Everything on the internet says that the first step in an LBO model is to assume the purchase price. Why would you assume the purchase price if you are using the model to determine the maximum price a PE firm would pay given a targeted IRR? In other words, why assume the purchase price if you are trying to calculate the purchase price?
What am I missing here?
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You’re right in that an “LBO valuation” is essentially goal-seeking to see what purchase price equates to a minimally acceptable IRR.
You can indeed build a “reverse LBO” (with target IRR as the key assumption, spitting out a purchase price), but typically you’re just building a traditional LBO and showing sensitivities of different entrance and exit multiples, growth metrics, leverages, etc. to give a sense of what’s reasonable. Remember, valuation’s goal is to present both a range of numbers and a holistic sense of various scenarios, not just a single $ figure. A more traditional model is both more flexible / “accurate” and less complex, as there’s no iterative back-solving (and almost all reverse LBOs take shortcuts around cash flow circularity), so people generally just stick with that, even if the output isn’t as direct as the reverse LBO’s. Plus, regular models are more easily adaptable to other analyses.
This makes sense. Thanks for the help!
For more practice, check out "Conceptual Fundamentals - LBO Modeling" on Udemy- a good sequel to the Street of Walls primer on LBO modeling. The Udemy course is on sale, and provides a view into deal structuring dynamics.
I think something that hasn't been mentioned yet is that the concept of "floor valuation" is a bit of a misnomer. The phrase itself is troublesome and confusing. LBO models aren't supposed to be valuations at all. If we use the commonly accepted definition of valuation as finding what something should be worth, it's clear that LBO model doesn't solve for that.
LBO tells you your yield (IRR) given a certain purchase price and allows you to play around with scenarios to see how it impacts IRR, debt covenants and credit ratios, and more. Doesn't sound like valuation to me. If you're asked to talk about valuation methods in an interview, I wouldn't mention LBO.
As a financial investor will likely invest at a smaller multiple than a strategic - synergies would not be factored into valuation unless you assume the Company is an add-on to an existing one in the portfolio - I would assume that their bet would be the minimum that would be paid for a Company. This obviously has its caveats - certain fin. investors might pay more in certain occasions (i.e. PPP) - but I think overall is a valid statement
What do you think?
I disagree. First, the idea of price paid and valuation needs to be distinguished. They are not the same.
Second, if we are talking about price paid, on average sponsor-led transactions probably are purchased at a lower multiple than strategics for the reason you mentioned. But that’s only on average. If sponsors are doing a take private, they don’t always need to pay a synergy premium as you pointed out but they still need to pay a share-price and control premium. Also, if they are bidding against strategics, “financial theory” goes out the door in terms of what premiums should and shouldn’t be paid. They will simply pay the price that allows them to stay competitive while also giving them acceptable returns. To draw a comparison, I’ve taken my school’s MBA classes on LBOs but also worked as a junior monkey on (closed) deals for a PE internship. For the class, I learned how to do it “by the book”, thinking about exactly how to measure control premiums, synergy premiums, etc. On the job, we literally adjusted our bid up and down depending on how much we “liked” the company and “wanted to stay competitive.” It’s much less scientific in real life.
You seem confused. Valuation means price. A LbO valuation indeed tells you how much price should you pay if you’re looking to achieve a certain returns threshold. Your investment is illiquid and the increased debt level enhances the riskiness of investment.
However you are right that LBO valuation does borrow some parts from other metholodologisz (comparable analyses, precedents) As these analysis impact the exit / entry multiples one assumes. But DCF also relies on these methodologies when you’re estimating terminal value. Yes, you can use perpetuity growth method but you always sane test your implied exit multiple
With your logic, to the extent practical from a modeling standpoint, you'd use return metrics such as IRR or MOM as your inputs, instead of outputs, to derive the implied entry value, subject to some sort of hurdle return metrics.
The logic is fine, it's just that in excel, it's quite cumbersome to model in this manner.
The other important thing is related to how a sale process would be run in practice. Your desired IRR or MOM, how you finance a deal, etc could be drastically different from a competing bidder. So if bid prices are calculated in this sequence, the implied entry value could be all over the places and a complete mess. Sale process is supposed to function as a vetting machine to filter out potential bidders that don't represent good fit with the target (whether it's financial/valuation or business related). Providing a targeted/expected valuation to all bidders, and let bidders individually figure out if the target/investment opportunity works for them would drastically improve the efficiency of the sale process.
There is one thing I really don't get:
I once got a private company to value at a case study. No info given except for P&L and some overview of management business plan. No comps.
Now I have no idea whether the business trades at 6x or 26x. Assuming desired IRR of 20%, and also assuming entry mult = exit mult - I get 20% at 10x and at 20x (when you make a huge sensitivity table sensitizing entry mult to exit mult you will see that 20% IRR pops up at different combos). Does this mean that the fund is comfortable to buy at 20x because it will get 20% IRR? But there is no guarantee SOMEONE WILL BUY it in 5 years at 20x. I also can't say I value this business at 10x because the fund will probably be the lowest bidder and lose the auction.
So how do you know what to value the company at?
Appreciate any advice, as I am depserate. LBO valuation seems to be so straightforward - set IRR at 20% and see where you will buy it. But there are many prices that yield 20%, also typically I need to make my own revenue and margin projections - that can also massively change valuation, and there is no way to make decent revenue forecast when you have 1.5h on your hands to do the whole thing.
DCF, Perpertuity valuation at the time of the exit of your LBO will give you the LBO exit multiple for then and then you backsolve purchase price based on a target IRR.
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