LBO Modeling is a method to measure the implied returns on a leveraged buyout transaction (LBO), 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, LBO modeling tests, and most importantly, on the job.
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.
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The infographic can serve as a quick reference “cheat sheet” during the recruiting process.
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.
The next step is to create the sources & uses schedule, which approximates:
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:
From here, numerous financing assumptions are made regarding the “Sources” of funds, such as the:
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:
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In the subsequent step, the company's financial performance is projected for a minimum five-year time horizon, which is the standard holding period assumed on the job.
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 following components:
For the LBO model to accurately calculate the returns, the debt schedule must adjust each debt tranche accordingly to determine the amount of debt paid down in each period (and the ending balances).
Next, assumptions regarding the exit – i.e. the realization of the investment by the financial sponsor – are necessary, most notably the exit EV/EBITDA multiple.
In practice, the conservative assumption is to set the exit multiple equal to the purchase multiple.
The exit enterprise value is determined by multiplying the exit multiple assumption by the exit year EBITDA.
In the next step, 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.
After calculating the exit equity value because of the sponsor, the key LBO return metrics – i.e. the internal rate of return (IRR) and multiple of money (MoM) – can be estimated.
The internal rate of return (IRR) is the annualized yield on an investment, with the effects of compounding factored.
In the final step, different operating cases must be considered—e.g. a “Base Case”, “Upside Case”, and a “Downside Case”—along with sensitivity analysis to assess how adjusting certain assumptions impacts the implied returns from the LBO model.
The downside case is of particular importance in private equity (LBO) investing, because of the debt load placed on the capital structure of the target post-LBO.
In conclusion, the entry multiple and exit multiples are usually the two assumptions with the most impact on returns, followed by the leverage multiple and other operational characteristics, such as revenue growth and profit margins.
Since we've covered the core components that underpin an LBO model, including the intuition behind each step, here are a couple of practical LBO modeling tests to help prepare for private equity recruiting, ordered by ascending difficulty.
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