What is an LBO?
An LBO model is the basic analysis that projects the returns of an invesment
In a LBO we put debt in a company and the idea is that the cashflow from the company pays down debt
LBO modeling requires 3 statement modeling because that is how we calculate cash flows
In its simplest form an LBO is just a projection of the cashflows of the company. How much do we pay to get in, how much cash we generate over time, how much cash we get when we sell, what are our returns.
What are the key LBO value drivers?
1) EBITDA Growth
- Grow revenue
- Cut costs
- Make acquisitions to grow EBITDA
2) Raise Debt and Pay it down
- Allows us to buy bigger companies with a lower cost of capital than equity
- Need to make sure that cash flow is consistent so that we can pay off debt
- Reduce capex to pay more debt down
3) Multiple expansion
- Build a higher quality business
Key Sections of an LBO Model
- Transaction Assumptions
- Sources & uses
- Financial Forecast / Operating Model
- 3-Statement Model (IS/CF/BS)
- Returns Analysis
What has higher impact in an LBO: Multiple expansion or EBITDA margin expansion?
It depends….but typically you would see multiple expansion being a greater drive of returns as your are expanding your exit value by a one turn of EBITDA. Its rare to get that much value from margin expansion unless you have a significant margin expansion.
How can we decide on the premium per share price for an LBO?
Rule of thumb is 15% - 30% premium
Private Company EV Buld
How are growth equity deal modeled? Do they also use LBOs?
Growth equity deals tend to use more structured securities. (i.e convertible pref, debt + warrants or earn-outs vs straight equity buyout)
What are options? What is the treasury stock method?
- Options are securities that can be excercised into shares
- When the option holder excercises its right to buy options the company receives money from the option holder
- Company uses the proceeds from the employees to buy back share?
Options can only be excercised if they are in the money. Option needs to be below the current share price to be excercised.
If option is $5 and current share price is $10 the option holder will excercise its rights
Transaction Assumptions
How do you determine equity value and enterprise value?
Enterprise Value
1) Calc fully diluted shares outstanding “FDSO”
FDSO = Basic Shares outstanding + Net Options + Net Warrants + Restricted Sotck Units
2) Calculate Common Equity Value
- FDSO * Proposed Purchase Price per Share
3) Add Debt to EQuity Value
- Debt, Convertible Debt, Preft Stock, Capitalized Leases
4) Substract Cash and Cash equivalents
- Cash, Mkt Securities, Liquid investments
Treasury Stock Method
- Cash Proceeds: Options outstanding * option price
- Shares Repurchased: Cash proceeds / Current Share Price
- Net Shares: Shares - Shares Repurchase
2) Sources & Uses
LBO Model Steps
- Ater defining transaction assumptions.
- Next steps is the S&U
- Think about that in the S&U section we define how we are going to fund the purchase of this business
Sources (Equity)
- Common Equity: Bottom of the cap structure
- Pref Stock: Higher claim than common equity. Hybrid between debt and equity as they get a dividend before common stock. More downside protection due to liquidation preferences at exit.
- Options: Security that allows you to receive shares down the road.
Uses
- Purchase equity: Buy shares from existing owners
- Refinance existing debt or assume it: When you buy a company you can buy the shares only. You also need to assume the debt
- Cash to BS: We need to send some cash fo the B/S so the company can keep operating. Keep in mind that in the EV calc we take net debt therefore there is no cash left to run the business
- OID: Think of it like a debt fee to make debt more attractive
- Fees: Amortize over life of debt. Treat this similar to interest expenses because they save you on taxable income
- Expenses: Fees on advisors (bankers, lawyers, accountants). This can’t be amortized as this are one time expenses
Section 3 of an LBO: 3 statement model
Flowing Revenue to Free Cash Flow
Balancing a Balance Sheet
Net Working Capital and why do we care?
Net working capital matters in an LBO because any additonal net working capital that the business needs is a use of cash.
For example, if our accounts receivables increase our customers owe us more money therefore more cash is tied in the business
Other Balance Sheet Items
LBO Purchase Accounting
- When we do an LBO we recap the business therefore we wipe out all the equity and debt in the existing business and replace it with new equity and debt
Godwill Calculation in an LBO
- Goodwill is used in a LBO to account for the “excess purchase price” of another company
- To calc goodwill we calc the step-up of equity
- Step-up of equity = Purchase price - (FV of Assets - FV of Liabilities) + Existing Goodwill
- Keep in mind that the FV of Assets and FV of liabilities is equal to your Book Value of Equity
The Paper LBO
- Tests LBO concepts without having to open excel
- Simple paper LBO steps
1) Transaction Assumptions
2) Sources & Uses
3) Walk from Income Stament to Cash Flow Statement
4) Calculate Returns
- Rule of 72 (Double your money)
- Rule of 114 (Triple your money)
- Rule of 144 (Quadruple your money)
- Rule of 72: Stipulates that the aprox return required to double an investment can be calculated by dividing ( 72 / number of year)
i.e What is the rate of return I need to double my money in 5 years? (72 / 5) = 15%
