Walk Me Through an LBO Model?
Understanding the mechanics of an LBO model is necessary to answer the technical questions in private equity interviews accurately, as well as to perform well on modeling tests.
- What is a leveraged buyout (LBO)?
- What are the steps to building an LBO model?
- How do private equity firms profit from an LBO?
- What sorts of insights are obtained from an LBO model?
Table of Contents
LBO Model Overview
LBO models estimate the implied returns from the buyout of a company by a financial sponsor (i.e. private equity firm), in which a significant portion of the purchase price is funded with debt capital.
Following the buyout, the firm 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.
The following information should be determined from an LBO model:
- 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 of Money (MoM)
Entry Valuation – Step 1
The first step to building an LBO model is calculating the implied entry valuation based on an entry multiple assumption.
If we assume a “cash-free, debt-free” transaction, then the calculated enterprise value is the purchase price of the LBO target.
Sources & Uses Schedule – Step 2
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 attributable to 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)
- 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 & uses side to be equal is the equity contributed by the financial sponsor (i.e. the “plug”).
Financial Forecast and Debt Schedule – Step 3
In the subsequent step, the financial performance of the company is projected for a minimum five-year time horizon, which is the standard holding period assumed for modeling purposes.
A complete 3-statement model is required for the LBO assumptions to properly impact the income statement and cash flow statement (i.e. the free cash flow build).
The debt schedule is used to closely track the:
- Revolver Drawdown / (Paydown)
- Mandatory Amortization
- Cash Sweeps (i.e. Optional Prepayment)
- Calculating Interest Expense
For the LBO model to calculate the returns accurately, the debt schedule must adjust each debt tranche accordingly to determine the amount of debt paid down in each period (and the ending balances).
Exit Valuation and LBO Returns – Step 4
Next, the assumptions regarding the exit must be made – most notably, the exit EV/EBITDA multiple.
In practice, the conservative assumption is to set the exit multiple equal to the purchase multiple.
Upon calculating the exit enterprise value using the exit multiple assumption and exit year EBITDA, the remaining net debt on the balance sheet as of the presumed date of exit can be deducted to arrive at the exit equity value.
Sensitivity Analysis – Step 5
In the final step, different operating cases must be considered – e.g. a “Base Case”, “Upside Case”, and a “Downside Case” – along with sensitivity analyses to assess how adjusting certain assumptions impacts the implied returns from the LBO model.
Typically, the entry multiple and exit multiples are the two assumptions with the most significant impact on returns, followed by the leverage multiple and other operational characteristics (e.g. revenue growth, margins).