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LBO Model Prep (Basic)graded A+
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LBO Model Prep (Basic)graded A+
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LBO Model Prep (Basic)Walk me through a basic LBO model. - ANSIn an LBO Model, Step 1 is making assumptions
about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you
might also assume something about
the company's operations, such as Revenue Growth or Margins, depending on how much
information you have.
Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and
what you use the capital for; this also tells you how much Investor Equity is required.
Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also
add in Goodwill & Other Intangibles on the Assets side to make everything balance.
In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow
Statement, and determine how much debt is paid off each year, based on the available Cash
Flow and the required Interest Payments.
Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an
EBITDA Exit Multiple, and calculate the return based on how much equity
is returned to the firm.
Why would you use leverage when buying a company? - ANSTo boost your return.
Remember, any debt you use in an LBO is not "your money" - so if you're paying $5 billion for a
company, it's easier to earn a high return on $2 billion of your own money and $3 billion
borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.
A secondary benefit is that the firm also has more capital available to purchase other companies
because they've used leverage.
What variables impact an LBO model the most? - ANSPurchase and exit multiples have the
biggest impact on the returns of a model. After that, the amount of leverage (debt) used also
has a significant impact, followed by operational characteristics such as revenue growth and
EBITDA margins.
How do you pick purchase multiples and exit multiples in an LBO model? - ANSSame way as
anything else. You look at comps and other LBO transactions. As always, you show a range of
multiples.
Sometimes you change purchase and exit multiples based on a specific IRR you're trying to
achieve. This is only if you're using an LBO model to value the company.
, What is an "ideal" candidate for an LBO? - ANS"Ideal" candidates have stable and predictable
cash flows, low-risk businesses, not much need for ongoing investments such as Capital
Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong
management team
also helps, as does a base of assets to use as collateral for debt.
The most important part is stable cash flow.
How do you use an LBO model to value a company, and why do we sometimes say that it sets
the "floor valuation" for the company? - ANSYou use it to value a company by first setting an
IRR (25% for example) and then back-solving the model to find the purchase price a PE firm
would pay to meet that IRR.
Give an example of a 'real-life' LBO. - ANSThe most common example is taking out a mortgage
when you buy a house. Here's how the analogy works:
• Down Payment: Investor Equity in an LBO
• Mortgage: Debt in an LBO
• Mortgage Interest Payments: Debt Interest in an LBO
• Mortgage Repayments: Debt Principal Repayments in an LBO
• Selling the House: Selling the Company / Taking It Public in an LBO
Can you explain how the Balance Sheet is adjusted in an LBO model? - ANSFirst the Liabilities
& Equities side is adjusted - the new debt is added on, and the shareholder's equity is wiped out
and replaced by however much equity the private equity firm is contributing.
On the other side, csh is adjusted based on any cash that is used to finance the transaction.
Then, Goodwill & Other Intangibles are used as a plug to balance things out.
Depending on the transaction there could be other effects as well.
Why are Goodwill & Other Intangibles created in an LBO? - ANSThey act as the premium paid
over the 'Fair Market Value'. In an LBO, they act as the 'plug' and ensure that both Assets and
Liabilities balance on the Balance Sheet.
We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that's
the case, why would a PE firm want to use debt in an LBO? - ANSIt's a different scenario
because:
1. The PE firm intends to sell the company after a few years, so it is less concerned with the
'expense' of cash vs debt and more so with using leverage to boos their ROI.
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