Most of you probably already know this, but sometimes it doesn't hurt to say it again out loud. Especially since I've seen a few confusingly (and unnecessarily) circular models lately, it might be a good time to review.
When designing your models, like a good computer program, your information should flow in one direction: S&U -> PF Cap -> Model -> Outputs (PF leverage, accretion etc.)
In an M&A model, the first thing you should start on is your sources and uses. And you should start on your uses first. The first question is what am I buying and how much am I paying for it? (Forget fees for now). Once you have that answer, you can start thinking about funding sources (How will I pay for it).
Usually something on your sources calc will be a "plug". Example 1: do an equity swap deal, max out secured debt at 3.0x and raise "the rest" in high yield notes. Example 2: max out secured debt at 3.0x, cap high yield cap at 5.0x and raise "the rest" with an equity financing.
The first (and one of only two) circularities you will find in your model is in calculating fees. If you need a $100 million plug for your financing, but your fees are 3%, that means you need to raise an additional $3 to pay the fees. But now you need to raise incremental value to cover the fees associated with the incremental $3 and so on (you can actually calculate this without circularity).
Once your sources matches your uses, it's time to add the pro forma adjustments your cap table. Every line in your sources table should flow into an adjustment in your PF Cap. Equity issuances (to market or target) should be accounted for with incremental new shares. EBITDA should be adjusted for target contributions and synergies (as appropriate).
PF Cap table should flow into the starting balances of each debt tranche in your model. If your are building a full on three statement model, you should go IS -> CFS -> BS (note: every CFS item should flow into something on your BS, then you will be guaranteed to balance). If you are building a short hand model (more common in IB) then you should have Operating Model (Revenue -> EBITDA) -> LFCF build -> debt schedule. Interest calc will be the second and final circularity in your model.
Key lines in the model should flow to output.
In the same way that the key to answering the Three Statement Capex Question is all about structuring your thoughts and being organized, so too is building an M&A model. It's all about maintaining a logical flow which allows you to easily check for busts as well as be flexible.
i see your analysts are scrubs.
Summers
If you want to avoid circularity entirely, just calc interest off beginning debt balances (note: this works well for M&A and lbo models as it's conservative from a buyer's perspective - assumes you paying slightly more interest than what you'll actually pay - likely not a good practice if you're trying to model out debt returns and need more precise interest payments)
its called a circuit breaker
Circuit breaker is usually a good solution.
Very rarely, I've had clients that just can't wrap their heads around it and prefer no circularity.
Can you provide a sample model to illustrate your point?
Thanks for this, great post. Only other circ I've seen in a model is where the acquisition is funded by a rights issue at an x% discount to TERP.
Curious to learn how this is created. Normally see the usual practice of issuing at discount to market.
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