Walk Me Through an LBO Model?

JAC's picture
Rank: Chimp | 12

Hi,

I need your help.

What is the best way to respond to "walk me through an LBO model" question.

Any good advice/suggestions? Things to avoid?

Much appreciated.

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Interview Question - Leveraged Buyout Walkthrough

This is a very common interview question especially within private equity interviews. It is answered in detail in our WSO Private Equity interview guide.

At a high level, there are 5 steps to an LBO:

  1. Calculate the total acquisition price, including acquisition of the target's equity, repayment of any
    outstanding debt, and any transaction fees (such as the fees paid to investment banks and deal
    lawyers, accountants, consultants, etc.).
  2. Determine how that total price will be paid including: equity from the PE sponsor, roll-over equity
    from existing owners or managers, debt, seller financing, etc.
  3. Project the target's operating performance over ~5 years and determine how much of the debt
    principal used to acquire the target can be paid down using the target's FCF over that time.
  4. Project how much the target could be sold for after ~5 years in light of its projected operating
    performance; Subtract any remaining net debt from this total to determine projected returns for
    equity holders.
  5. Calculate the projected IRR and MoM return on equity based on the amount of equity originally
    used to acquire the target and the projected equity returns upon exit.

What Is An LBO?

If your interviewer wants you to explain an LBO conceptually watch the below video for a great interview answer to "what is an LBO?"

Also - check out the WSO finance dictionary description of a Leveraged Buyout to learn more.

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Comments (24)

May 1, 2007

have you built models before?

May 1, 2007

Yes, Merger/Accretion and discounted cash flow among others, but not LBO unfortunately.

Any advice for an upcoming interview? I would really like to do well. Thanks.

May 1, 2007

If you want to go the paying route I know the tts, dealmaven, wall street prep online courses all have lbo model training components to them. Might want to take a look at that

    • 1
May 1, 2007

Yes - I guess I should be more specific.

I know how to build one. That is not a problem.

But what are the general points that interviewers would like me to hit when answering this question? I am not sure how detailed it should be.

Essentially, what is the "right" way to answer this question based on everyone else's experience?

Best Response
May 1, 2007

To me, somebody best demonstrates their understanding of LBO models if they can adequately explain in what context they are used. So, start off with the why: for what purpose have you built LBO models? Have you mainly done exploratory or confirmatory work, or both? In other words, do you use them as a valuation tool, pre-transaction, to "reality check" what you think a buyer may be able to pay for the business, given what you know about the amount (and type) of leverage you could put on the business, the projected cash flow profile, some assumed exit multiple, and "market" IRRs? Or have you used them to model out specific transactions, after you receive LOIs and after you have lender proposals on the table, to do sensitivity analyses on the proposed deals and capital structures?

After you tell them what you're typically using the model for, then get into what specific areas and assumptions you usually key in on. For instance, if I'm using the model as a valuation tool, I'm going to be very attuned to leverage and returns: how much leverage can I get (ABL and cash flow), what can the company bear (not necessarily the same), what's the pricing/am on that debt, how am I going to structure my equity (all common, preferred, participating preferred, etc...), and what do my returns look like at a variety of valuations going into the deal (and assuming no multiple arbitrage at exit and at a variety of other exit multiples). The whole theory is if I know what kind of returns I'm looking for, what the company's projected cash flows will look like, what I can make the balance sheet look like in terms of capital structure, and at what valuation I can get OUT at, then I can see if what I want to pay for the business is reasonable.

If I'm using a model as a confirmatory tool, then really I just want to make sure the assumptions are realistic on the proposed capital structure, make sure the company isn't going to blow through all their covenants if they have a flat or down year next year, and see what the returns will be to the different classes of shareholders/capital providers given a variety of scenarios (sensitivity...you get the point).

Anyway man, I know that's a longwinded answer...I just wrote down what came to mind. Hopefully it'll give you a mental foothold and get you thinking about where to at least start. I know you haven't built one from the ground up, but if you know how, you probably know at least what they're used for and how to evaluate one. Private message me if you're still stuck after you've thought about it some more.

    • 9
    • 1
May 1, 2007

"Indeed" has provided a very nice answer. At a high-level, understanding an "LBO Model" is no more complicated than understanding how to tie financial statements.

The only difference is a one-step adjustment to the balance sheet which occurs at the time of purchase.

Aside from that, IRRs should flow directly from cash flow distributions to each individual security (e.g., senior debt, sub-debt, mezz, seller notes, PIK notes, preferred equity and common equity).

May 2, 2007

Thanks that was great.

May 2, 2007

Indeed... nice post.

May 16, 2007

nice

May 21, 2007

do analysts get that question, wouldn't that be more for an associate position

would an analyst really do an LBO model?

Jan 25, 2010

LBO is the acquisition of a company through the use of a substantial amount of borrowed funds. The power of an LBO comes from the use of high amounts of debt or leverage. The higher the leverage, the higher the risk. Usually an LBO will have three exit strategies for their investment: the sale of a company, recapitalization, or an IPO...

This was according to http://www.InterviewCrusher.com

Jan 25, 2010

Agree with the other posters. The one aspect I would want to add is that I think it's also important to understand the effects on IRRs if any of a number of variables were changed

  1. taking a longer/less time to exit
  2. If both exit multiples and purchase multiples were raised/lowered (e.g. 8x for both to 10x for both)
  3. Various different changes to debt paydown schedules
Oct 1, 2014

hi what are the responses to 1 and 2? For 1, for the same amount of initial PE equity, it depends on the exit equity return, right? Although it may take longer, the but if the equity return could be higher, then the effect is not clear. For Q2, is there even an answer? Coz i think it really depends.... thanks

Oct 1, 2014

how about you take a stab at it and im sure people on this board will help tweak your answer

    • 1
Oct 1, 2014

you make the acquisition assumptions (offer price; number of shares; offer value; transaction value, fees, etc); complete the sources (debt structure) and uses; then the PF B/S; complete the balance sheet forecasts and income statement; then the debt repayment profiles; then the CF statement; balance the B/S. Afterwards, you can create debt ratios, return analysis (you need to complete the ownership structure) with sensitivity tables, etc.
Does that answer your question? Good luck for your interviews.

Oct 1, 2014

http://www.ibankingfaq.com/category/interviewing-t...
They have a good short text on this. (The best way to understand how LBOs work is to have had deal experience with them. That way, if someone asks you to go into further detail, you won't be stumped--plus you would have had a chance to apply this stuff in a real world context.)

Oct 1, 2014

Thanks a million, very helpful link!

Oct 1, 2014

Only thing different about an lbo model is that you build the capital structure. You will have your various pieces of debt, likely a 1st and 2nd lein bank loan, possibly some unsecured bonds or preferred equity and then finally your equity. This allows you to build a realistic and detailed balance sheet for the new entity. You will also define uses of capital such as paying off old debt or issuing a dividend. An LBO model will show you how much interest and amortization a company can support giving you an idea of how much leverage you can use.

Account Inactive

Oct 1, 2014

Unless you're an experience hire, getting asked about an LBO at the college level is a d*ck move. We've never asked out candidates about an LBO unless they had summer analyst experience and if they talked about the "deals" that they were working on.

Oct 1, 2014
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