Day 134 MIT Sloan Fellows Class 2023, M&A and PE 9 "LBO modeling"
LBO modeling
Leveraged Buyout (LBO) modeling is a key tool used by private equity (PE) firms to evaluate the potential acquisition of a company using a significant amount of debt. The goal is to achieve high returns by using leverage, improving the target company's operations, and eventually exiting the investment through a sale or public offering. Here's a step-by-step guide to the LBO modeling process:
- Sourcing the target company:
The first step is to identify a suitable target company with strong cash flows, manageable debt levels, and potential for operational improvement. Criteria may also include industry trends, competitive positioning, and growth potential. - Developing the transaction assumptions:
Private equity firms need to make key assumptions about the deal, including the purchase price, transaction structure (debt and equity mix), and financing sources (senior debt, subordinated debt, mezzanine financing, or equity). These assumptions will influence the model's output and must be based on market conditions, target company fundamentals, and investor preferences. - Building the historical financial statements:
Construct the target company's historical financial statements, including the income statement, balance sheet, and cash flow statement. This will provide a foundation for forecasting the company's future performance and help identify trends and areas for operational improvement. - Forecasting future financial performance:
Using the historical financial statements as a starting point, forecast the target company's financial performance for a period of 5-7 years. Key assumptions will include revenue growth, margin improvements, working capital requirements, capital expenditures, and taxes. - Determining the appropriate capital structure:
Based on the transaction assumptions, determine the target company's new capital structure, which will include the debt and equity mix used to finance the acquisition. Consider factors such as debt serviceability, interest coverage, and credit ratings when deciding on the debt levels. - Modeling the debt repayment schedule:
Develop a debt repayment schedule based on the terms and conditions of the debt facilities, including interest rates, amortization, and maturity. This will affect the target company's cash flows and the private equity firm's return on investment. - Calculating the free cash flow to equity (FCFE):
Calculate the free cash flow to equity, which is the cash flow available to equity investors after accounting for all operational expenses, taxes, capital expenditures, and debt service. This is a crucial metric to assess the target company's ability to service its debt and generate returns for equity investors. - Estimating the exit value:
To determine the potential return on investment, private equity firms need to estimate the target company's exit value at the end of the investment horizon. This can be done using valuation multiples (such as EV/EBITDA) or the discounted cash flow (DCF) method. - Calculating the internal rate of return (IRR) and cash-on-cash multiple:
Using the FCFE, exit value, and initial investment, calculate the internal rate of return (IRR) and cash-on-cash multiple. These metrics are used to evaluate the attractiveness of the investment and compare it to other potential opportunities. - Sensitivity analysis:
Perform sensitivity analysis on key assumptions to understand the impact of changes in variables such as purchase price, growth rates, and exit multiples on the investment's IRR and cash-on-cash multiple. This helps identify potential risks and opportunities in the investment.
Operating Projection example
Important points
- What is the improvement opporunities? growth? margin?
Sources and Uses of funds
Simple LBO projection
After paying down debt, what is the debt and EV at exit date?
- Paydown
- EV/EBITDA multiples
- Net value for PE funds
The only two variables you need to use.
- Ending Net debt at exit date
- EBITDA at exit date
Exit Value Information
