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It's an output
Although, the whole model is tweaked to get the desired irr just like most financial models. Reverse engineering to sell the idea!!!
Agree. It should be an output, but most bankers will backsolve the assumptions (inputs) to produce the desired IRR (output) so the client does the deal and bankers collect their fee.
I'm joking. To some extent.
In the conventional lbo model sense it's an output, but it is actually used as an input when you're using LBO analysis as a strict valuation methodology to back into a purchase price rather than an attempt to determine whether to make an investment given specific terms about a new capital structure.
The way this works as a valuation methodology is that you select a hurdle IRR that a sponsor might use on the equity portion of the deal (typically 20-25%), and you run the rest of your model with pretty standard time until exit, financing, and exit valuation to figure out what kind of initial purchase price (thereby present day enterprise value) is realistic for the company.
I understand the thinking behind this ie sponsor has target 25% IRR, so back solve to max price the sponsor will pay.
However, I find it an odd way to work out the price that would be paid. The purchase price will be a function of market valuation, often (intellectually cheaply) benchmarked through comparable transactions analysis and/or bidding tension than a back solve on target IRR. The backsolve just tells you where the sponsor will bid up to before the price doesn't make sense anymore.
Yeah, it is a little odd you're right. this maximum purchase price is typically not too far out of line with a very optimistic DCF, and is obviously more relevant when valuing companies that also happen to be attractive LBO targets. In all other cases, it is really just more of a common sense check on DCF, comps, and transactions.
It provides a set of parameters for your purchase price. More helpful for MM deals that are heavily marketed to PE compared to strategic deals (probably obvious). You need to know where to expect initial bids and the level you can push PE groups without breaking their hurdle.
Besides, it helps set client expectations from the beginning. Sometimes comps are out of whack (such as right now) and those could skew multiples for a deal you are out to market with six months out (or beyond in niche industries/markets).
lbo models are an ability-to-pay model more so than a valuation model. You are essentially asking how would I need to structure a transaction to meet irr/moc targets, meet covenants, feel good about downside scenarios, etc at any given price, if possible. So while you are valuing a target, you are doing it only from your perspective so you can make decision.... The actual value of a company could be 8x, but you can only get comfortable at 7x... So a strategic or someone else will step ahead of you by paying more.
Isn't it both?
Input - Finding the maximum price you can pay
Output - As a consequence of the FCF of the company, what is the IRR and whether it is worth investing.
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