Leveraged Buyout (LBO) Modelling

Author: Joris Kersten MSc (Kersten Corporate Finance)

Kersten Corporate Finance: M&A consultants + Valuators + 6-day valuation training (15-21 March 2023 Netherlands).

Source used: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions. Second edition (2013). Joshua Rosenbaum & Joshua Pearl. Wiley Publishing company. 9781118472200.

Leveraged Buyout Analysis (LBOs)

Leveraged Buyouts

A leveraged buyout (LBO) is the acquisition of a company, division, business, or collection of assets (“target”) using debt to finance a large portion of the purchase price. The remaining portion is financed with an equity contribution by a financial sponsor (private equity party).

Historically financial sponsors sought a 20% annual return and an investment exit of 5 years. In a traditional LBO, debt has typically comprised 60% to 70% of the financing structure, with equity comprising the remaining 30% to 40%.

Companies with stable and predictive cash flows, as well as substantial assets, generally represent attractive LBO candidates due to their ability to support larger quantities of debt.

Cash flow is primary used to repay debt during to time to which the sponsor acquires the target until the exit. The debt portion of the LBO consists a broad array of loans like bank debt, high yield bonds, mezzanine debt and equity.

LBO analysis is used to check whether the deal is interesting for a financial sponsor. The LBO analysis is used to check whether the sponsor can make the needed returns (e.g. 20%) with a certain financial projection (operating scenarios), purchase price, financing structure and exit multiple after a certain number of years (e.g. 5 years).

In sell side advisory I always make the LBO model of the deal because I want to check how the deal “looks” for a financial sponsor. In other words: Is the deal interesting for private equity?

Also in buy side advisory it is interesting to make this analysis. For example it is interesting for a strategic party who wants to buy a certain target to know what competitive bidders (like private equity) are willing to pay for the target. You will never know for sure, but at least you can make an “educated guess” when you build the LBO model.

LBO model

Income statements

Let’s assume we want to build a model for a certain target. Here fore we need financial projections of the company, these can for example be obtained from a “Confidential Information Memorandum” (CIM) or from a “Discounted cash flow model” (DCF) if we have made the DCF analysis already.

We first need to build the historical and projected income statements (P&L’s) through EBIT. You can first start with typing in the numbers you have received from the CIM and then later on you can add multiple operating scenarios. The different scenarios can be typed in in a separate tab in excel and with the “CHOOSE function”, and a built in “toggle”, you can easily switch between operating scenarios.

So in first in stance we build the model until EBIT, because we do not know yet how the deal will be financed. So we also do not know yet the interest payments that need to be taken up in the projected income statements. This does not matter for now since we get back to this later on.

Balance sheets

After a start of the estimated P&Ls we need to start building the projected balance sheets. The opening balance sheet is typically provided in the CIM and entered into the model. And you need to add extra line items for the new financing structure after the deal.

In order to build the balance sheet after the deal you need to add two adjustment columns in which you type in the sources (how the deal is paid) and uses (what is paid for) of the deal. And also add a column in which you give the “pro forma balance sheet”, so actually this is the opening balance sheet after the deal.

Cash flow statements

Of course does a LBO model also need cash flow statements (CFSs). We build them through the indirect method starting with net income and adding depreciation and amortisation since these are “non-cash” items. The net income is still not correct, because the right interest expenses are not yet taken up, but this does not matter since for now we are just building up the model.

In the CFSs we also need to show the year on year (YOY) changes in the balance sheet, think about the property, plant and equipment (PPE) and also the working capital line items (e.g. accounts receivable, inventories, prepaid and other current assets, accounts payable, accrued liabilities and other current liabilities).

The amounts of the above line items are forecasted in the balance sheet also through a separate “assumption tab”. Together with estimating the operating scenarios in the P&L, also estimates can be made for the line items in relation to the working capital. And with the “CHOOSE-function” in excel and a built in “toggle” you can switch between scenarios and this also effects the working capital (and the investments in working capital in the CFSs).

Also CAPEX (capital expenditures = investments in assets) need to be taken off as a “cash out” in the CFSs. They are also the result of the delta on YOY line items in the balance (e.g.

PPE). And this line item PPE is estimated again in the “assumptions tab”, for example as a percentage of sales.

The financing section of the CFSs will be still left blanc, because we have not assessed yet how to finance the deal (in different financing scenarios).

Transaction structure

When we have built the estimated P&Ls, balance sheets and CFSs it is time to enter the purchase price assumptions. To calculate the price of the shares we for example take a LTM EBITDA (last twelve months) (earnings before interest tax depreciation and amortisation) times a certain “multiple”, let’s say for example a multiple of 8. Then we have calculated the enterprise value (EV).

In order to get from EV to the price for the shares we need to deduct “net debt”, which consists out of total debt minus (excess) cash. Actually here we also need to take the “equity bridge” with "cash like" and "debt like" items into account, but I will not get into details about the "equity bridge" here.

Then in the LBO model we need to add the sources and uses. Uses is where we spend the money on for the acquisition, e.g.: equity purchase price + repayment of existing debt + call premiums (if any) + financing fees + transaction fees for the investment banker or corporate finance consultant.

These “uses” need to be financed with "sources", for example: a revolving credit facility + certain term loans + notes/ bonds + equity + cash on hand. It is common to fill the model with multiple “financing structures” since Microsoft excel enables us to run sensitivity analyses on these different financing structures.

When we have added the sources and uses we need to connect them to the balance sheet. Most likely goodwill will be paid in a transaction. This simply means that a buyer pays more than the book value of the “net identifiable assets”. We need to make these adjustments in the balance sheet as well.

Debt schedule

After that we can start filling the model with a debt schedule. When all the different debt components are modelled we can then also finish the: P&Ls, balance sheets and CFSs. This since we then know the interest payments for the P&Ls, paying back of principal and heights of the debt components at the end of different years for the balance sheets and CFSs.

For the interest payments we can use the forward Libor Curve from Bloomberg as a starting point. On top of that a spread is added for the different debt components.

In a discounted cash flow model we speak of a “free cash flow”, but you can also see this term back in a LBO model. In a LBO model the term “free cash flow” means: Cash available for debt repayments.

And in the LBO model it is common to build in a “cash sweep”, which means that all excess cash, after the mandatory principal repayments, will be used to pay back debt. And of course it makes sense to model in a “minimum cash amount” that should stay on the balance sheet for “working capital” purposes.

Further more the debt schedule needs to be modelled like a “waterfall”, so the cash needs to flow back to the lenders depending on the level of seniority, e.g. from the revolving credit facility to the term loans, to the notes/ bonds etc.

After that the P&Ls should be finished with the interest expenses and the balance sheets and CFSs with the principal repayments and new debt amounts at the end of the year.

Perform LBO analysis

When your model is complete we want to perform LBO analysis. First of all we need to know the credit statistics since the deal is highly leveraged. So your model needs to show insights on the main credit statistics like: EBITDA over interest, senior secured debt over EBITDA, net debt over EBITDA etc. Of course, this needs to be shown for all the years of your forecast.

We also need to know what the returns are for the investment. Here fore we need to take an exit into account. The common practice for an analyst for modelling practises is to take (in first instance when you build the model) a similar exit multiple on EBITDA as the EBITDA multiple on which you can buy the company. E.g. when you can buy the shares for 8 times EBITDA enterprise value, then also model an 8 times “EBITDA year 5” as exit enterprise value.

In most LBO models a “cash sweep” is modelled in as mentioned before. This way in most models you see an original equity contribution. This is the equity contribution the financial sponsor has put in at the date of the acquisition. Then we assume we sell the shares again at a certain EBITDA multiple at year 5. And then we need to deduct the “net debt” level at year 5 as well. What is left is the equity value after year 5.

Imagine you buy a firm with an equity contribution of 20 million euro (the rest is debt) at the date of the acquisition. And you then you sell it for 50 million share value at year 5 (enterprise value - net debt). Here you make a cash return of 2,5 (50 million/ 20 million).

This cash return is a number we always need to know. But a more elegant number is the IRR (internal rate of return). It basically is the honest yearly return the investor makes. And it stands for a “discount rate” in which the present value is exactly zero, so it shows the honest return for an investor.

At the same way as we calculate the cash return we like to calculate the IRRs of the LBO model for a range of for example 10 exit years. And then the most important IRR is the IRR with an exit after year 5 since this is an average holding period for a financial sponsor.

Personally, I am a big fan of the LBO model and always like to calculate the IRR of an acquisition since it is so honest. And you can even take up the LBO “valuation” on the football field if wanted next to “comps” and “DCF”.

Thanks for reading, have a great weekend, best Joris

6-day Business Valuation & Deal Structuring training: 15 - 21 March 2023 at Hotel vd Valk Uden The Netherlands.

Source used: Investment Banking: Valuation, leveraged buyouts and mergers & acquisitions. Second edition (2013). Joshua Rosenbaum & Joshua Pearl. Wiley Publishing company. 9781118472200.