Leveraged Buyouts and How to Model Them

Introduction

A leveraged buyout (LBO) is an acquisition strategy that companies use to purchase another company using a combination of their own funds and debt financing. The introduction of LBO modeling has increased the complexity and scope of financial analysis of a potential buyout process, which requires a close examination of a range of factors and key components.

LBO modeling is a process of analyzing the available financial data and assumptions to understand the full implications of a leveraged buyout. This can include determining the financing costs and factoring in the returns. There are several benefits to undertaking an LBO transaction, such as improving operational performance and realizing strategic value.

Definition of Leveraged Buyouts

A Leveraged Buyout (LBO) is the process of acquiring a company by taking out a loan, or multiple loans, that is secured against future earnings and assets of the company. The company is then purchased with a combination of the loan and equity. LBOs are often used in private equity transactions and are seen as a way to maximize returns while minimizing risk.

Overview of LBO Modeling Process

LBO modeling involves creating a financial model that evaluates the projected financial performance of the company being purchased. The model is used to analyze the cash flow of the company's financials, the debt financing required to complete the buyout, and business projections for the new company. LBO modeling is typically used to assess the viability of an LBO transaction and to identify the potential returns and risks associated with the transaction.

Key Components of LBO Modeling

LBO modeling requires analyzing a range of key components to understand the full implications of a leveraged buyout.

• Projected financial performance of the company being purchased
• Debt financing required to complete the buyout
• Business projections for the new company
• Costs and risks associated with the LBO
• The potential returns and impacts on stakeholders

Benefits of Leveraged Buyouts

There are several benefits to undertaking an LBO transaction, such as:

• Potential returns on investment
• Reducing debt burden and improving operational performance
• Realizing strategic value for stakeholders
• Reducing risk by transferring debt obligations to lenders
• Increasing exit options for shareholders

Assumptions That Underlie LBO Modeling

Leveraged Buyout (LBO) modeling is a process used to evaluate the potential value of a company. It involves creating a financial model to assess the sources of funding for the acquisition and project the potential financial and cash flow performance. Understanding the assumptions that underpin the model are key to being able to accurately assess the value of a company.

Assumptions Made About Sources of Funding

LBO models make a number of assumptions regarding the sources of funding for the acquisition. These include the amount of debt used, the cost of capital associated with various forms of debt and equity, and the source and cost of any additional equity. These assumptions are based on the expected value of the company, which is reliant on the expected cash flow performance and available investors.

Assumptions Made About Exit Multiple and Timing

LBO models also assume the exit multiple and timing of an equity sale. This usually reflects the expectations of the investors, given the expected cash flow performance and the current market conditions. The timing of the sale is particularly important, as it affects the overall value of the investment and can have an impact on the return on investment.

Assumptions Made About Interest Rate & Cost of Capital

Finally, LBO models make assumptions regarding the interest rate and cost of capital. This will depend on the investor risk profile, the debt structure and the available financial products. The cost of capital is especially important, as it directly affects the expected return on investment.

• Cost of capital is a key factor in determining the expected return on investment.
• The expected exit multiple and timing should reflect the expectations of the investors.
• The sources of capital should reflect the expected value of the company.

Gathering Data for the Model

An LBO Model is built upon the company's financial statements and external assumptions to project a binding estimate of the enterprise value. Thus, the first step in building an LBO Model is gathering all the necessary data. Depending upon the analyst’s objectives, data can comprise of historical financials, financial projections, offering memoranda, and transaction comparables. Historical financials paint the picture of the company’s recent performance and brings underlying assumptions to light.

Creating Balance Sheet Accounts

Once the data is collected, the next step is to create balance sheet accounts. Balance sheets are a snapshot of the company’s financial position. They are divided into three main categories: Assets, liabilities, and owners' equity. Assets include items like property and equipment, accounts receivable, and cash and cash equivalents. Liabilities include items like debt, accrued expenses, and accounts payable. Owners' equity is the total remaining value of the company's assets after liabilities are deducted. Analysts can customize balance sheet accounts as per their needs.

Constructing Cash Flow Statement

The third step of the process is constructing a cash flow statement. A cash flow statement records the inflows and outflows of the company’s finances. It is divided into three main sections: Operating activities, Investing activities and Financing activities. Operating activities include the company’s core operations such as sales, COGS, administrative expenses etc. Investing activities include activities such as capital expenditures and sales of investments. Financing activities include activities such as debt payments and stock repurchases.

Calculating Leverage

After constructing balance sheets and cash flow statement, it’s time to calculate leverage. Leverage is an important factor in an LBO Model because it affects the company’s cost of equity. There are various methods to measure leverage such as debt-service coverage ratio, debt-to-equity ratio and debt-to-EBITDA ratio. These ratios take into consideration the company’s debts and recent cash flows.

Analyzing Equity Value

Finally, analysts calculate the equity value by assessing the amount of economic value that is theoretically available to shareholders after debt is paid off. Equity value can be determined using two approaches: Free cash flow and Adjusted EBITDA. In free cash flow approach, analysts can compute predicted enterprise value by removing the company’s capital expenditures and debt payments from the expected cash flows. In adjusted EBITDA approach, analysts determine enterprise value by subtracting total debt from the company’s EBITDA.

Analyzing Leverage Buyouts

Calculating the return on a Leverage Buyout (LBO) requires an analysis of factors such as EBITDAD, Free Cash Flow to Debt (FCFD), and the distribution of gains among parties. In an LBO investment, the risk is relevant to the debt burden. It is important to consider each of these aspects of a leverage buyout when evaluating the potential return.

Calculation of Return for LBOs

The return on a leverage buyout is the excess of the value of the equity over the purchase price of the equity. This can be expressed as a return on capital of Equity/ (Debt + Equity). A higher return on capital is indicative of a greater return for shareholders. Calculating a return on an LBO also requires consideration of other factors such as the cost of debt and the repurchase of debt.

Analyzing Earnings Before Interest, Taxes, Dividends & Depreciation (EBITDAD)

EBITDAD (earnings before interest, taxes, dividends, and depreciation) is a measure of profitability that excludes certain costs. It is important in the analysis of an LBO because it provides an indication of a company's ability to generate cash. By doing an EBITDAD analysis, investors can better understand the potential returns on an LBO.

Analyzing Free Cash Flow to Debt (FCFD)

Free cash flow to debt is a measure of a company's ability to generate free cash flow. Companies use free cash flow to repay debt, and by calculating a company's FCFD investors can more accurately assess their risk in a potential LBO. To calculate FCFD, investors must subtract the company's capital expenditure from its operating cash flow.

Seeing Who Benefits

In an LBO transaction, the benefits are divided among multiple groups, such as the owners of the equity, the lenders, and the company itself. It is important to understand how each party benefits from an LBO as this will impact the potential returns. Additionally, it is important to consider the costs associated with the LBO, such as the interest payments and the cost of borrowing the money.

Limitations of LBO Modeling

Leveraged buyout (LBO) models are useful tools for entrepreneurs and investors to understand the dynamics of a business acquisition. The model helps to assess the returns of a leveraged buyout, by projecting the expected cash flows of the target entity. However, LBO models also have various limitations, which can negatively affect the accuracy of the projections.

Limitations of Assumptions

LBO models are built on a series of assumptions about the future of the company, its growth and its ability to pay debt. If any of these assumptions prove to be inaccurate, the projections and conclusions of the model become less reliable. Additionally, the LBO model assumes a certain debt/equity ratio and cost of capital, which can have an effect on the calculation of returns. These assumptions can easily be overridden, but it is important to keep in mind that the model's accuracy relies heavily on their accuracy.

Limitations of Modeling

The LBO model assumes a certain 'static' state of the company, based on its current financials and projections. However, in practice companies are highly dynamic, and the LBO model does not provide the full picture. Additionally, LBO models does not factor in any non-financial elements of the investment, such as the competitive landscape, government regulations or technological developments, among others.

Limitations of Data

The accuracy of a LBO model depends largely on the quality of its inputs. If a company's financials are inaccurate or incomplete, the results obtain from the model will suffer. Additionally, LBO modeling requires detailed data on the company, such as balance sheets, sales and costs. If any of these inputs is not available, the accuracy of the model further decreases.

• Using reliable and up-to-date data is paramount for obtaining accurate results.
• Being aware of the limitations mentioned above will help to decrease the likelihood of errors when using a LBO model.

Examples of Successful LBOs

The leveraged buyout (LBO) is an incredibly complex transaction, and many firms have managed to pull off successful deals. Here, we will look at three such firms and their accomplishments.

Vista Equity Partners

Vista Equity Partners is amongst the fastest-growing private equity firms in the United States. It specializes in software-driven investments and operational improvements. Vista Equity has successfully completed numerous LBOs, such as the acquisition of SmartBear, SumTotal Systems, and JD Edwards.

Apollo Global Management

Apollo Global Management is a major private equity firm established in 1990. It employs a full range of investment strategies and has acquired or invested in over 200 companies. Notable LBOs include Claires Accessories, Realogy, and Ticketmaster.

Thoma Bravo

Thoma Bravo is one of the largest private equity firms in the US, with a focus on software, financial services, and healthcare. The firm has managed multiple large-scale LBOs, such as Qlik, Dynatrace, and SunGard.

Conclusion

Leveraged Buyout (LBO) Modeling is a method used by financial professionals to analyze the feasibility of a potential buyout of a target company and to assess potential value creation opportunities. This analysis typically involves the use of financial models and sophisticated software to evaluate the potential purchase price and capital structure of the transaction. The objective of this introduction was to provide an overview of LBO Modeling, including its components and the modeling process.

Summary of Introduction to LBO Modeling

This introduction has covered the following topics:

• Components of an LBO Model
• The Modeling Process
• Validation Tools and Techniques

Overview of the Modeling Process

The LBO Modeling process includes the following steps:

• Determine the target company's market value
• Identify potential acquisition sources and available financing options
• Calculate the purchase price and capital structure required to meet the target's return criteria
• Develop a plan to optimize capital structure
• Simulate the transaction and its outcomes
• Evaluate the performance of the investment over time

Benefits & Limitations of LBO Modeling

LBO Modeling provides valuable insights into the potential success of a target company's buyout. It allows financial professionals to analyze the target company's financial metrics, as well as the various scenarios and capital structures that may be beneficial to the target company. However, LBO Models can be complex and require specialized knowledge and experience to interpret the results accurately.