A leveraged buyout (LBO) is a common financing strategy employed by private equity (PE) firms for acquiring companies. An LBO involves acquiring another company using a significant amount of borrowed funds to fund the cost of the acquisition, using the assets of the target as collateral for the loans. Ideal target companies are typically mature businesses that are either underperforming or undervalued and exhibit the following three characteristics:
- Strong asset bases to collateralize the loans
- Stable cash flows to service the debt
- Operations in stable industries with consistent demand
The LBO Model
When evaluating investment opportunities, PE firms heavily rely on an LBO Model to accurately assess value and thus the LBO model serves as a crucial tool in the PE diligence process. One of the primary functions of the LBO model is to quantify the impact of deal terms and synergies on investment returns. PE firms use the model to assess the feasibility and potential outcomes of implementing growth strategies such as expanding into new markets, launching new products, or increasing market share. By inputting key financial data and assumptions into the LBO model, analysts can stress test various assumptions and scenarios to assess the investment’s sensitivity to changes in key variables such as revenue growth, operating margins, and exit multiples. By running these different scenarios, PE firms can evaluate the investments resilience to potential market fluctuations, operational challenges, or unforeseen events thereby mitigating risk and optimizing returns.
Our typical LBO models are split into three components: inputs, calculations, and outputs. We often separate between standard assumptions and scenario assumptions for a cleaner user interface. This separation allows analysts to run different scenarios on the fly and to adjust the assumptions as they see fit. For the calculations, it’s important to have as much detail as possible while balancing the complexity of the model.
Monthly Modelling for Debt Management and Seasonal Cash Flow Analysis
Monthly modelling allows us to incorporate seasonality on sales, expenses, working capital, and more. Furthermore, monthly modelling enables a deep understanding of the cash needs of the business, which are heavily impacted by the debt load associated with LBOs. Buyers are often looking for a target that can pay down debt while also leaving cash leftover for dividends, while meeting debt covenants. Evaluating debt service ability is a crucial factor in the go/no-go decision of an LBO. A monthly model helps assess the business’ ability to meet debt obligations while accounting for seasonality in sales, expenses, and working capital. By incorporating debt covenants directly into the model, it flags potential issues early on, allowing users to stress test various deal terms and ensure the covenants remain compliant under different scenarios.
Once the calculations are complete, the model can be consolidated into a 3-statement annual or quarterly format, which is then used to evaluate the LBO deal. Analysts can extract cash flows from the model to calculate the IRR and NPV of the investment under various scenarios. In practice, an analyst will conduct multiple scenario analyses, projecting different assumptions for debt reduction, cost savings, sales growth, and returns to identify key factors driving the deal’s risk and return. A downside scenario, where revenues decline and planned cost-cutting or debt reduction isn’t executed, is of particular interest. In such cases, if the exit enterprise value (EV) is lower than the outstanding debt, the PE firm would face insolvency, rendering the equity investment worthless.
LBO Model Outputs Example
Private Equity Co. is a strategic buyer looking to purchase a tire manufacturing company. They believe they will be able to achieve synergies through their existing bulk contracts for materials, distribution network and the absorption of the target companies’ marketing team. In the following chart, we can see how an analyst might structure the scenarios in this case.
This example showcases the importance of an LBO model, and although this is a simplified view of the model’s inputs and outputs it is clear that small changes in the inputs can significantly impact the outputs. This is often the case with LBO models, which tend to be highly impacted by the cash generation of the business and how well the company can service its debt. In practice, the inputs are typically built at a granular level. Revenues and costs would be modelled by revenue stream, SKU #, or even at the customer level. Additionally, price and quantities would be modelled separately, and the inputs would be split out on a monthly basis to account for more granular movements like seasonality.
The Role of LBO Models in Private Equity Acquisitions
An LBO model is a complex but powerful tool used by PE firms to acquire and enhance the value of target companies. By strategically borrowing against the assets and cash flows of the acquired company, PE firms can use financial leverage to maximize returns, provided the target has the necessary characteristics such as a strong asset base, stable cash flows, and operations in a stable industry.
The LBO model is essential in this process, offering a detailed and dynamic framework for analyzing investment opportunities. It allows for the assessment of various growth and operational strategies while evaluating the impact of different scenarios on the investment’s risk and return. As demonstrated in the example, even minor changes in inputs can significantly affect the outcome, highlighting the importance of meticulous scenario planning and sensitivity analysis. Ultimately, the success of an LBO depends on the buyer’s ability to maintain or enhance the target company’s operational efficiency and profitability while effectively managing the associated debt burden.
