By Victor Paquet (Mergersight Operations) and Carlo Lepoardi & Tommaso Arona (Boston University partners)
Walkthrough
A Leveraged Buyout (LBO) model is a financial analysis of the projected returns on a predominantly debt-funded acquisition of a company, division, business or collection of assets (at least 60-70% debt usually).
It is most commonly used by private equity firms to analyze how they can use the future cash flows of a target company to pay off debt used to finance a takeover, while still expecting a return on their investment. The same core mechanics of an LBO can be applied to minority investments, full takeovers, levered recaps, and other structured investments.
Additionally, it is important to note that the pre-acquisition capital structure of the target does not affect the model.
Sources of capital fall on a spectrum between debt and equity. PE firms try to maximize the amount of debt used in a transaction as it is cheaper than equity considering that interest expenses are tax-deductible and debt shareholders are higher on the capital structure than equity shareholders, making lenders’ risk and expected return lower.
Lowering the cost of financing allows PE firms to buy much larger companies as it reduces the amount of equity needed, consequently increasing the return on investments. However, excessive debt can increase the risk of default on debt-related payments. Thus, PE firms will be looking to invest with a mixture of debt and equity in companies with a track record of stable cash flows to maximize the use of debt while minimizing the risk of default.
1 - Determine Transactions Assumptions
What entry multiple is being used? What is the entry enterprise and equity value of the target? How much debt and equity are being used to buy the target? This information should be synthesized in your Sources & Uses section of your LBO.
2 - Determine Future Cash Flows
Determine how much cash flow the business is generating? This includes forecasting revenue down to cash flow for the investment time horizon (typically 3-7 years).
3 - Calculate Debt Pay-Down and Returns
How much of the cash flow generated is going to pay-down during the forecasted period? What is the exit multiple used? What is the exit enterprise and equity value?
IRR and MoM
Two common metrics are used to measure the profitability of a leveraged buyout: IRR (Internal Rate of Return) and MoM (Multiple of Money).
IRR calculates the average annual return on an investment, it is equivalent to an investment’s CAGR. Mathematically, it is the discount rate that makes your future cash flow’s NPV (Net Present Value) equal to zero. Despite being a great metric, it is highly sensitive to timing, and should be used in conjunction with another metric like MoM.
MoM is simply calculated by dividing the total final proceeds by the total initial investment (total inflow / total outflow). MoM disregards the time value of money, thus should be used only in conjunction with IRR.
Exit - Key Lever - Investment Banks
PE firms will aim to exit the target via an IPO, a strategic buyer, or another PE firm’s acquisition. Typically, seeking for a 20%+ IRR for the given time horizon, implying an average annual growth of 20% on the PE’s initial equity investment.
Key LBO levers that will improve returns include EBITDA growth (growing revenue and cutting costs), debt raising and pay-down (ensuring consistency in cash flow, refinancing debt at cheaper rates, paying down debt throughout the investment period), and multiples expansion (building a higher quality business or investing in markets that will trade at higher valuations).
Investment bankers will use LBOs to show their clients what the terms or potential returns of a transaction will look like.