LBO MODEL VALUATION

Step by Step Process

V. Ravichandran
What is “LBO Valuation”?

• A leveraged buyout (an LBO) is an acquisition by a financial sponsor,

financed using significant amounts of debt.
• Leverage is used to increase the returns to equity holders, and debt is
repaid from the company’s operational cash flows.
• Private equity funds expect to exit the investment within the medium
term to monetize their returns.
• An LBO transaction is evaluated by calculating an internal rate of return
(IRR).
• The IRR compares the equity investment upon exit versus the amount
invested at entry and calculates an annualized return on the investment.
What is “LBO Valuation”?
• A Leveraged Buyout (or ‘LBO’ for short) is a transaction where a Private
Equity firm (‘PE Firm’ or ‘Financial Sponsor’) purchases a Business using
Debt to fund a significant portion of the Purchase Price.
• The portion of the Purchase Price not funded by Debt will come from the
PE Firm’s Investors, which is called ‘Sponsor Equity.’
• An LBO Purchase is very similar to how you would buy a house with a
mortgage and fund the remainder of the Purchase Price with a Down
Payment.
• The primary reason for using Debt (as opposed to investing more Equity)
is to increase the potential for higher returns for the Private Equity
firm’s Investors
Characteristics of Target Companies

• Investment strategies of sponsor funds can differ significantly, but

target companies usually have:
• Stable cash flows and low fixed costs
• Potential for operational improvements
• An attractive valuation upon entry and present a clear exit strategy
Valuation Key Steps

• Valuing a company as if it were a target for an LBO can provide valuable

insight into the business and give an indication of whether the company is a
potential LBO candidate.
• In order to perform an LBO valuation, the following is required (as a
minimum):
• An operating model, forecasting EBIT and EBITDA
• A debt repayment model forecasting how debt will develop from acquisition to
exit
• An assumption of when and at what multiple the LBO investor can exit
• An assumption about how much debt a buyer could raise to fund the
transaction
6 Steps process in detail
1.Calculate Purchase Price (or ‘Enterprise Value)
Determine the price to pay by multiplying the EV/EBITDA* Multiple
by the Target Company’s EBITDA.
Then add any Financing or Advisory fees to arrive at the Total Uses of
Funds.
6 Steps process in detail
2/ Determine Debt and Equity Funding
• Determine the Debt available based on a multiple of EBITDA
(typically 4-7x).
• Subtract Debt from the Total Uses Sources of Funds to determine the
Sponsor Equity required to fund the Purchase.
Uses and Sources

Uses: The “Uses” side calculates the total amount

of capital required to make the acquisition (i.e. the
purchase price and transaction fees).

Sources: The “Sources” side details how exactly

the deal is going to be funded, including the
required amount of debt and equity financing.
How much equity and debt ?
• One of the main purposes of a LBO model is to evaluate how
much an initial equity investment by a sponsor has grown,
therefore we must evaluate the necessary initial equity
contribution from the sponsor.
• The proposed capital structure is among the most important
return drivers in a LBO, and the investor usually has the role
of “plugging” (i.e. with equity) the remaining gap between the
sources and uses for the transaction to proceed and close.
6 Steps process in detail
3/ Project Cash Flows
Calculate Free Cash Flow over a five-year horizon, including Interest
Expense.
6 Steps process in detail

Calculate Purchase Price (or ‘Enterprise

Value)
• Determine the price to pay by multiplying the
EV/EBITDA Multiple by the Target Company’s EBITDA.
• Then add any Financing or Advisory fees to arrive at
the Total Uses of Funds.
6 Steps process in detail

Determine Debt and Equity Funding

• Determine the Debt available based on a
multiple of EBITDA (typically 4-7x).
• Subtract Debt from the Total Uses Sources of
Funds to determine the Sponsor Equity
required to fund the Purchase.
Project Cash Flows
• Calculate Free Cash Flow over a five-year horizon, including Interest
Expense.

Calculate Exit Sale Value (or ‘Enterprise Value’)

• Determine the sale price by multiplying an EV/EBITDA multiple by the
Target Company’s EBITDA at Exit (typically Year 5).
• Note that the Exit EV/EBITDA multiple is typically assumed to be the
same as the initial Purchase EV/EBITDA multiple.
Work to Exit Owner Value (or ‘Equity Value’)
• Subtract the cumulative Cash Flows (Step 3 above) from the Debt used to fund
the deal (Step 2 above). This will give you the Debt that needs to be repaid
when the Company is sold. Exit Equity Value is then calculated by subtracting
the Debt repaid at Exit from the Exit Sale Value (‘Enterprise Value’). This is the
money returned to the Investors in the deal.

Assess Investor Returns (IRR or MOIC)

• Use the Exit Equity Value and the initial Sponsor Equity to calculate the
Internal Rate of Return and the Multiple of Invested Capital. See below for
detailed calculations (and a helpful shortcut).
How to Calculate the LBO Purchase Price

• In the LBO world, the most commonly used approach to calculate the Purchase
Price is to use peer multiples.
• The most common multiple is an Enterprise Value / EBITDA (or EV/EBITDA)
multiple.
• Enterprise Value = EBITDA * Multiple
• Alternatively, if a Business has a higher level of Capital Intensity, you
might instead use EV/EBITDA – Capital Expenditures.
• This approach helps to normalize across Businesses with high reinvestment needs.
• With either approach, we would take the Peer Multiple and multiply it by the
• Acquisition Target’s EBITDA (or EBITDA – Capital Expenditures) to arrive at
the Purchase Price (or Enterprise Value).
LBO Purchase Price ?
Transaction and Advisory Fees

• In addition to paying the Purchase Price (Enterprise Value) of the LBO

Target Company, we must also pay Fees to close the deal.
• The two primary types of fees we need to pay are:
• Advisory Fees – payments to Investment
Bankers, Accountants, Consultants, and Lawyers.
• Financing Fees – payments to Lenders in return for providing Debt to
fund the deal.
In short, to calculate the total
payment (or ‘Uses of Funds’) needed to
close the deal, we have to include
the Purchase Price plus our Fees paid to
Lenders and Advisors.
LBO Value Creation Driver #1: Purchase
Price
• Before we continue, let’s quickly discuss LBO Value Drivers. If you would like to take
a deeper dive into these drivers, check out our LBO Value Creation Drivers video.
• In any LBO transaction, there are a variety of factors that will impact the
transaction.
• However, in the end, the value created in an LBO boils down to just three factors:
Purchase Price, Cash Flow, and EBITDA Growth (which drives the Exit Sale Price).
• The first LBO Value Creation Driver, Purchase Price, creates value by increasing the
potential for growth in the value of the Business over the course of the LBO.
• A lower Purchase Price may also result in a lower required Equity Investment at
Purchase.
• Now that we’ve calculated the Purchase Price (including Fees), let’s jump to Step
#2 and determine how to fund the LBO transaction.
LBO Step #2: Debt and Equity Funding

• A PE Firm typically funds an LBO purchase with a significant amount of

Debt, similar to the structure used to fund the purchase of a Home.
• The level of Debt in an LBO transaction is typically a function of the
Business’ EBITDA generation.
• It’s worth noting that Debt levels are generally expressed as multiples (or
‘Turns’) of EBITDA in the LBO world.
• The level of Debt for an LBO can vary from as low as 1-2x EBITDA to
over 10x EBITDA.
• Unlike the structure for a Home purchase, however, the LBO Debt
structure is typically composed of Loan and Bond Debt (as opposed to a
Mortgage).
LBO Debt Funding Source #1: Loan Debt

• The primary Source of Funding for the vast majority of LBO transactions is Loan
Debt.
Loan Debt typically comes in a few forms:
• Revolving Credit Facility (or ‘Revolver’) – a short-term borrowing facility that the
Company can utilize for borrowings on an as-needed basis.
• First-Lien Term Loan – a first-priority Loan that typically requires some principal
repayment (‘Amortization’) over the course of the Loan.
• Second-Lien Term Loan – a second-priority (and thus higher cost) Loan.
• Side Note: It’s worth mentioning that ‘Loan Debt’ is often referred to as ‘Bank
Debt’ because back in the day, this type of Debt was primarily offered by
Banks. Today, there are many specialty, non-bank lenders that offer Loan Debt, but
the name has stuck.
LBO Debt Funding Source #2: Bond Debt

• For larger deals, Private Equity firms may seek funding from
the Bond market.
• The Bonds raised for LBO transactions are quite different from run-
of-the-mill Bonds issued by large, high-quality Companies like
Microsoft, Ford, or Kellogg’s.
• LBO Bonds are referred to as ‘High Yield’ (or ‘Junk’) Bonds because
they are much riskier given the level of Debt typically used in an LBO
transaction.
• Because of their riskiness, they carry a much higher cost than
a traditional Bond.
LBO Debt Funding Source #3: Mezzanine Debt

• The last source of Debt funding is a catch-all for any other type
of Debt that doesn’t neatly fit into the categories above.
• Like a Mezzanine floor in a building, Mezzanine
Debt sits between the Debt and Equity in an LBO structure.
It typically has characteristics of both Debt (i.e. Interest Payments)
and Equity (i.e. Upside in the Investment).
LBO Structure: Equity Funding

• Whatever can’t be funded with Debt must be funded with an

Investment (or ‘Sponsor Equity’) by the Private Equity Firm (or
‘Financial Sponsor’).
• In short, the Private Equity firm is the funding backstop.
• If we were to rewind to the early days of LBOs in the 1970s to the
1990s, we would see LBOs funded with as little as 10% Equity.
• Over time Lenders have pushed Equity funding requirements higher
to ensure the Private Equity firms have meaningful ‘skin in the game.’
• Today, the Sponsor ‘Equity Contribution’ typically composes at least
40% or more of the Purchase Price in an LBO transaction.
How to Calculate Free Cash Flow for an LBO
LBO Value Creation Driver #2: Cash Flow

• Cash Flow is the second primary value driver in an LBO

transaction.
• Cash Flow creates value in an LBO in two ways:
1. Debt Paydown
2. Invest in High Return on Capital opportunities
How Debt Paydown Creates Value

• Debt paydown reduces the level of Debt the Private Equity

firm needs to repay when it sells the Business.
• The lower level of debt at Exit increases the Equity available to
the Private Equity Investors.
• The process above is similar to how you would receive a higher
payout if you pay down more of your mortgage before selling a
house.
How Reinvestment Creates Value

• Alternatively, a Private Equity firm could reinvest the excess

cash in high return on capital reinvestment opportunities.
• The goal would be to grow the Business and thus EBITDA.
• Growing EBITDA drives a higher Exit Enterprise Value at Sale and
thus a higher return for the Private Equity firm.
LBO Step #4: Exit Enterprise Value
LBO Step #4: Exit Enterprise Value

• after we’ve made five years of Cash Flow projections, we’ll set up
an Exit Analysis.
• In an Exit analysis, we assume that the Private
Equity firm puts the Business up for sale to another Buyer.
• As with our Purchase Price analysis in Step #1, Buyers will
typically base their purchase on the EBITDA of
the Business and relevant Peer Valuation
Multiples (again EV/EBITDA or EV/EBITDA – Capital
Expenditures).
• Based on the above, we can see that higher EBITDA and higher
EV/EBITDA multiples will increase the Business’s Sale Value.
What is the Right Exit Multiple Assumption?

• It is worth noting, however, that when analyzing an LBO

investment, most Private Equity investors assume that the Exit
Multiple at Sale will be the same or less than the Purchase
Valuation multiple.
• PE Firms make this assumption due to conservatism and
because PE Firms have been burned in past cycles (e.g. the 2008
crisis) by assuming Exit Multiples would continue to expand.
Value Creation Driver #3: EBITDA Expansion

• EBITDA expansion is the third and final LBO Value Driver.

• Because the Exit Multiple is typically held constant (vs the
Purchase Multiple), the Exit Valuation is primarily
dependent on EBITDA Expansion (or Contraction).
• This is because as EBITDA expands (holding the Exit Multiple
constant), the Sale Value at Exit also increases.
• Once we’ve calculated the Exit Valuation, based on our Exit Year
EBITDA and the appropriate Valuation Multiple, we can move to
Step #5.
LBO Step #5: Exit Equity Value
• When a Private Equity Firm sells a Business, they don’t keep all of
the proceeds because Lenders must be repaid first.
• On a more positive note, they do get to keep any excess Cash on
the Balance Sheet.
• To calculate the Exit Equity Value that would return to the Private
Equity firm, we would:
1. Calculate Exit Enterprise Value (from Step #4).
2. Subtract the total Principal value of all outstanding Debt.
3. Add any excess Cash on the Balance Sheet.
• The dollars that remain after completing this calculation are what
the Private Equity firm will keep (and thus return to investors.
LBO Step #6: Investor Returns

• To calculate the returns to Investors in an LBO deal, Private

Equity firms primarily rely on two metrics:
1. Internal Rate of Return (‘IRR’) – reflects the time-
weighted Return to Investors in the deal.
2. Multiple of Invested Capital (‘MOIC’) –
reflects dollars returned vs. dollars invested.
Valuing an LBO

• Once the above has been established the following steps are taken to
perform an LBO valuation:
• The expected EV at exit is established using the forecast (exit)
EBITDA level from the operating model times the expected
EV/EBITDA multiple at exit (the exit multiple).
Valuing an LBO

• The expected exit net debt is deducted from the EV to get to the
expected exit equity valuation.
• The expected equity value at exit is then discounted back to the deal
date using the buyers minimum IRR requirement. This, in turn, gives
the maximum equity investment by the buyer (entry equity valuation).
Valuing an LBO

• Since the buyer will change the financing structure of the company in
the LBO, we then have to add the post-transaction debt (available debt
financing, entry) to get the maximum EV a buyer would pay at the
deal date. Maximum equity and maximum debt give maximum EV.
• Once the maximum EV is established, we finally walk the EV to
Equity bridge using the pre-deal (ie existing) debt and arrive at the
maximum amount a buyer could pay for the equity of the business.
Summary
• A leveraged buyout or LBO is an acquisition of an underperforming
company funded using significant amounts of debt
• The investors (acquires) aim to increase the returns to equity holders and
repay debt from the company’s operational cash flows
• Target companies usually have key characteristics which make them an
attractive investment for investors including stable cash flows, potential for
operational improvements or reduced costs and a clear exit strategy
• There are multiple steps that need to be undertaken to indicate whether a
company is a potential LBO candidate
• A key assumption is that the investor is able to sell the business in order to
understand what they could pay today