Steps to LBO Modeling

What is a leveraged buyout

A Leveraged Buyout (LBO) unfolds when a private equity firm (or a group of private equity firms) seeks to acquire another entity, primarily relying on borrowed funds with a minimal contribution of equity. 

In an LBO, the assets of the acquiring and the acquired company are used as collateral for financing the business operations.

The intricacy of generating profits through leveraging makes it imperative to employ a comprehensive analytical model for a clearer understanding of the situation.

In this financial maneuver, the purchaser allocates roughly 10% of their capital to acquire the target company, while the predominant 90% is financed through bonds or loans. 

Since the borrowed funds are used predominantly in the transaction, the Debt-to-Equity ratio is usually greater than 1-2x.

Consequently, navigating the intricacies of buying a company demands vigilant tracking of profits and losses post-acquisition due to the elevated risk associated with substantial reliance on borrowed funds.

Collateralizing the borrowed funds, both the assets of the acquiring entity and those of the target company plays a pivotal role in securing loans and mitigating risks for the lenders.

However, how can this transaction be completed? As a client, my objective is to pay the least amount of money and have the debt or non-company assets cover the rest, enabling the purchase of the unit. 

To achieve this goal, the buyer develops a leveraged buyout model to maximize the internal rate of return. 

Structure of Leverage Buyouts (LBOs)

The capital structure in LBO modeling involves financing the purchased product by acquiring the majority of the company through the safest and most cost-effective means, followed by addressing other considerations that may not be optimal.

Initially, bank debt is often utilized as it represents the most economical method of borrowing, covering 50 to 80% of the acquired company's cost.

However, it has drawbacks as it does not allow the company to acquire another company while they’re in debt or distribute dividends to the company shareholders, which could hurt it. In the event of liquidation, the repayments to the bank take precedence.

On the other hand, several types of loans could occur but in a smaller percentage, as the company pays a higher interest rate to the loaners (high yield return), but that comes with a risk that, in the event of liquidation, is paid after the bank loans.

Finally, mezzanine debt bears a higher interest rate, has fewer restrictions, and constitutes a smaller portion of the acquiring company's debt.

It comes with the privilege of purchasing the acquiring company's stock at a discounted price in the future to incentivize additional investment.

Lastly, we have equity, which finances 20 to 30% of the LBO and represents private equity funds at a very high interest rate. Equity is paid last after settling all other debts, and these investors may not receive payment if the company defaults on its obligations.

This is why the steps involved in LBO modeling vary depending on the acquiree and acquirer. However, most of them can be broken down into three parts:

1. Input for the model
2. The Cash Sweep
3. Model outputs

Input for the model in LBO

Initiating the Leveraged Buyout (LBO) modeling process commences with establishing model inputs. 

This crucial step involves formulating a spectrum of pivotal assumptions that pertain to different facets of the acquisition.

Let's break down this step into its components:

1. Acquisition Assumptions
   • Define the target company for acquisition.
   • Determine the proposed purchase price and key deal parameters.
   • Identify potential synergies and strategic considerations.
2. Financing Assumptions
   • Assess the optimal capital structure, specifying the debt and equity financing mix.
   • Establish assumptions regarding the cost of debt, interest rates, and other financing terms.
   • Model the debt repayment schedule and covenants.
3. Exit Assumptions
   • Define the anticipated exit strategy, including the exit year and method.
   • Specify the targeted exit EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiple.
   • Consider market conditions and potential buyers at the time of exit.
4. Interest Rate Assumptions
   • Set assumptions for interest rates on the debt used to finance the acquisition.
   • Consider the type of debt instruments (senior debt, subordinated debt) and their associated interest rates.
   • Evaluate the impact of changing interest rates on the financial model.
5. Fees Assumptions
   • Account for the fees associated with the transaction, such as advisory fees and legal fees.
   • Include any upfront fees or costs incurred during the acquisition process.
6. Sources and Uses of Funds Table
   • Table creation that includes the uses and sources of funds in the transaction.
   • Specify if the funds will come from debt or equity and how they will be allocated (buying the company, transaction costs, fees, etc.).
7. Public Company Considerations
   • If the target is a public company, include the current share price.
   • Determine the premium to be paid above the current share price.
   • Calculate the market value of equity and the acquisition equity value.

This initial step is crucial to establishing the assumptions that will drive our LBO model.

This is why the accuracy of these assumptions is key to having an insightful analysis and view of the financial projection of the model, assessing the feasibility of the deal, and making informed investment decisions. 

Once these inputs are defined, they are incorporated into the LBO model's subsequent steps, such as projecting financial statements, estimating cash flows, and evaluating returns.

The Cash Sweep

In the context of LBO modeling, the cash sweep is a critical step aimed at reducing debt as rapidly as possible. This process involves creating an operating forecast, including an income statement, certain balance sheet items, and a cash flow statement. 

The primary objective of the cash sweep is to allocate available cash to pay down debt systematically.

Key components of the cash sweep:

1. Operating forecast
   • Income statement: Create a thorough forecast of the target company's earnings for a given time frame, including revenues, costs, and profits. Sales, operational costs, taxes, interest, and cost of goods sold (COGS) projections are all part of this.
   • Balance sheet Items: Project important components from the balance sheet, like fixed assets, working capital, and other assets and liabilities.
2. Cash flow statement
   • Make a cash flow that states the company's profits and losses in debt, so how the money is circulating, including information about operations made, investment, and financing.
3. Cash sweep mechanism
   • Identify all potential future cash flows that can be used to repay debt. This includes operating cash flow, asset sales, or any other sources of cash.
   • Set up this mechanism essentially to repay debt. The objective is to swiftly reduce leverage and enhance the financial health of the acquired company.
4. Debt schedule
   • Develop a debt schedule that records the level of debt at each point in time. This schedule is dynamic and reflects changes in debt due to cash repayments. It typically outlines the outstanding debt, interest expense, and principal repayments for each period.

Importance of the cash sweep

Cash sweep is the most effective technique to maximize company profit and manage money. Cash Sweep has recently increased as companies look to enhance their financial management. 

We'll discuss the value of cash sweep in this section and why you might want to consider employing it.

1. Debt reduction
   • Reducing financial leverage by methodically retiring debt is the main objective of the cash sweep. This aligns with the customary leveraged buyout approach, which aims to improve financial stability by deleveraging the acquired company.
2. Enhanced financial flexibility
   • Repayment of debt is given priority by the cash sweep, which increases financial flexibility. Reduced debt amounts result in fewer interest costs and, as a result, more cash on hand for dividends, reinvestment, or additional debt reduction.
3. Investor returns
   • An important factor in determining investment returns is the cash sweep. Equity investors' ownership position grows as debt is repaid, which could result in larger returns on their initial investment.
4. Risk mitigation
   • Quick loan repayment reduces the financial risks of high leverage. It protects the acquired company from unanticipated economic difficulties or downturns that can affect its capacity to pay off debt.

A crucial part of LBO modeling is the cash sweep, which complements the deleveraging strategy to maximize returns for equity investors and optimize financial structure. 

The leveraged buyout's overall profitability and financial stability are largely due to the systematic distribution of available resources toward debt reduction.

Model outputs in leveraged buyout (lBOs)

The third step in Leveraged Buyout (LBO) modeling includes generating model outputs, which help as crucial tools for assessing the financial health, feasibility, and potential returns of the transaction. 

This step surrounds various analyses and calculations to provide valuable insights into the LBO's performance. 

Let's break down the key components of model outputs:

1. Credit Ratios
   • Reason: Credit ratios are figured out to ensure that the money a company owes doesn't exceed certain limits or promises they made
   • How: Popular credit ratios, like Debt/EBITDA, Debt/Equity ratio, and interest coverage ratios, help do the math
   • Why It Matters: Checking these credit ratios is super important to keep the money situation steady, stick to promises about money, avoid possible money troubles, and keep the company's money set up healthy
2. Equity Internal Rate of Return (IRR)
   • Purpose: Calculating equity IRR helps assess the returns generated for various groups of shareholders, typically including different classes of equity investors.
   • Calculation: Equity IRR represents the discount rate that makes the net present value of future cash flows equal to the initial equity investment. It is a key performance metric for evaluating the attractiveness of the investment.
   • Importance: Equity IRR is a critical measure for equity investors to gauge the profitability and success of the LBO. It aids in decision-making and comparing potential investments.
3. Sensitivity Tables
   • Purpose: Sensitivity analysis involves testing the impact of variations in key assumptions on the model outputs. For example, it assesses how changes in exit year, EBITDA growth rates, or discount rates affect equity IRRs
   • Calculation: Perform scenario analyses by adjusting one variable at a time while keeping others constant. Create tables or graphs to visualize the sensitivity of key metrics.
   • Importance: Sensitivity tables provide insights into the robustness of the LBO model and help identify the most critical assumptions influencing the investment's performance. They assist in making informed decisions and understanding potential risks.
4. Levered Valuation
   • Reason: Levered valuation is about figuring out how much a company is worth when you include the money it owes
   • How: We use a fancy math method called discounted cash flow (DCF) analysis, using the weighted average cost of capital (WACC) that looks at both the money the company owns and the money it owes. Then, we compare this to how much we paid initially to see if it's a good investment.
   • Why It Matters: Levered valuation is like a big tool to decide if buying a company is a good idea. It helps people who invest in it know if they're paying a fair price and if they can make money from it.

Conclusion

For investors and analysts, knowing the LBO model is important. This article gives a detailed guide on how to make an LBO model, as it covers the three essential parts of the modeling. 

Firstly, the model input is characterized by making assumptions about many primary ideas like interest rate and funding which company to buy profitability. 

Secondly, the cash sweep, a detailed transfer of money in the corporation like how debt is being prioritized and returned to the investors, and how money and profitability are entering as it has many benefits, most importantly to reducing debt, enhancing stability, and reducing risk on the acquirer and the investors. 

Lastly, the model outputs include the internal rate of return to track profits and the levered valuation to know the value of the acquired company, including the debt we have to return.

Gaining expertise in these areas enables people to make well-informed financial choices regarding purchases and investments.

Researched and authored by Marc Raphael Matta | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Earnout
• Independent Variable
• Paper LBO
• Scenario Analysis
• Types of Financial Modelling