Walk Me Through an LBO

Leveraged Buyout (or LBO) is an important concept in private equity interviews. You are guaranteed to get questions related to LBO during the technical interview round for any private equity firm. However, not many candidates can confidently answer these questions. The reasons for this are first because leveraged buyout is a fairly advanced concept in finance, and second because there are many steps and assumptions involved in the construction of an LBO model, which makes it harder for a candidate to organize their thoughts at the snap of the moment.

1. What is Leveraged Buyout (LBO)?

You can conceptualize this process using the home-flipping example. A PE firm would search for an undervalued company that has potentials for yielding high returns and then purchase it, just like a real estate investor seeks to acquire a house. The real estate investor use a combination of down payment and a mortgage to finance their purchase, while the PE use a combination of debt and cash. The real estate investor will renovate the property to sell it at a higher price. Likewise, A PE firm will run the company for several years to improve management and sell the company eventually to profit from the markup in selling price. 

2. Why Leveraged Buyout (LBO)?

Leveraged Buyout (LBO) is often very attractive because private equity firms prefer to use as much debt and as little of their money as possible in funding a deals because:

1. Using debt reduces upfront cost of acquisition, which makes it easier to PE firm to earn higher returns
2. The PE firms can use the company’s cash flows to repay the debt and make interest payments.

Private equity firms benefit tremendously from LBO and they do so through taking advantage of a legal structure that makes LBO possible.

The PE firm does not technically own the company in a leveraged buyout. Instead, it forms a holding company, which it owns, and it is this holding company that acquires the target company. Banks and other lenders that help finance the transaction lend to this holding company, so the debt is at the holding company level. Managers and executives owning shares after the deal takes place actually owns shares in the holding company. This structure is important because it means that the acquired company is responsible for paying all the debt, not the PE fund. The PE firm not only borrows other peoples’ money to do the deal, but it doesn’t even borrow the money directly – the company borrows money so the PE firm can do the deal.

3. What Makes an Ideal Candidate for an LBO?

4. Walk Me Through a Leveraged Buyout (LBO)

Having understood conceptually what LBO is and how it works, it is now helpful to transition into building the model. There are four steps involved in an LBO model.

Step 1: Make basic transaction assumptions

At the most basic level, you need to know the purchase enterprise value and the proportion of debt and equity used. To calculate the acquisition price (or enterprise value) for a public company, you would calculate the purchase equity value and then adjust for cash and debt in order to arrive at the enterprise value.

There are no hard and fast rules to calculating purchase enterprise value as it gets confusing when existing investors and the management team roll over their shares in the transactions and sometimes fees are involved. So it is best to be flexible with this item on the model. 

In making assumptions about how much debt is required for a deal, analysts often use multiple tranches of debt depending on investors’ risk appetite. PE firms might be risk-seeking and go up to 6x Debt/EBITDA. They have to find investors who are willing to make loans that are similar to them in their risk appetite. These more aggressive investors might be hedge funds, merchant banks, or mezzanine funds; they could also be institutional investors that specialize in higher-risk Debt.

Step 2: Project cash flows and debt repayment 

In order to project cash flows and debt repayment, some key assumptions about the business’ financial conditions need to be made. Assumptions, however, vary depending on the level of details given. Oftentimes, analysts will make key forecasts for the following metrics:

Here is another example of key financial assumptions about the business’ operations

In a more detailed version, you would make three groups of assumptions: the base case (if the business operates as normal), the upside case (if the business goes right), and the downside case (if the business goes wrong). The next step for you is to create a dynamic model that allows you to choose the case you want to use for the analysis. 

Having established forecasts and scenarios, you would then go about modeling financial statements for 5 years into the future. Analysts often start with the income statement, and then the balance sheet, and finally the cash flow statement. In the process of doing this, it is important to remember how the three financial statements are linked together. Another key part that will help with arriving at the final future free cash flow is supporting schedules. Supporting schedules are sections in an LBO model that help fill in information that cannot be worked out using just three financial statements. Those include a working capital and depreciation schedule and debt & interest schedule.

Example of working capital and depreciation schedule

Example of debt and interest schedule

Step 3: Make exit assumptions and calculate the returns

At the end of the projection period, we will assume that the PE firm sells the company to another firm, a normal company or another PE firm. Normally, we will use an EBITDA exit multiple to calculate the exit enterprise value. For example, if we use a 10x EBITDA exit multiple, and the EBITDA at the end of the 5 year projection period is $100 million, then we get the exit enterprise value of $1000 million. 

The standard assumption in an LBO model is that the PE firm must pay the remaining debt balance upon exit and claim the company’s cash. Therefore, in calculating the equity proceeds to the PE firm, we subtract net debt and add cash. However, the assumption on cash is often murkier. If the remaining cash is not substantial, the PE firm might claim the cash. On the contrary, if the company has significant excess cash, the PE firm might also have a choice to issue a dividend to itself.

The next step is to calculate return metrics. Two return metrics often used in private equity are internal rate of return (IRR) and Money-on-money multiple (otherwise known as MOIC). A detailed elaboration on IRR and MOIC can be found in this article. 

Rules of thumbs for calculating IRR:

The most important approximations are as follows:

• Double Your Money in 1 Year = 100% IRR
• Double Your Money in 2 Years = ~40% IRR
• Double Your Money in 3 Years = ~25% IRR
• Double Your Money in 4 Years = ~20% IRR
• Double Your Money in 5 Years = ~15% IRR
• Triple Your Money in 3 Years = ~45% IRR
• Triple Your Money in 5 Years = ~25% IRR

We can even go further and perform a returns attribution analysis.

For the return from EBITDA growth, we subtract the initial EBITDA from the final year EBITDA and multiply the difference by the purchase EBITDA multiple and multiply by the PE firm’s ownership percentage.

For the returns from Multiple Expansion, we subtract the Initial Multiple from the Exit Multiple, multiply by the Final Year EBITDA, and then multiply by the PE firm’s ownership %.

For the return from “Debt Paydown and Cash Generation” we take the Total Return to Equity Investors and subtract the returns sources above.

Step 4: Draw conclusions

In order for the conclusions to be comprehensive, analysts often perform sensitivity analysis  on key variables such as purchase and exit multiples, debt level, revenue growth, and EBITDA margin levels. Based on the IRRs and MOICs from the sensitivity analysis, you then evaluate if it is a good investment for the PE firm.

Your final recommendation should look something like this:

“Since we could realize an IRR of 20% and a MoM multiple of 2.5x in our Base Case and a 1x multiple even in the most pessimistic scenarios, we recommend doing the deal and acquiring Company X for an EV / EBITDA multiple of 10.0x. The company has been spending progressively less on CapEx as a % of revenue over time, even when its revenue is growing year on year. Even if its growth rate declines to the levels it were during the midst of the pandemic recession in March, the math still works. For the deal not to work, the company’s revenue growth would have to decline to (-15%), which is well below even the worst-performing company in the industry.”

We hope that the fundamentals of the leveraged buyout model are covered well in this article. LBO is an advanced model that requires sophisticated understanding of financial and operational situations of a business, as well as different forms of funding. The LBO model also requires a lot of flexibility. Depending on the fine prints of the transactions, the model might vary in terms of its level of details and difficulties of calculations. That said, LBO is an extremely important model in private equity, and for anyone who wants to break into this industry, understanding how to build the model is what you need to do as an analyst.