How to apply the LBO model?

Dear all,

I would like to kindly ask a question regarding valuation of certain PE company. I am supposed to prepare a valuation of private bakery business. I am am not given any specific financial statements, just some analysis of the industry and 2013 budget projected by the management. My task is to value the company with 20% IRR on equity. What I have done so far is that prepared income statement and free cash flows statement projected for 5 years. Since I was not given any other documents I was not able to prepare the balance sheet. What should I do next? How should I value the company for the buyout and for the exit? Using multiples of publicly traded peers? I am not very familiar with the lbo model so it would be very helpful if you could describe steps I should follow now. Thank you in advance!!

 

I'd say you buy at xEBITDA management projections and sell out (y-time frame) at xEBITDA (again projected) - be it plus or minus/looking at capex/leverage/cash generation, etcetc. hence the IRR?

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Best Response

The point of an LBO model is more of a sense check. Once you have the model built out, play with the entry (and exit) multiples until you hit your targeted IRR, which is 20% in this case. Looking at where comps trade at can be a good way to get a sense for what might be a feasible multiple.

If you have BS and CF, then all you really need is net working capital (you have capex from CF). Look at a few comps to get a sense for NWC as a % of sales. Historical cap table is irrelevant, since you will resetting the capitalization of the company to whatever amount of new debt and equity you put in.

Basically, if you have IS down to Net Income, then adjust back to cash that is available to repay debt from the LBO. Add depreciation, PIK interest if there is any, subtract increase in NWC and capex. There may be other adjustments too (e.g. tax shield from amortizing financing fees, basis step up, etc.), but those four are a good start.

 

Ok, thx for your reply so far. However I dont really understand what you mean. I do not have any balance sheet. All I have is IS and free cash flow statement. I calculated capex and change in NWC using comparable peers as you mentioned. Nevertheless, the task is to determine the purchase price if the buyer must make 20% IRR on equity. So I can establish the purchase price by using the Management projected EBITDA for the year of purchase and then the exit value by using the same multiple but with projected EBITDA in the year of exit? And then? I guess I need to calculate structure of financing - equity/debt in order to achieve the desired IRR.

 
Jig:

Ok, thx for your reply so far. However I dont really understand what you mean. I do not have any balance sheet. All I have is IS and free cash flow statement. I calculated capex and change in NWC using comparable peers as you mentioned. Nevertheless, the task is to determine the purchase price if the buyer must make 20% IRR on equity. So I can establish the purchase price by using the Management projected EBITDA for the year of purchase and then the exit value by using the same multiple but with projected EBITDA in the year of exit? And then? I guess I need to calculate structure of financing - equity/debt in order to achieve the desired IRR.

You don't need a balance sheet to build an LBO model, and once you're on the job, you'll see that most of the time you'll go into a pitch with very bare bones information (almost never a balance sheet, usually just a summary IS).

You need to figure out the structure of financing, so break it out into various debt tranches and lever it at a multiple of EBITDA. For example, you might use a senior term loan and second lien loan to fund the transaction, with the term loan coming in at 3x EBITDA and the second lien coming in at 2x EBITDA. The rest of the purchase price is funded by the PE firm's equity (possibly also management, but ignore this for now if it's your first LBO model). You'll also have to come up with debt pricing, and the term loan will be structured as LIBOR + a certain amount (e.g. L+400, which is 6% interest if LIBOR is 2%), and the second lien might be priced at L+800 or something.

So if your company's EBITDA is $10, and your entry/exit multiple is 8x, then 30 of that comes from the senior term loan, 20 from the second lien loan, and 30 from sponsor equity. Use the debt balances to project interest expense (here is where you'll run into circularity in excel). Figure out how much cash the PE firm is putting in/taking out at certain points and calculate IRR off that.

 
CHItizen:
Jig:

Ok, thx for your reply so far. However I dont really understand what you mean. I do not have any balance sheet. All I have is IS and free cash flow statement. I calculated capex and change in NWC using comparable peers as you mentioned. Nevertheless, the task is to determine the purchase price if the buyer must make 20% IRR on equity. So I can establish the purchase price by using the Management projected EBITDA for the year of purchase and then the exit value by using the same multiple but with projected EBITDA in the year of exit? And then? I guess I need to calculate structure of financing - equity/debt in order to achieve the desired IRR.

You don't need a balance sheet to build an LBO model, and once you're on the job, you'll see that most of the time you'll go into a pitch with very bare bones information (almost never a balance sheet, usually just a summary IS).

You need to figure out the structure of financing, so break it out into various debt tranches and lever it at a multiple of EBITDA. For example, you might use a senior term loan and second lien loan to fund the transaction, with the term loan coming in at 3x EBITDA and the second lien coming in at 2x EBITDA. The rest of the purchase price is funded by the PE firm's equity (possibly also management, but ignore this for now if it's your first LBO model). You'll also have to come up with debt pricing, and the term loan will be structured as LIBOR + a certain amount (e.g. L+400, which is 6% interest if LIBOR is 2%), and the second lien might be priced at L+800 or something.

So if your company's EBITDA is $10, and your entry/exit multiple is 8x, then 30 of that comes from the senior term loan, 20 from the second lien loan, and 30 from sponsor equity. Use the debt balances to project interest expense (here is where you'll run into circularity in excel). Figure out how much cash the PE firm is putting in/taking out at certain points and calculate IRR off that.

Ok, this was really helpful, thank you. So, lets assume that my entry/exit multiple is 8,5 x EBITDA. Also assume that the company does not have any debt. I chose the sources of financing as follows: 5 x EBITDA senior loan (int.rate 4% plus LIBOR 2%). The rest (3,5 x EBITDA) will be financed by the equity. Now I need to calculate interest expenses during the investment (4 years). Should I assume that the principal amount (5 x EBITDA) will be paid from the amount when the company is sold after 4 years? And then, I can use the difference (selling price - senior loan principal - interest expenses) for calculating the IRR on equity?

 
Jig:
CHItizen:
Jig:

Ok, thx for your reply so far. However I dont really understand what you mean. I do not have any balance sheet. All I have is IS and free cash flow statement. I calculated capex and change in NWC using comparable peers as you mentioned. Nevertheless, the task is to determine the purchase price if the buyer must make 20% IRR on equity. So I can establish the purchase price by using the Management projected EBITDA for the year of purchase and then the exit value by using the same multiple but with projected EBITDA in the year of exit? And then? I guess I need to calculate structure of financing - equity/debt in order to achieve the desired IRR.

You don't need a balance sheet to build an LBO model, and once you're on the job, you'll see that most of the time you'll go into a pitch with very bare bones information (almost never a balance sheet, usually just a summary IS).

You need to figure out the structure of financing, so break it out into various debt tranches and lever it at a multiple of EBITDA. For example, you might use a senior term loan and second lien loan to fund the transaction, with the term loan coming in at 3x EBITDA and the second lien coming in at 2x EBITDA. The rest of the purchase price is funded by the PE firm's equity (possibly also management, but ignore this for now if it's your first LBO model). You'll also have to come up with debt pricing, and the term loan will be structured as LIBOR + a certain amount (e.g. L+400, which is 6% interest if LIBOR is 2%), and the second lien might be priced at L+800 or something.

So if your company's EBITDA is $10, and your entry/exit multiple is 8x, then 30 of that comes from the senior term loan, 20 from the second lien loan, and 30 from sponsor equity. Use the debt balances to project interest expense (here is where you'll run into circularity in excel). Figure out how much cash the PE firm is putting in/taking out at certain points and calculate IRR off that.

Ok, this was really helpful, thank you. So, lets assume that my entry/exit multiple is 8,5 x EBITDA. Also assume that the company does not have any debt. I chose the sources of financing as follows: 5 x EBITDA senior loan (int.rate 4% plus LIBOR 2%). The rest (3,5 x EBITDA) will be financed by the equity. Now I need to calculate interest expenses during the investment (4 years). Should I assume that the principal amount (5 x EBITDA) will be paid from the amount when the company is sold after 4 years? And then, I can use the difference (selling price - senior loan principal - interest expenses) for calculating the IRR on equity?

To make things more realistic, you should cap the senior loan at 3x and put in a 2x subordinated/mezzanine tranche to fill in the gap (say 12% + 2% PIK). You should assume that excess cash flow generated from business operations goes towards paying down the senior tranche first, beginning in year (or period) 1.

As you pay down the debt, you are increasing the equity value from X% to Y%.

 

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