How to Answer, “Walk Me Through an LBO Model”
Basically, an LBO Model measures the implied returns on a leveraged buyout transaction, which is a specialized type of acquisition where a substantial percentage of the purchase price is funded using debt.
Understanding the basics of LBO modeling in Excel is necessary to perform well in private equity (PE) interviews and LBO modeling tests.
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Basics of an LBO Model | Private Equity Modeling Tutorial
An LBO model estimates the implied returns from the buyout of a target company by a financial sponsor, or private equity firm, in which a significant portion of the purchase price is funded with debt capital.
Following the leveraged buyout (LBO), the financial sponsor operates the post-LBO company for around five to seven years – with the free cash flows (FCFs) of the company used to pay down more debt each year.
From the perspective of a private equity (PE) firm, the following pieces of information must be derived from an LBO model to analyze a potential investment opportunity.
- Entry Valuation → Pre-LBO Entry Equity Value and Enterprise Value
- Default Risk → Credit Ratios (e.g. Leverage Ratio, Interest Coverage Ratio, Solvency Ratio)
- Free Cash Flows (FCFs) → Cumulative Debt Paid Down (and Net Debt in Exit Years)
- Exit Valuation → Post-LBO Exit Equity Value and Enterprise Value of the Target Company
- LBO Return Metrics → Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC)
Step 1. LBO Entry Valuation
Suppose you’re currently recruiting for a position to join a private equity firm (PE), and the interviewer sitting across from you asked the following question:
Q. “Walk me through an LBO model?”
So, the first step to building an LBO model is to calculate the implied entry valuation based on an entry multiple assumption.
To calculate the enterprise value at entry, the entry multiple is multiplied by either the last twelve months (LTM) EBITDA of the target company or the next twelve months (NTM) EBITDA.
If we assume a “cash-free, debt-free (CFDF)” transaction, the enterprise value is the purchase price of the LBO target.
Step 2. Sources and Uses of Funds Table (S&U)
All else being equal, the lower the required upfront equity contribution from the financial sponsor, the higher the returns.
The next step is to create the sources & uses schedule, which approximates:
- Uses Side → The total amount of capital required to complete the acquisition
- Sources Side → The specific details on how the firm plans to come up with the required funding
The majority of the “Uses” side will be because of the buyout of the target’s existing equity. But in addition, other transaction assumptions are made, such as:
- Transaction Expenses (e.g. M&A Advisory, Legal Fees)
- Financing Fees
From here, numerous financing assumptions are made regarding the “Sources” of funds, such as the:
- Total Debt Financing (i.e. Leverage Multiple, Senior Leverage Multiple)
- Lending Terms for Each Debt Tranche (e.g. Interest Rate Pricing, Required Amortization, Cash Sweep)
- Management Rollover Assumptions
- Cash to B/S (i.e. Excess Cash)
The remaining amount for the Sources and Uses to be equal is the equity contribution by the financial sponsor (i.e. the equity investment to “plug” the remaining funds required).
In the sources and uses of funds table, the total sources must equate to the total uses (Total Uses = Total Sources), akin to the fundamental balance sheet equation.
Where:
- Total Uses → Purchase Enterprise Value (TEV), Transaction Fees, Financing Fees
- Total Sources → Debt Capital (Senior Debt, Subordinated Debt), Mezzanine Financing, Preferred Stock, Sponsor Equity Contribution
