Use of LBO model as a valuation tool

How does a lbo model is used in sell side M&A assignment. My understanding is that LBO model is used for going private transactions. How do we use this model as a valuation tool and what are the steps involved to use this model as a valuation tooll

 

You take a basic set of assumptions and designate a range of expected IRR (i.e. 20-25%) and back into the value that way... For example, you say the company is acquired at 8x EBITDA, can hold 4x leverage, and all the necessary assumptions, run the model, and whatever range of entry multiples yield the expected range of IRR gives you the appropriate enterprise valuation.

 

Sure, but you think a PE firm is going to acquire a public company at its current share price? Short answer, no. For a public company, you can do one of two things: start with a metric (revenue, EBITDA, net income/EPS) and apply an acquisition multiple, or start with the current share price and apply a percent premium (we would generally assume a 15-20% premium and run sensitivity analysis to see how much of a premium can be paid while still achieving appropriate returns).

 

Because the LBO model looks at the valuation from a financial buyers point of view only (aka no synergies, economies of scale, ect) the valuation is usually lower than the other methods (just like Comp Transactions are higher because of the control premiums involved). The LBO model is used as a floor valuation and is a bankers way of saying "the absolute lowest possible price we will get you is....."

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Best Response

Exactly. To be honest, we've never used an LBO model as a primary means of valuation -- we use LBOs in much the same way we use the DCF -- we use it as a way to hone in on a valuation generally derived from some multiples-based valuation. In other words... we adjust the IRR range to match the valuation we get from our multiples-based analysis. An LBO is basically a sanity check.

Gekko21, I have never, EVER heard of a legitimate banking group using an LBO-based valuation to set a "floor" -- does your group actually practice this?

 

In theory a lot of this works, but in reality, sponsors bid higher than strategics; I personally question this "floor" valuation these days, especially since there is so much dry capital on the sidelines buy all types of Buyout and Credit funds. A PE firm hungry to do a deal will really eat into this 20% return on base assumptions and start to refine cost assumptions, something banks never factor into this floor analysis.

I haven't seen a group of PE firms be kicked around in an auction by a strategic in a long time, its usually the contrary.

Also with LBOs, the nuances of a deal can really generate a few hundred basis points on the IRR, something that a floor valuation may fail to miss and may skew some of these multiple ranges.

 

Ok, honest response so I'll give you a proper answer... making me feel bad and $hit

In theory, because a financial sponsor cannot extract synergies the same way a strategic buyer can, he is limited in his bid price. A strategic can bid up to the maximum value of the synergies he expects to extract and as a result he can bid alot higher. The PE shop can't bid for these synergies on a base case so it is considered the bottom for what an investor would pay for this business, with market terms on leverage, in order to hit 20-25% IRR.

 

On a basic level, an LBO model is a DCF analysis that takes into account the types and cost of debt used to make the acquisition.

You should probably read and complete the guide to LBO modelling here and then come back with questions once you have a better understanding of the basics: http://www.macabacus.com/

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Thanks for the responses. I guess what I'm stuck on is which part in the LBO tells you how much the company is worth, similar to how the DCF has specific lines that tell you what company A is worth.

 

Buyout Monkey-

It's not an explicit valuation method, in terms of establishing intrinsic value range for the target. Instead, as Mezz mentioned, it's really an affordability valuation methodology.

By establishing the end variable, which is the required return or IRR that the PE shop benchmarks the investment with, you can then back into the purchase price. It's simple math, if given all of the variables (cash flows, required return, debt repayment schedule, exit or sale price) except one (purchase price), you can then solve for that one variable, which happens to be the purchase price. Tada, valuation.

Given the target IRR, you will not pay any more than the modeled purchase price that you back into, otherwise your return will obviously shrink below the threshold. Therefore, it's a valuation of affordability which allows you to back into a purchase price given the exit price, target return, and debt repayment schedule.

 
youngblood:
Buyout Monkey-

It's not an explicit valuation method, in terms of establishing intrinsic value range for the target. Instead, as Mezz mentioned, it's really an affordability valuation methodology.

By establishing the end variable, which is the required return or IRR that the PE shop benchmarks the investment with, you can then back into the purchase price. It's simple math, if given all of the variables (cash flows, required return, debt repayment schedule, exit or sale price) except one (purchase price), you can then solve for that one variable, which happens to be the purchase price. Tada, valuation.

Given the target IRR, you will not pay any more than the modeled purchase price that you back into, otherwise your return will obviously shrink below the threshold. Therefore, it's a valuation of affordability which allows you to back into a purchase price given the exit price, target return, and debt repayment schedule.

C'mon now, that's not true. The range of purchase prices is an input (per your MD), and assumptions like leverage at acquisition, exit multiple, revenue growth are variables -- whatever they need to be to support your MD's wishes.

 
youngblood:
Buyout Monkey-

It's not an explicit valuation method, in terms of establishing intrinsic value range for the target. Instead, as Mezz mentioned, it's really an affordability valuation methodology.

By establishing the end variable, which is the required return or IRR that the PE shop benchmarks the investment with, you can then back into the purchase price. It's simple math, if given all of the variables (cash flows, required return, debt repayment schedule, exit or sale price) except one (purchase price), you can then solve for that one variable, which happens to be the purchase price. Tada, valuation.

Given the target IRR, you will not pay any more than the modeled purchase price that you back into, otherwise your return will obviously shrink below the threshold. Therefore, it's a valuation of affordability which allows you to back into a purchase price given the exit price, target return, and debt repayment schedule.

Exactly the answer I was looking for. Thanks.

 
youngblood:
Buyout Monkey-

It's not an explicit valuation method, in terms of establishing intrinsic value range for the target. Instead, as Mezz mentioned, it's really an affordability valuation methodology.

By establishing the end variable, which is the required return or IRR that the PE shop benchmarks the investment with, you can then back into the purchase price. It's simple math, if given all of the variables (cash flows, required return, debt repayment schedule, exit or sale price) except one (purchase price), you can then solve for that one variable, which happens to be the purchase price. Tada, valuation.

Given the target IRR, you will not pay any more than the modeled purchase price that you back into, otherwise your return will obviously shrink below the threshold. Therefore, it's a valuation of affordability which allows you to back into a purchase price given the exit price, target return, and debt repayment schedule.

This is a pretty old post, so I'm not sure what my chances of getting a response are, but here goes nothing:

Your response was really helpful for me, but I have follow up question. You would be able to back into the "affordability valuation", but a pretty key assumption would be the exit price. How would you determine your exit price in this instance?

The reason I ask: I have an interview with a small PE shop coming up on Monday and will need to build an LBO for a private company to determine the appropriate purchase price. I will have the financials provided, but I don't think I'll be given access to the internet to find multiples of comparable companies. If I don't have some sort of multiple to determine the exit price, I'm not sure how I'll back into my acquisition value. I know the exit price is always a bit of wild ass guess anyway, but clearly you need to come up with something reasonable. Even doing a DCF to determine initial acquisition price seems a little circular, since I'd be lost for what to use as the discount rate (PE firm's required rate of return?)

Any insight would be helpful.

 

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