LBO model - Base vs Optimistic
Hi, I'm doing a LBO model and this is how I differentiate base case vs optimistic case in the model:
- In optimistic case, I use more leverage (the deal is financed 70% by debt and Debt/EBITDA is 8x, is this realistic?)
- I use lower premium in optimistic case than base case
- I set interest rate in optimistic case slightly lower
- I use lower cash retaining balance in optimistic case
- Is this ok if my IRR for base case is just 10% but for optimistic case it's 23%?
Please correct me if I'm wrong and show me the right way to approach the model. Thanks for reading.
Not fully aware of US market but 7.0x is about max for leverage and 6.0x more common. Most LBOs go at 5.0x I would say.
Most important for your return is exit multiple (often assumed to be same as entry multiple) and EBITDA growth through sales growth or margin expansion. You could also factor in add on acquisitions with pricing arbitrage (small companies often sold at lower multiple) and/or synergies.
20% IRR and 2.5x money multiple in 5 years are bare minimum I would say. On the other hand; not every business is capable of growing fast enough to do this (or reduce W/C or do buy and build at price arbitrage, or sell to a strategic that is willing to pay a higher multiple at exit, etc etc).
That’s the case in an average year, but these days most leverage multiples have generally landed in the 6.0x + range. I know several off the top of my head that are above 7.0x, as sky-high as 7.5x (and thats off their hocus-pocus marketed “PF run-rate adj. EBITDA”). I’m seeing sponsors push for 6.0x even on tough-sell industrials deals. Given the multiples that assets are trading for these days, you just can’t get there on returns without that much leverage. These are all of course all large cap, auction-process deals, may be different in MM/LMM.
That being said, I have definitely not seen 8.0x, and I think for OP’s purposes I would say an “optimistic case” leverage read is around 6.5x with base at 5.5x-6.0x.
EDIT: for any of you who may be interested, just found a stat that noted 39% of LBOs in 2018 were at/above 6.0x leverage, and 12% were at/above 7.0x. Thought that was an interesting stat that may help to quantify the above.
Great response from @Rover-S, as usual. On your assumptions, I would drop interest rate differences for the different scenarios. If you're changing the interest rate you "have to" mean something about the whole world economy. I would rather forecast more aggressive growth in earnings, or similar posts and then put a sensitivity analysis together with your valuation in the end. Look up "sensitivity table matrix" or "table matrix" on YouTube and you should find some decent guides on how to put it.
If anything, pricing on the deal would get higher in the optimistic case because it assumes greater leverage.
Sorry, poor choice of words. I meant that he should not use different interest rates for the different scenarios.
I think it's more informative to use a matrix, in the end, to show what the share price will be given x interest rate and y growth. If you only use one or two different interest rates scenarios you will most likely get questions on how/why/what interest rates you've used and it's not a given that your buyer/seller agrees with your assumptions.
I don't know the context of why you're building this model, but I might suggest you reconsider which variables you adjust for your "optimistic" case. Right now you're only playing around with exogenous assumptions. Yes, leverage amounts and deal pricing can be negotiated, but that's more or less driven by the market and not by how your investment performs. It might be more useful to do a sensitivity analysis around performance-based metrics, like revenue growth and margin expansion of the target co.
Completely agreed, was about to post something very similar.
You can think about sensitizing an LBO via two broad categories: financing/valuation and operational/performance assumptions.
Financing / valuation assumptions: * Leverage amount * Structure / tranches of debt
* Pricing (more on the downside i.e. flex in a bad market or syndication) * Purchase / exit multiple * Timing of entry / exit
Operating assumptions: * Topline growth (broken down into constituent revenue drivers as appropriate for the deal) * Margins (GP, EBITDA, etc.) / associated costs * Cash flow items including capex, capitalized software, net working capital * Cost savings or synergies that will be implemented or realized post-LBO
It's hard to compare when you flex both financing and operating assumptions at the same time, particularly when you are trying to decompose the drivers of IRR or cash flow paydown. Therefore, it's much better to systematically hold one of those scenarios constant, such as for a given financing scenario, what happens when operating assumptions are positive, base case, negative, more negative, super negative ("worst case")? Then if you want to show a different financing scenario, run the same operating scenarios for comparability.
As for metrics beyond IRR you might consider:
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