Leveraged Buyout (LBO) Model

The leveraged buyout (LBO) model is used to model for one of the most complex types of transactions in finance. It is built not just for the basic valuation of a company but also to account for the debt raised to finance the transaction and forecast how much return the private equity firm can make.

A leveraged buyout transaction is where a sponsor purchases a company using large amounts of debt financing. These transactions employ incredibly high leverage, with debt comprising anywhere from 50-90% of the purchase. This debt is raised from various sources, such as banks and private lenders, and the rest of the money is raised from investors (usually 20-30%).

Usually, a leveraged buyout includes purchasing all or majority of the shares outstanding of a company so that the sponsor can take it under their direct control and make extensive changes to increase the company's valuation before exiting through taking the company public once again or selling it to another private buyer.

There are two types of LBO models. The first and easiest method is dubbed the quick and dirty (Q&D) LBO model. While easy to build, it relies on many assumptions and does not allow for much due diligence.

While it may be slightly less reliable than a fully integrated LBO model, it can be built quickly and gives a rough idea of the outlook of the transaction. A Q&D model may be done for preliminary screening to shortlist the targets for acquisition. Once the targets have been shortlisted, a fully integrated model can be built to analyze if the target company is a potentially profitable purchase.

Fully integrated models are different from Q&D models because of the detail involved. Unlike a Q&D model, it includes constructing a pro forma balance sheet and the calculation of goodwill in the purchase.

Both models look relatively similar and contain similar steps. However, the fully integrated model is used for a more thorough examination of the transaction with options to plug in and account for minute details.

What is a Leveraged Buyout (LBO)?

A leveraged buyout (LBO) is when a sponsor, typically a private equity (PE) firm, uses a relatively high amount of debt combined with some equity capital to purchase a company in the hopes that it can increase the company's share value before exit.

LBOs are unique as they use an incredible amount of debt financing. Usually, these transactions use anywhere from 50% to 90% leverage.

The remaining part of the transaction is financed by raising capital from equity investors (also called limited partners) of the PE firm and may even include money from the sponsor itself.

Usually, the companies acquired are taken private to improve the decision-making and execution processes much faster. In many cases, the sponsor will form a special purpose vehicle (SPV) to purchase the company's outstanding shares and take it private.

This reduction in red tapes helps the PE firm take quick actions to turn around companies or spin off its assets with little to no hindrances from regulatory authorities or other shareholders.

The usual targets for an LBO are companies with steady cash flows that are non-cyclical and stable during economic downturns. In addition, because of the amount of leverage used, sponsors need to minimize the risk of default on the debt payments (both principal and interest).

A leveraged buyout is typically an intense and fast process where the sponsor intends to manage the company for only 3-5 years before exiting for a profit, which is usually about 20-30% IRR.

Therefore, the longer the sponsor owns the company, the more interest liability builds up from the loans taken. This means that the debt burden will eat into the sponsor's profit as time passes, increasing the risk to the equity investors.

Once the sponsor has successfully invested in a company and improved its operations, thereby increasing the valuation, it will look to exit and bag the returns, which in most cases are above 20% IRR.

Two primary ways of an exit are:

• taking the company public through an IPO or
• looking for another investor willing to acquire the sponsor's share of equity in the company.

Sponsors look to make a substantial profit from this transaction and usually run very detailed calculations on:

• What are the sources available to finance the transaction?
• When will the debt payments be owed?
• How much will be paid in interest expenses?
• How much will the target company grow?
• What is the return it can promise investors?
• How much return can the firm bag for itself?

Usually, sponsors look for an internal rate of return (IRR) of 20-30%, which is justified due to the considerable risk.

How to Build an LBO Model?

LBO models are considered one of the more complex financial models, requiring a lot of due diligence to make them accurate and reliable. Usually, these models are created within Excel, as many of its functions are useful for the calculations necessary in this model. Further, a good LBO model automatically updates itself when its inputs are changed.

Calculate Purchase Price Using DCF And Entry Multiples

First, a sponsor must estimate the purchase price of the targeted company. Typically, they estimate the target company's earnings at the time of acquisition. Then they determine an entry multiple and an exit multiple, which are both usually EBITDA multiples.

The entry multiple is then multiplied with the EBITDA to estimate the target company's enterprise value (EV). The present value of debt is then subtracted, and cash is added to the EV to find the estimated equity value of the target company.

The equity value divided by the number of shares outstanding yields the offer price per share, which is usually at a premium to the target company's current share price.

The entire process above can be summarized as follow:

EBITDA * Entry Multiple = EV

EV - Debt + Cash and Cash Equivalents = Equity Value

Equity Value / Shares Outstanding = Share price offering

It should be noted that there are some other things that are taken into consideration while valuing the target company.

One of the factors is goodwill, which is the value of intangible assets such as intellectual property as well as the brand image and other such things that add value but cannot be seen or touched (not tangible).

Calculate The Amount, Sources, And Use Of Financing Required

After valuing the target company, the sponsor needs to find how much leverage the company will use and how they will finance this acquisition.

This is usually summarized by the leverage ratio, often a debt to equity ratio, which measures the amount of debt compared to the amount of equity. The sponsor typically agrees to covenants with the creditors, which are contractual obligations prohibiting the debtor from certain actions. If they break the covenants, the creditors have the authority to seize the debtor's assets.

Usually, debt is organized into tranches, which essentially organizes the debt into levels of risk and cost, as certain types of debt will be paid back before others in the event that the sponsor does not have money to pay back all the debt. The lower tranche debts are paid off last but carry a higher interest rate than the higher tranche ones.

Sources Of LBO Funding

The senior tranche is considered the most secure, carries the lowest interest rate, and is paid back first. It usually includes debt from banks.

It also typically has some of the strictest covenants, including prohibiting the sponsor from paying dividends or engaging in other types of spending before the debt is repaid.

The junior tranche is riskier, carries higher interest rates, and gets paid back after the senior tranche. It is also called subordinated debt.

Most debts are usually paid off through bullet amortization, meaning that the interest needs to be paid throughout the life of the loan and with principal repayment only at maturity. This tranche also usually has less restrictive covenants than the senior tranche, making it riskier.

The mezzanine debt is the lowest and most risky tranche, which is repaid last. However, it also carries the highest interest rate to make up for these.

Mezzanine debt often includes buying the stock at a certain price to incentivize creditors (convertible debt). It is also generally paid back via bullet amortization. This tranche also has less restrictive covenants, giving the sponsor more flexibility.

Finally, the rest of the financing comes from the firm's investors. This technically isn't a debt tranche but the equity portion of the financing. In case of financial troubles or liquidation, these investors would be paid back last and sometimes not at all. However, compensating for this risk is the potential for very large returns (usually 20-30% IRR).

The debt is organized under two categories: uses and sources. The sum of both of these sections should be equal.

Check out the video below from our LBO Modeling Course that demonstrates filling in the sources of debt!

Build Pro forma financial statements

An LBO model requires the sponsor to create pro forma financial statements, which are forecasted financial statements used to estimate future financial performance.

In particular, it will involve estimating the balance sheet taking into account the debt used to purchase the target company. As the sponsor company acquires the target company, it will need to know where to allocate money to invest in its operations to boost its value upon exit.

These pro forma financial statements should also forecast future periodic cash flows can help prepare for its cash sweep. A cash sweep in an LBO is the action of using excess cash flows to pay off debt, often before the loan's maturity, to avoid the extra interest expenses.

Once the pro forma financial statements are created and the cash sweep determined, it is time to calculate the exit value.

Calculate Exit Value using Exit Multiple

Usually, PE firms plan to exit a leveraged buyout in about 3-5 years. With future cash flows already forecasted, the exit value is calculated by multiplying the final predicted cash flow with the exit multiple. Usually, both the multiple of money (also known as cash on cash) and the internal rate of return (IRR) of the investment are calculated.

MoM = Total Investment/Gross Profit

IRR = MoM^{1/number of periods} - 1

Please check out the video below from our LBO Modeling Course that explains how to calculate IRR using Excel!

Build the sensitivity analysis table to estimate the margin of error

Once the model is complete, the next step involves performing sensitivity analysis to check for vulnerabilities in the model and the margin of error to profit from the investment. Typically, attractive companies have large profit margins, which minimizes the risk that the model is incorrect and the deal is unprofitable. A sensitivity table shows various entry and exit multiples and the different IRRs that are possible with varying combinations of the two. Check out our video on sensitivity analysis from our LBO Modeling Course!

M&A vs. LBO

Mergers and acquisitions (M&As) and leveraged buyouts have similarities and differences, and it is worth outlining those differences here.

A merger is when two companies combine to form a single company, usually because they can take advantage of synergies, a word used to describe the benefits available to the merged company, which was not available to the individual companies. An example of synergies is shared expenses that are reduced due to the merger. Another one is that enhanced operational efficiency can improve both profits and valuation.

In short, companies merge because their value as a single entity is greater than the sum of the individual companies.

Acquisitions are very similar to mergers; however, one company acquires another instead of the two companies merging.

Leveraged buyouts are a type of acquisition typically done by private equity firms.

The biggest difference between LBOs and M&A is the calculation of synergies. In the merger model, the company must combine the two companies' assets on the balance sheet to analyze potential areas of synergy. This is done through the accretion/dilution analysis to understand whether the share price would be positively or negatively impacted.

On the other hand, LBO models have to account for exit value and IRR, which is very rarely accounted for in M&A models.

Another difference with LBOs is the high degree of leverage involved. Usually, LBOs are financed with large amounts of debt (usually 50 - 90%), which is much different from M&A transactions, which are usually financed by equity and cash.

LBO vs. MBO

A leveraged buyout (LBO) and management buyout (MBO) are very different, though they may sound very similar. We explore these differences below.

A management buyout is when a company's management buys its assets and operations. In many cases, this is accomplished by purchasing the shares outstanding of the company to take it private under the ownership of the management.

MBOs typically require a large amount of financing, which is usually provided by hedge funds, private equity firms, debt, or from the company itself.

The biggest difference between an MBO and LBO is that the former is perpetrated by the company's management that is being bought out. The latter is done by a sponsor who has no relation to the target company.

What may be surprising is that leverage may not be a key differentiating factor, as both LBOs and MBOs require a great deal of financing to complete the transaction.

Likewise, both are typically done for similar reasons: to take a company private so that the management or sponsor can make major changes to the target company's operations to increase efficiency and profitability and improve its valuation before taking it public once again.

More on Excel

To continue your journey towards becoming an Excel wizard, check out these additional helpful WSO resources.

• Overview of Financial Modeling
• Valuation Modeling in Excel
• Scenario Analysis
• DCF Model Training
• 3 Statement Model