build a Simple LBO
What is an LBO?
An LBO analyses the implied financial returns of the acquisition of a company purchased with a significant amount of debt, by a financial sponsor / private equity firm. The implied returns are typically expressed as an internal rate of return (IRR) or multiple-on-money (MoM). The acquirer aims to use the minimum possible amount of equity capital to fund the acquisition in order to maximise returns.
Step by Step Guide:
1. Assumptions
Entry assumptions
To determine the purchase price of the target company, the required assumptions depend on whether it is a public vs. private transaction. For a public transaction, the purchase price will typically be an assumed % premium to market capitalization. For a private transaction, an entry EV/EBITDA multiple is typically assumed, which is applied to LTM or NTM EBITDA. Net debt is subtracted to give purchase equity value (assuming the transaction is on a cash-free debt-free basis).
The other assumptions typically set out here include the minimum cash to balance sheet, transaction expenses and what %, if any, is the management equity rollover.
Debt assumptions
The debt assumptions set out the various levels of debt financing used to acquire the target company. Types of debt used include Senior / Bank Debt, High Yield / Subordinated Debt and Mezzanine Debt. An assumed leverage multiple is applied to leverageable EBITDA to give the quantum of each level of debt. Each level of debt will have different interest rate assumptions and underwriting fees. Dependent on the instrument, the interest rate will be fixed or variable (expressed as a fixed rate above a variable floor such as LIBOR). Finally, any mandatory amortisation assumptions are set out here. If a revolver is used, then the maximum capacity will also be detailed here.
2. Sources and Uses
The sources side sets out how the transaction will be funded, which breaks down the quantum of the equity investment (including any assumed rollover equity) and the various types of debt.
The uses side sets out how capital will be allocated to complete the transaction. This includes the purchase equity value, refinancing of debt (assuming a cash-free, debt-free transaction), minimum cash to BS, underwriting fees and transaction fees.
The sources and uses must balance. The equity investment is used as the plug to achieve this.
3. Pro Forma Balance Sheet
In simpler LBO models, a pro forma balance sheet is typically not required. It is used to show the impact of the transaction on the target company’s balance sheet. To bridge from the pre-transaction balance sheet to the pro forma, the impacts are categorised into debits or credits. The key impacts include the refinancing of net debt, the introduction of the debt used to finance the acquisition, the minimum cash requirement, goodwill creation & any intangibles write-up, capitalisation of financing fees, deferred tax liability and shareholders’ equity.
4. Financial Projections
The next stage is to project out the income statement for the investment horizon period. The level of detail in the projection drivers varies considerably. For a 2 hour interview exercise, the drivers will be very simplistic. However, for a real LBO model, the financial projections will be extremely detailed with numerous backing sheets.
Next is the calculation of levered FCF. This involves bridging from net income by first adding back any non-cash expenses (i.e. D&A, amortisation of intangible write-up and amortisation of financing fees) then subtracting Capex, any increase in NWC and any unwind of the deferred tax liability.
5. Debt Schedule
The debt schedule sets out the various levels of debt in order of seniority. For each level of debt, the mandatory amortisation (repayment) is set out followed by the cash sweep. This is the optional repayment of the debt using the cash flows generated by the company over the investment horizon. Interest expense is calculated for each type of debt based on the average of the opening and closing balance.
Typically, a high-level summary balance sheet is also shown here (if the balance sheet is not projected elsewhere) which includes total cash and the various levels of debt.
Finally, credit metrics are added to indicate how the level of leverage changes over the investment horizon (e.g. Debt / EBITDA, Net Debt / EBITDA, Debt / Equity, EBITDA / Interest Expense).
6. Exit Analysis
Exit analysis is performed to assess the implied financial returns. Firstly, for each year of the investment horizon, calculate enterprise value at exit by multiplying EBITDA by the assumed exit multiple. Subtracting net debt gives the equity value on exit. The % ownership by the financial sponsor is applied to the equity value to give value to the financial sponsor. An XIRR formula is then used to calculate the IRR at the end of each year. The MoM is also calculated here.
7. Sensitivity Analysis
The final step is to complete a sensitivity analysis of the implied financial returns (IRR and MoM) using the data table function. The most typical variables to sensitise are entry and exit multiple. However, any key input that drives returns can be used.
What is an LBO?
An LBO analyses the implied financial returns of the acquisition of a company purchased with a significant amount of debt, by a financial sponsor / private equity firm. The implied returns are typically expressed as an internal rate of return (IRR) or multiple-on-money (MoM). The acquirer aims to use the minimum possible amount of equity capital to fund the acquisition in order to maximise returns.
Step by Step Guide:
1. Assumptions
Entry assumptions
To determine the purchase price of the target company, the required assumptions depend on whether it is a public vs. private transaction. For a public transaction, the purchase price will typically be an assumed % premium to market capitalization. For a private transaction, an entry EV/EBITDA multiple is typically assumed, which is applied to LTM or NTM EBITDA. Net debt is subtracted to give purchase equity value (assuming the transaction is on a cash-free debt-free basis).
The other assumptions typically set out here include the minimum cash to balance sheet, transaction expenses and what %, if any, is the management equity rollover.
Debt assumptions
The debt assumptions set out the various levels of debt financing used to acquire the target company. Types of debt used include Senior / Bank Debt, High Yield / Subordinated Debt and Mezzanine Debt. An assumed leverage multiple is applied to leverageable EBITDA to give the quantum of each level of debt. Each level of debt will have different interest rate assumptions and underwriting fees. Dependent on the instrument, the interest rate will be fixed or variable (expressed as a fixed rate above a variable floor such as LIBOR). Finally, any mandatory amortisation assumptions are set out here. If a revolver is used, then the maximum capacity will also be detailed here.
2. Sources and Uses
The sources side sets out how the transaction will be funded, which breaks down the quantum of the equity investment (including any assumed rollover equity) and the various types of debt.
The uses side sets out how capital will be allocated to complete the transaction. This includes the purchase equity value, refinancing of debt (assuming a cash-free, debt-free transaction), minimum cash to BS, underwriting fees and transaction fees.
The sources and uses must balance. The equity investment is used as the plug to achieve this.
3. Pro Forma Balance Sheet
In simpler LBO models, a pro forma balance sheet is typically not required. It is used to show the impact of the transaction on the target company’s balance sheet. To bridge from the pre-transaction balance sheet to the pro forma, the impacts are categorised into debits or credits. The key impacts include the refinancing of net debt, the introduction of the debt used to finance the acquisition, the minimum cash requirement, goodwill creation & any intangibles write-up, capitalisation of financing fees, deferred tax liability and shareholders’ equity.
4. Financial Projections
The next stage is to project out the income statement for the investment horizon period. The level of detail in the projection drivers varies considerably. For a 2 hour interview exercise, the drivers will be very simplistic. However, for a real LBO model, the financial projections will be extremely detailed with numerous backing sheets.
Next is the calculation of levered FCF. This involves bridging from net income by first adding back any non-cash expenses (i.e. D&A, amortisation of intangible write-up and amortisation of financing fees) then subtracting Capex, any increase in NWC and any unwind of the deferred tax liability.
5. Debt Schedule
The debt schedule sets out the various levels of debt in order of seniority. For each level of debt, the mandatory amortisation (repayment) is set out followed by the cash sweep. This is the optional repayment of the debt using the cash flows generated by the company over the investment horizon. Interest expense is calculated for each type of debt based on the average of the opening and closing balance.
Typically, a high-level summary balance sheet is also shown here (if the balance sheet is not projected elsewhere) which includes total cash and the various levels of debt.
Finally, credit metrics are added to indicate how the level of leverage changes over the investment horizon (e.g. Debt / EBITDA, Net Debt / EBITDA, Debt / Equity, EBITDA / Interest Expense).
6. Exit Analysis
Exit analysis is performed to assess the implied financial returns. Firstly, for each year of the investment horizon, calculate enterprise value at exit by multiplying EBITDA by the assumed exit multiple. Subtracting net debt gives the equity value on exit. The % ownership by the financial sponsor is applied to the equity value to give value to the financial sponsor. An XIRR formula is then used to calculate the IRR at the end of each year. The MoM is also calculated here.
7. Sensitivity Analysis
The final step is to complete a sensitivity analysis of the implied financial returns (IRR and MoM) using the data table function. The most typical variables to sensitise are entry and exit multiple. However, any key input that drives returns can be used.