Could someone please clarify for what purposes lbo models are actually created? I understand one reason is for valuation, though I've heard it's not used too frequently by investment banks, but for what kinds of engagements would investment banks want to make an lbo model? I thought PE shops were the only ones that would really find these models useful. Thanks for any help.
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PE.
Useful for banks to run... example: if your client is looking to buy a strategic asset, you would want to assess the likelihood of a sponsor stepping in and making the process more competitive to your client. You run the lbo to infer attractiveness to potential sponsors.
^wrong
not wrong.
so it would only be used on M&A engagements?
First and foremost there's not much of a difference between an LBO model and a run of the mill plain vanilla model. The differences lie in the fact that: (1) in an LBO model you strip out the existing capital structure of the company and canvass a new capital structure you/your client are proposing to institute; (2) the LBO model includes a returns analysis which calculates the IRR, as a result you're making assumptions based on purchase and exit multiples and pre and post investment adjustments; (3) there are additional changes to the BS besides the debt/equity changes, these include write-up up the assets and addition of goodwill, amortization of fees, not that major.
So you do an LBO model, because there's not that much more work to go from the regular model to the LBO model. The benefits include: - testing various different capital structures on the company - creating a floor of what you're willing to pay for a company based on a hurdle return (not a DCF)
The LBO model is generally the backbone of any financial model I build. Thats my starting point, even if there are no Cap Structure changes, my PF BS adjustments are just blank... everything else gets bolted onto that.
you generally run a LBO if you are screening if the target company could be a good LBO target (aka IRR > 20 % with reasonable estimate of growth)
Used by PE, LF, and I hear more and more in M&A. You use it in leveraged finance to come up with new capital structure (cash-free & debt-free sale) and see how much leverage is possible. Thus, it gives one measure of the target's value, based on enterprise value. It's not complicated at all, basically just the 3 statements, capital structure, and IRR.
wrongish
LBO models are used extensively by investment banks, esp. middle market banks, in a valuation context. The though process is the following:
There are a few "knowns" in any normal valuation situation.
We know how much EBITDA a company has We know how much the market will bear in terms of leverage on that EBITDA We know how large an equity check (in terms of percent of EV) market transactions are trading at We know generally what return PE funds are required to create for their LPs
This really leaves very little to the imagination.
So assuming a certain EBITDA multiple of leverage and assuming the IRR on the equity is 20% or so, then the only thing left is the initial purchase price. When you zero in on a entry multiple that makes the whole thing work more or less, then you've essentially drilled down to a valuation. Assuming your projections are the same as the PE funds projections, these are what financial bids for the business will look like. Banks like it because it's a transactional approach that appears to use a lot more market data than a traditional DCF. You can screw around with a DCF to make it say whatever you want. I suppose you can do the same with an LBO, but its a little harder to get away with.
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