LBO sensitivity table - sense check?
Hi guys:
For some of the more complex LBO models, I often run into the problem of not being sure if my sensitivity table outputs make sense. Sometimes a variable would cause large fluctuations in return, other times the fluctuations in return are smaller than I expect. (For example, sometimes declining margin by 2% causes 8% change in IRR, which seem big to me).
Assuming one has already checked the linking of cells to sensitivity table, what are some math checks/approximations that one can use to think through if the outputs of the sensitivity tables are right, or if there's something off in the model that's causing larger than expected fluctuation?
Thanks!
Check the outlier assumptions in your model and see what causes this. LBO is super sensitive for margin, because it has a direct impact on exit proceeds which is by far the most important source of return in your LBO.
LBO example of 2% lower margin Lets say EBITDA margin is 10% from entry to exit and you lower exit to 8%. You pay for the 10% business, and you lose 20% of your EBITDA during the holding period in this case! Exit enterprise value is now 20% lower and probably you still have quite some debt on the balance sheet after 5 years because your margin went down, so equity proceeds at exit will be at least 20% less but probably much less.
Example of losing margin and growing sales * Let say you have 100 m sales, 10% margin = 10m EBITDA * 2%point lower EBITDA = 8% marign = 8m EBITDA left from the 10m * From this point, to get back to 10m EBITDA you need to grow revenue by (2m/8%) 25million to 125m just to maintain your valuation!
Thank you @Rover-S! Your methods are super helpful!
I tried to put my problem through the method you mentioned, do you think the thought process below makes sense?
I'm looking at something where EBITDA margin was ~25%. If I decline the EBITDA by 1% to 24%, that's essentially a 4% decrease in EBITDA dollar amount every year.
With that, there are also some exogenous costs items below EBITDA line that are linked to sales, not EBITDA. so in effect, cash flow to the business declines by more than 4%. And now, I factor in the final exit which is also now lower. With that in mind, if IRR declines from ~20% to ~16%, that's not too drastic/impossible of a change, right?
Thanks!
Add a tab to your model and build a short form LBO with just the line items you need (which isn't many: revenue, EBITDA, cash flow available for debt service, and the margin associated with each).
Pull those from your long form model but run the returns off the short form. The IRRs will be different but not by much, and you'll be able to see: a) what's driving the change, and b) if the relationship between revenue, EBITDA and cash flow makes intuitive sense.
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