LBO model - Few questions

A few questions about LBO's.

1) Do sponsors refinance existing debt because they have to or they want to, and why?

2) I was having a hard time including interest payments without a circular reference, is there a common way around this?

3) In general, is the adjusted goodwill added to the new goodwill, and if not, do you include existing goodwill in calculating the new goodwill (MV- tangible book).

 
Best Response

1) Debt usually has change of control clauses that allow the lender the option of putting the debt back to the issuer. Second, most of the time the maturity comes to early for the sponsor so they want more "LBO" type debt facilities with at least 5 year maturities

2) Nope. The circular reference shouldn't cause any issue though. Due to the fact that your cash balance generates income it rolls up into the IS and flows back into the CF statement. Its impossible to avoid especially if you have cash sweeps.

3) You add the new goodwill to existing goodwill. Therefore the net assets calculation includes BV GW.

 

In regards to your second question, it is possible to avoid the circular reference in an LBO model. I typically use a toggle switch on my assumptions page to turn the circular reference on/off. I like to build my models knowing exactly where the circular references lie, thinking this provides a fool proof way of tracking all circular references, since once I turn it off the model shouldn't be circular anymore. Here's how to build an LBO model without a circular reference:

The reason an LBO model is circular is b/c you need you need a net income number to sweep out your cash to pay down your debt, but you need an interest expense to get to your bottom line. Most models will calculate interest expense using an average balance throughout the year. If you use a switch (CHOOSE function is my method of choice) to calculate the interest expense and choose between:

  1. Interest expense calculated off an average debt for the year. This is circular.

or

  1. Interest expense calculated off the debt balance from the previous year. This is not circular and is considered a bit less "accurate."

My view on this is the model itself is filled with assumptions and is inherently an "educated guess," so it's not completely illogical to make the model non-circular for stability (I've only had a few models bite the dust b/c of circular references).

 

I changed banks about two years ago and was told to stop modelling with circular references and just use closing balances to calculate interest costs.

If anything, you are slightly more conservative on interest payments (i.e. higher using closing balance vs. average balance) and to re-iterate what MM said, it's only an educated guess, no use in making it super accurate at the expense of stability as it's definately false precision.

However, if you want to be more precise but avoid circularities, you can use simple cash flow phasing assumptions for your debt tranches by calculatting interest payments semi-annually or quarterly and basing the interest calc on the ending balance of the previous quarter, this will allow you to catch any amortisation/sweep payments made during the year and still won't create a circularity. But again, its false precision

 

Its not the end of the world if your model crashes, its not like you have to rebuild it from scratch, or like it even takes more than 30 seconds to fix.

I usually have my D&I schedule where each tranche of debt is built up and interest is calculated, then I have an Interest Summary which lists all cash interest items, then total cash interest, then PIK interest items, then TOTAL INTEREST. My IS pulls interest expense from this interest summary table. If my model crashes, I just clear out the sum line on the bottom of the table, INT EXP in IS is not zero, killing the circular reference, and re-enter the sum formula at the end of the table.

 

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