If you already had an experience buying your own house on a mortgage and then later on selling it, congratulations, you had already experienced leveraged buyout!
LBO is mainly about buying an investment by using mostly loaned funds and then selling the property in the future. Hopefully, after paying off the debts there would still be enough funds to call as profit.
One of the misconceptions about LBOs is that it’s only for the analysts who had already worked so many years on Wall Street. But the truth is, any finance student or rookie analyst can do it, you just have to know the idea or concepts behind this model.
That’s what we’re going to do in this tutorial. We’re going to explore the LBO Model in a slightly basic way. We’ll make it sure that after this, you’ll be able to understand the main concepts behind LBOs.
We will be making a quite basic LBO model. If you think this is not for you, maybe you should take a look at some advanced courses about LBOs.
However, if you think the discussion would fit you, go on reading!
How does a leveraged buyout work?
A leveraged buyout happens when a financial sponsor buys a target company, using both its own cash as well as loans from banks. It aims to buy a target company at a low price, with hopes that the company will be selling at a substantially higher price 3-7 years from purchase date.
Usually, sponsors like PE firms earn around 20-30% profit from this type of transaction. No wonder this method had brought about a lot of billionaires already.
But, why do private equity use leverage when buying out a company?
Sponsors do this mainly to increase profitability.
To make a point, let’s have an LBO Model case study.
For example, there’s a target company whose valuation is set at $200M. The sponsor paid out $200M from its own treasury. At the end of 5 years, the company was sold at a profit of $50M.
Now suppose that half of the $200M was loaned from banks, in such case, only $100M was shouldered by the financial sponsor.
In the first scenario, the return is 25% (50/200), but in the second scenario, it’s 50%. The second one is a better deal, right?
What are the characteristics of a company that is a good LBO candidate?
Not all companies could be targeted with LBO. Also, not just because a company is small, it’s a good target already. Nor if a company is so big it can no longer be purchased through LBO.
Ideal candidates for an LBO transaction should already have stable operations capable of generating a steady stream of cash inflows. This is very much needed especially that there’s a lot of leverage and continuous interest payments involved.
Additionally, the business should be subject to minimal risk only.
Also, since the sponsor is aiming to sell high in the future, the target should be undervalued as of entry date. Creating an LBO Model in Excel will be a good way to effectively determine if the company is over or undervalued.
Companies with large cash requirements because of on-going capital formation activities are also not good targets of LBO. As much as possible, targets should not be cash-hungry entities; the sponsors need cash in order to repay liabilities.
Having sound financials and management group will definitely make a company a good LBO target.
Having large asset base that is marketable is a good way to get approved for loans. Thus, LBOs are great for these types of businesses.
Step by step Guide how to create a basic LBO Model
We have an LBO Model template to accompany this tutorial, you can download in order for you to understand better this LBO model tutorial (available with our courses).
We’re going to have a walkthrough of each of the elements of LBO Model basics. You will see how each section is going to be inputted, and how each section is interconnected with one another.
Here are the LBO model steps we’re going to do.
Frist, we will discuss the inputs for Shares data and the financial statements. We need these things to be set-up first before we can fully fill-up out LBO’s Assumptions, Equity Value, Enterprise Value and Debt Schedule sections.
Overall, this is how the basic model will be structured:
First, we will have to input some data, especially those that relate to the shares and financial statements of the company. Some of the cells would be interconnected with one another.
Since we will not be creating a full-blown model, we will be making some assumptions in order to simplify our discussion.
Let’s get going.
1. Shares Data
On the Shares data section, you will have to input the market price and diluted number of shares of the company.
It will be better if you can separately compute the total diluted number of shares.
In our illustration, we just assumed that we already had computed the shares beforehand.
2. Income Statement
We will be using only a simple condensed income statement. But in real-life, you will encounter a much longer and much more head-spinning statement than this.
We will just assume the growth rate of Sales, Cost of Goods Sold and Operating Expenses are all the same. The important figure here is the EBITDA (Earnings before Interest and Taxes).
3. Statement of Financial Position
We will be only needing a very few balance sheet accounts relating to the entry year.
We need Cash and Debt in computing our Free Cash Flows and Debt Schedule. On the other hand, we need the Shares amounts in order to compute Enterprise Value, Equity Value, and some multiples.
4. Free Cash Flows
We will be dealing with a pretty much condensed cash flows statement too.
First, we will just assume that Free Cash Flows every year has the same ratio with Sales. In our LBO model example, we just assumed that FCF is always 50% of Sales every year.
In our first line, we have our FCF before debt repayments. The Required Debt Payment of 1,500 is just assumed. In practice, required debt payments are dictated by the lenders. They add a provision like this so that the risk on their part will be reduced.
The difference between FCF and required debt payment will give us Net Free Cash Flows. For a company to survive, it needs to maintain a certain level of funding. We will have to take that into account in our model.
In our illustration above, our Required Minimum Cash for Operations is 800M.
Notice that the last line is titled “Cash for Additional Paydown”.We are assuming that there’s another agreement with the lender that all cash remaining after debt repayments and operational requirements will be paid to the lender. This is another way banks mitigate risks, and to prevent the borrower (financial sponsor) from taking advantage of all the rewards from the investment while the banks are faced with big uncertainties.
5. LBO Assumptions
In our assumptions, we must indicate a timeline. We need to state when does the financial sponsor intend to buy the target company, and when does it intend to exit.
Also, in order to aid in our analysis, we need to know how much the financial sponsor intends to sell the company at the exit date. Thus, we need to know the exit multiple (EV/EBITDA). We will, later on, use this multiple in calculating the possible sales price of the company.
We also need to input how much the Required Rate of Return of the financial sponsor is.
6. Equity Value and Enterprise Value
Equity Value is simply the Current Stock Price (Which we had inputted in the Shares section) and the Diluted Number of Shares.
Net Debt, on the other hand, is the Total of Debt, Preferred Shares (and Noncontrolling interests) less Cash.
Adding Equity Value and Net Debt will give us the Enterprise Value.
Notice that we also computed the EV/EBITDA Multiple as of entry date. You might probably need this multiple in analyzing the LBO model. Sometimes the entry date multiple is the same multiple sponsors use to compute how much they are willing to sell the target at the Exit year.
7. Debt Schedule
Since LBOs need heavy funding requirements, LBO modelers are expected to always create a debt schedule. Our figure above shows a simple example.
The LBO Debt Capacity is the maximum multiple of EBITDA that lenders can borrow the financial sponsor. This multiple is based on a lot of factors like interest rates, the liquidity of the market and nature of the company to be targeted.
In our example, we are assuming an LBO Debt Capacity of 5x, meaning, lenders are willing to lend the financial sponsor 5x the EBITDA of the target company.
In this illustration, we are also assuming that interest rate is 5% and that the required annual payment of the lender is 1,500M.
Using the debt schedule we can easily get the running balance of Debt each year. Simply start with the opening balance, deduct the required repayments, and then subtract the Additional Paydown (from the Free Cash Flows section).
At the end of our exit year, our remaining debt is 4207.75.
Since we retained 1500 on our exit year (since 1500 is our minimum operations requirement), our net debt for the exit year is 2707.75
LBO Analysis walkthrough
Now that we have created our model, we have done around half of the job.
We will now have to analyze our LBO transaction.
In order to make a deeper analysis, let us first compute the Enterprise Value and Equity Value at the Exit Year.
Enterprise Value can be computed by multiplying the EBITDA multiple (at the exit year) we placed on the LBO Assumptions section, by the EBITDA in the EXIT year (in our case, 2020). The result for our example is 13,310.
Equity Value is the difference between the Enterprise Value and Net Debt as of Exit Year. It’s just like your equity, after selling out the investment and paying off all your liabilities. We have 10,602.25 in our illustration.
How much should be the maximum equity that can be contributed by the sponsor? To answer, we’ll need to get the present value of the Equity Value of the Exit year. The PV will be computed using the required profit rate (in LBO Assumptions), discounted by the holding period (3 years in our case).
The maximum equity the sponsor can give, that will still meet its profitability condition is 6971.15.
Adding the equity of the sponsor, and the loan to be granted by banks, we will get 16,971.15, which is the total price to be paid for the LBO transaction. Dividing it by the total diluted number of shares, we will realize that the purchase price per share is 77.14.
The current market value is just 5, which gives us more than 14x premium. If this company is real, this could be the next WhatsApp!
IF upon your analysis, you discovered that the returns are too low, you can advise your firm to reduce the purchase price or increase the leverage. You ca also go back and check if you can assume a higher growth rate for the company.
The LBO Model definition can be described by three terms: buy, wait and sell. It’s very similar to trading stocks or debt securities in exchanges.
The only difference is that were talking of undervalued companies that have potentials to increase in value in 3-7 years’ time. Financial sponsors invest significant effort in building these companies in hope of big returns. They usually earn 20-30% per transaction.
LBOs are leveraged in order to increase profitability. Instead of using their own cash, sponsors ask banks for loans in order to finance the purchase of target companies. Effectively, the sponsor’s risk is reduced, and rate of return increases.
Download your free LBO Model in XLS format so that you can have your own copy to practice on.
If this basic tutorial isn’t for you, then maybe you need our advanced courses on LBO models.
If you encountered problems doing your own LBO model, let us know by typing in your comments below.
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