Guide to LBO Modeling

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Guide to LBO Modeling

• Educational Presentation #7 – Private Equity

• 27.02.24

• Property of the ESCP Alternative Investment Society (AIS)

• Sources: Wall Street Prep

• Attachment: LBO Model Template & Answer Key

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Section I: Introduction to LBO Modelling

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I: Introduction to LBO Modelling

Introduction

Why understanding LBO Modeling is essential

What is a good target for an LBO? What is an LBO?

• Companies with stable and predictable cash flow

• LBOs are a preferred method for private equity firms to acquire targets

• An LBO involves acquiring a company using a significant amount of borrowed funds

• Firms undervalued relative to their industry peers

• Investors form a HoldCo to pool equity and secure additional debt

• Businesses operating in stable, non-cyclical markets

• The HoldCo purchases the target company using its LFCF to pay off debt

• Targets that offer opportunities for cost-cutting and operational efficiencies

• The aim is to enhance the company's operations and increase its market value

• A strong management team

• Ultimately, the company is sold at a profit, delivering high returns to investors

Out of all factors, stable cash flows are most important for LBOs, making industries with volatile revenues, like oil and gas, less ideal targets

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I: Introduction to LBO Modelling

Key drivers of value creation in an LBO model Why do LBOs work

LBOs deliver higher returns compared to using 100% cash because: • Using debt minimizes the upfront cash payment, enhancing overall returns. • The company's cash flows are used to repay debt principal and interest, delivering a higher return compared to simply holding the cash. • Selling the company in the future allows the PE firm to recoup most of the acquisition cost.

Minimized Initial Investment

Efficient Cash Flow Utilization Profitable Exit Strategy

Debt reduces initial outlay, enhancing equity

FCF is used to pay down debt annually

Divest company at an enhanced valuation

returns

Understanding the importance and mechanics of LBOs equips us with foundational finance skills and insights into value creation strategies, setting

the stage for exploring the step-by-step process of executing a successful LBO model

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I: Introduction to LBO Modelling

To work through an LBO, we will use the following 5- step approach Outline

1. Entry Assumptions: Determine acquisition price through methodologies such as CCA, CTA and DCF.

2. Sources and Uses: Identify capital structure for acquisition and allocation of funds.

3. Financial Projections: Forecast revenues, EBITDA, and capital expenditures to assess viability of transaction.

4. Debt Schedule: Develop detailed debt repayment plan that includes both mandatory and discretionary payments.

5. Exit and IRR: Calculate exit enterprise and equity values and measure MoM and IRR.

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Section II: Assumptions

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II: Assumption

Establishing the suitable assumptions for the transaction is a fundamental step in the LBO process LBO Assumptions Framework

First, the private equity firm needs to gather transaction assumptions

Gathering the right assumptions is a critical and time-consuming part of building an LBO model, requiring detailed

inputs on the following areas

Fees and expenses Debt Entry price

Costs incurred for legal, accounting, banking, and advisory services

The total amount paid to acquire the company

Various tranches of borrowed capital used to finance the acquisition

Operating assumptions

Financials Exit price

The total value for which the company is sold

Projections for revenue growth, margins, and other operational metrics

Historical income statements, cash flow statements, and balance sheets

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II: Assumption

Assumptions - Example

Entry assumptions that will be followed throughout the entirety of the LBO example

• Assumptions are based on a hypothetical scenario. For simplicity, the entry and exit multiples are assumed to be the same. However, in reality, some level of multiple expansion typically occurs

Entry

Financials (LTM)

Number Index

LTM EBITDA 250

Revenue 1,000

Hard Coded

EBITDA Multiple 10.0x

EBITDA 250

Formula

Enterprise Value 2,500

D&A 50

Existing Net Debt 500

Capex 75

Amount brought from hard coded

Equity Value 2,000

NWC 100

Fees and Expenses 50

Exit

Operating Assumptions

Capital Structure Amount Cost

EBITDA Multiple 10.0x

Revenue Growth 7.0%

Bank Debt 4.0x 6.0%

YoY margin expansion 1.0%

Senior Notes 2.0x 12.0%

Tax Rate 21.0%

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Section III: Sources and Uses

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III: Sources and Uses

Sources and Uses Table

Sources and Uses determination is often an investor-specific decision with no universally correct approach

Uses = Capital required to purchase the company

• The Sources and Uses table serves as a summary of how the acquisition will be financed and how these funds are allocated

• Purchase Enterprise Value: Total cost to acquire company, including equity and debt

• Cash to Balance Sheet: Cash set aside for post-acquisition costs

• This overview, often a focal point in interviews, breaks down the origin of funds, such as equity contributions and various debt tranches, and their specific uses, including the purchase price, transaction fees, and refinancing requirements

• Transaction fees: Fees for financial and legal advisors

• Financing Fees: Costs for arranging debt financing

Σ(Sum of Sources) = Σ(Sum of Uses)

Sources = Capital required to fund the transaction

• Sponsor Equity: Private Equity sponsor’s cash contribution

• Rollover Equity: Reinvested Equity from existing shareholders

• Term Loan: Senior secured loan with a fixed repayment schedule

• In this process, it always makes sense to determine the uses first, asking “How much money will I need for the acquisition and to cover expenses that are not covered by the cash flow?”

• Subordinated Debt: Higher risk debt with higher interest rates

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III: Sources and Uses

Uses - Example

The uses detail where every dollar raised will go, ensuring that the capital structure supports the acquisition and all expenses

Uses

• In this example the Total Uses is mainly calculated using two inputs from the assumptions; Existing Net Debt and Equity Value

Amount xEBITDA %Capital

Net Debt = Total Debt - Cash

Entry Assumptions

Existing Net Debt 500

Debt Retirement 500 4.0x 19.6%

Equity Payment 2,000 2.0x 78.4%

Equity Value = Enterprise

Entry Assumptions

Value – Net Debt

Equity Value 2,000

Fees and Expenses 50 0.2x 2.0%

• The fees and expenses value is already given; however, it’s common practice to assume it will represent 2% of the uses

Total Uses 2,550 10.2x 100.0%

Entry Assumptions

Fees and Expenses 50

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III: Sources and Uses

Sources - Example

Sources represent the forms of capital raised to fund the acquisition, which may include both debt instruments and equity contributions

Sources

• In this example the Total Debt required is calculated using two main inputs from the assumptions; LTM EBITDA and Capital Structure as a ratio to EBITDA

Amount xEBITDA %Capital

Bank Debt = LTM EBITDA x

Financial Assumptions

Bank Debt Assumption

LTM EBITDA 250

Bank Debt 1,000 4.0x 39.2%

Senior Notes 500 2.0x 19.6%

Senior Notes = LTM EBITDA

Capital Structure Assumptions

x Senior Notes Assumption

Bank Debt 4.0x

Total Debt 1,500 6.0x 58.8%

Senior Notes 2.0x

• Sponsor Equity is determined as the remaining capital needed to bridge the gap between the Total Sources and the Total Uses

Sponsor Equity 1,050 4.2x 41.2%

Uses

Sponsor Equity = Total Uses

– Total Debt

Total Uses 2,550

Total Sources 2,550 10.2x 100.0%

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III: Sources and Uses

Consolidated Sources and Uses - Example

This simplified example illustrates the typical structure encountered after completing the Sources and Uses Table

Sources Uses

Amount xEBITDA %Capital Amount xEBITDA %Capital

Bank Debt 1,000 4.0x 39.2% Debt Retirement 500 2.0x 19.6%

Senior Notes 500 2.0x 19.6% Equity Payment 2,000 8.0x 78.4%

Total Debt 1,500 6.0x 58.8% Fees and Expenses 50 0.2x 2.0%

Sponsor Equity 1,050 4.2x 41.2%

Total Sources 2,550 10.2x 100.0% Total Uses 2,550 10.2x 100.0%

Σ(Sum of Sources) = Σ(Sum of Uses)

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Section IV: Financial Projections

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IV: Financial Projections

Financial Projections Overview

Financial projections in an LBO assess cash flow, debt repayment, and returns, ensuring deal feasibility

Revenue Growth • Assumed annual growth rate for revenue over the holding period • Impacts projections for EBITDA, Free Cash Flow, and overall company valuation

EBITDA Margin • Projected EBITDA as a percentage of revenue reflects operational efficiency and profitability over time

• Forecasted investment in long-term assets required for business operations • Influences cash flow and potential need for financing

Capital Expenditures (Capex)

• Changes in working capital required to support day-to-day operations. • Helps manage liquidity and ensures business can meet short-term obligations.

Net Working Capital (NWC)

Free Cash Flow • Cash generated after operating expenses, capital expenditures, and changes in working capital • Used to pay down debt and grow equity, crucial for LBO success

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IV: Financial Projections

Financial Projections - Example

Financial projections offer a five-year outlook on revenue, EBITDA, CapEx, NWC changes, and cash flow

1 Revenue Growth: 7% annually 3 EBITDA Margin: 25% of Revenue

1 D&A: 5% of Revenue

2 CapEx: 7.5% of Revenue 4 NWC: 10% of Revenue

2 Change in NWC: 7% increase per year

Year

Year Revenue ($MM)

EBITDA ($MM)

CapEx ($MM)

NWC ($MM)

D&A ($MM)

CapEx ($MM)

Net Income ($MM)

Change in NWC ($MM)

Levered Cash Flow ($MM)

Year 1 1,070 278 80 107

Year 1 83 54 80 7 49

Year 2 1,145 309 86 114

Year 2 107 57 86 7 70

Year 3 1,225 343 92 123

Year 3 133 61 92 8 95

Year 4 1,311 380 98 131

Year 4 164 66 98 9 123

Year 5 1,403 421 105 140

Year 5 198 70 105 9 154

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Section V: Debt repayment

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V: Debt repayment

Understanding Debt Schedule

The role of the debt schedule in managing repayments in an LBO model

• With financial projections in place, the focus shifts towards understanding how cash flows will be used to manage debt effectively, as debt repayment is a critical component in an LBO model, impacting returns and the company’s financial health

Purpose of the Debt Schedule:

• Ensuring that debt obligations are met without jeopardizing the company’s liquidity needs, through a structured plan that tracks mandatory and optional debt repayments.

Mandatory Repayments Optional Repayments

Minimum Cash Balance

Additional payments applied when excess cash is available, allowing for

Cash reserve maintained to cover essential expenses and ensure stability

Fixed payments required by loan agreements that take priority each year

accelerated debt reduction

in operations

By accurately projecting debt repayments, the debt schedule allows us to understand the pace of debt reduction and its impact on overall returns, balancing between leveraging debt and maintaining liquidity

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V: Debt repayment

Breaking Down the Debt Schedule: Understanding Interest, Amortization, and Principal Repayment Key Components

• Bank debt gradually amortizes over time with increasing paydown; In this case Senior Notes act on a fixed principal balance with no amortization • Amortizing debt is repaid gradually over time, lowering both the principal and interest expense, while bullet repayment debt remains unchanged until a lump sum is paid at the end of term

1. Beginning Balance: The amount of debt carried forward from the previous year or initially borrowed

2. Interest Expense: The cost of borrowing, based on the debt balance and rate, decreasing with paydown

3. Paydown: The portion of principal repaid during the period, reducing the outstanding balance

4. Ending Balance: The remaining debt after principal repayment carried forward to the next period

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V: Debt repayment

Debt Schedule - Example

Understanding amortization, bullet repayments, and free cash flow allocation for effective debt management

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Bank Debt

Beginning Balance 1,000 951 881 786 663

Interest 60 57 53 47 40

Paydown 49 70 95 123 154

Ending Balance 1,000 951 881 786 663 509

Sr. Notes

Beginning Balance 500 500 500 500 500

Interest 60 60 60 60 60

Paydown 0 0 0 0 0

Ending Balance 500 500 500 500 500 500

Total Debt

Beginning Balance 1,500 1,451 1,381 1,286 1,163

Interest 120 117 113 107 100

Paydown 49 70 95 123 154

Ending Balance 1,500 1,451 1,381 1,286 1,163 1,009

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Section VI: Exit and Return Metrics

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VI: Exit and Return Metrics

Exit Valuation

The essential role of Exit Valuation in LBO Model

The Valuation offers insight into the projected returns at different exits of the PE firm. It’s outcome influences investment

decisions, by allowing to determine the feasibility, entry price, plan their exit, and benchmark their multiple against the

market.

Exit Equity Value

Exit Enterprise Value

Exit Enterprise Value = LTM EBITDA * Exit Multiple Exit Equity Value = Exit Enterprise Value – Net Debt

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VI: Exit and Return Metrics

Return Metrics

Return Metrics are key financial measures used to assess the profitability and success of an investment

Otherwise known as Multiple on Money (MoM) is a key metric for assessing the return on an investment and evaluating the performance of a fund.

Multiple on Invested Capital (MOIC)

MOIC = Total Cash Inflows / Total Cash Outflows

IRR is the discount rate that makes the net present value (NPV) of an investment’s cash flows equal to zero. In other words, it’s the annualized rate of return expected from an investment.

Internal Rate of Return (IRR)

IRR (%) = (Future Value of CF / Present Value of CF) ^(1/periods) – 1

IRR (%) = MoM^(1/periods) – 1

IRR as a benchmark • IRR can also be used as a conceptual benchmark to guide acquisition process of an LBO. Private Equity firms might target a specific IRR from an investment due to market conditions, risk, or the expected holding period until exit.

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VI: Exit and Return Metrics

Excel Applications

Excel Application: IRR-Function Excel Application: XIRR-Function

• The built-in function “=IRR” allows you to input the array of a periodic cash flow, to calculate a precise value

• For aperiodic (unevenly timed) series of cash flows, the function “=XIRR” will calculate a precise value for the IRR

=IRR(values,[guess¹]) =XIRR(values, dates,[guess¹])

Excel Application: Data Tables for Sensitivity Analysis

Excel Application: Goal Seek

• To determine the acquisition price, that will yield the IRR to equal the desired target, we can use the goal seek feature

• Analysis of how changes in one or two variables impact the resulting IRR

• Data -> What-If-Analyis-> Data Tables • Row Input Cell -> reference variable 1 • Column Input Cell -> reference variable 2

• Set value -> reference IRR cell • To value -> IRR target as a decimal • By changing cell -> reference acquisition price cell

• Settings & Shortcuts:

• This will change the acquisition price to the maximum amount you could pay to still achieve your targeted IRR

• Enable iterative calculation in your settings • Update/Refresh your Table with the following Shortcuts Windows: F9 Mac: Command (⌘) + =

1. guess is a set default of 10%, if omitted

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VI: Exit and Return Metrics

Analysing return metrics at different stages of the investment cycle is a critical step of the decision-making process Exit and Return Metrics - Example

Exit Valuation

Y0 Y5

Y1 Y2 Y3 Y4

EBITDA at Exit ($)

10x

Exit Multiple Assumption ($)

10x 10x 10x 10x

Enterprise Value at Exit ($)

4,210

2,780 3,090 3,430 3,800

1,009

1,451 1,381 1,286 1,163

Less: Net Debt ($)

Sponsor Equity Value ($)

3,198

1,329 1,709 2,144 2,637

Sponsor Equity Value at Entry ($)

1,050

1,050 1,050 1,050 1,050

Cash Flow to Equity

IRR MOIC

Initial

(1,050)

Y1

-

1,329 - - -

4.8% 1.0x

(1,050)

-

- 1,709 - -

Y2

10.2% 1.6x

(1,050)

Y3

-

- - 2,144 -

15.3% 2.0x

(1,050)

Y4

-

20.2% 2.5x

- - - 2,637

3,198

Y5

- - - -

(1,050)

25.0% 3.0x

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VI: Exit and Return Metrics

Sensitivity Analysis - Example

Sensitivity Analysis

In an LBO, sensitivity tables help evaluate how changes in key assumptions, such as entry multiple, exit multiple, or leverage, impact outcomes like IRR or equity returns. They provide a range of scenarios, aiding in risk assessment and decision-making.

Focuses on the absolute return, making it useful for assessing investment profitability without factoring duration.

IRR Table MOIC Table Crucial for evaluating the impact of holding period length and cash flow timing on returns.

Entry Multiple

Entry Multiple

IRR (%) MOIC (x)

9.5x 10.0x 10.5x 11.0x 9.0x

9.5x 10.0x 10.5x 11.0x 9.0x

9.0x

2.9x 2.2x 1.8x 1.5x 4.3x

9.0x

25% 21% 19% 16% 28%

9.5x

3.5x 2.6x 2.1x 1.8x 5.1x

9.5x

26% 23% 21% 18% 30%

10.0x

4.0x 3.0x 2.5x 2.1x 5.8x

10.0x

28% 25% 22% 20% 32%

10.5x

4.5x 3.4x 2.8x 2.3x 6.6x

10.5x

30% 27% 24% 21% 34%

Exit Multiple

11.0x

5.1x 3.9x 3.1x 2.6x 7.4x

Exit Multiple

11.0x

31% 28% 25% 23% 35%