LBO modeling

LBO Introduction

In this post, I'll try to explain the mechanics of LBO modeling and provide you with the excel model and presentation that I had created for one of the competitions during my B-School. (Files are at the end of the post). 

The main idea is that private equity companies are looking to invest in certain companies via a mix of equity and debt (debt is generally about 70%-80%) to make high returns. Most PE firms specialize in a few industries and try to make investments within the same. But at the end of the day, the main goal of a PE firm is to stay invested for 3-5 years, make some good returns (IRR) and move out.

I would strongly recommend reading this article if you are completely new to LBOs.

Case Overview:

Now I'll briefly explain the problem statement that was given-

A Private Equity firm (HNZ Capital) is looking to invest in one of the three companies via the LBO route. The three companies are:

• Flowserve
• Treehouse
• ASGN

Question Set-

1. Which company should HNZ Capital select for the LBO and why ?
2. Explain the industry landscape for the selected company
3. Perform a detailed LBO model to understand the IRR, sources and uses of fund etc.

Solutions-

How to select the right company for a LBO? 

Mainly you look for the following characteristics for an LBO candidate-

1. Stable companies with good cash flows
2. Ability to improve on the EBITDA margins
3. Low CAPEX requirements
4. Strong competitive advantages

You can check this article that gives more details on why the above conditions are required. Now, I will try to apply these principles on the three companies given in the case. You can check the below slide (12th slide in my PPT) to understand the reasons behind selecting Flowserve and rejecting other companies.

The excel tab 'Comparative Analysis' in the model has all the calculations that will support my thesis.

The LBO Model

To get started, you need to chalk out the assumptions that will be used in the deal. In the model, I have considered the following -

Entry multiple and premium paid - 

• Entry multiple means at what valuation does the PE company invest? --> Here, I have taken it as the average of all the peer companies (@14.4x) 
• The entry multiple implies as Enterprise value of $6,189mm and a premium of 14.4% to the current share price.  
• One way to verify whether the multiple makes sense or not is to check the premium paid. If it turns out to be very high (say >50%), you need to rethink the entry multiple. Also negative premium is not very common as the seller would want to sell the stake at some premium atleast!

How to structure the transaction? i.e. how much debt/equity?

• Remember that a PE firm generally invests very less amount in terms of equity. Mostly you will find debt in the range of 70% to 80% . Again go back to the basics here to understand why this is necessary.
• To calculate how much debt is possible for the LBO, you need to get the current Debt/EBITDA  of the company. Say it is 2x. Then it is considered that the maximum Debt/EBITDA ratio for an LBO is around 7x (or maybe 8x). So you can borrow the differential amount [(8x-2x)*EBITDA] as the extra debt for the deal.
• The remaining amount is funded via equity by the PE firm. Again there is no hard and fast rule here. These assumptions vary deal to deal.

            

Sources and Uses Table

• Sources section denotes how much amount was raised and via which instruments?
• Uses section shows how the raised amount is used up i.e. how much is used in paying for the stake acquisition? How much for the deal advisory fees etc.
• Here's a snip from my model (Refer to pg 7 in the PPT)

Income Statement Projections

• Next, you need to build out the income statement for the company. Generally, PE firms may invest for upto 8 years. So its a good idea to draw out projections till 8th year. 
• Try to keep the income statement simple and focus on EBITDA numbers. You can refer to 'Feeder' tab to understand the assumptions used

Cash Flow Projections

• The key to build an LBO model is to understand how the cash flows are generated and how the debt paydown occurs. You need to build out a cash schedule based on the income statement above. Remember that you the company is highly leveraged now with 8x debt. The debt needs to be paid down with interest. 
• The main idea is to understand how much additional cash the company is able to generate via its operations. The higher the cash available, the easier it is for companies to pay down the debt taken. This is the reason why we select stable and cash flow generating companies for LBO. 
• Starting from EBITDA, you need to deduct all the mandatory payments that the company has o pay (ie taxes, CAPEX needs, interest etc.). Post this, you will reach the actual cash that is left for debt servicing.
• What is minimum cash balance? --> To operate, a company will will need some amount of cash in the bank. That is why you cannot pay out the entire cash that is left. You need to remove the minimum cash. The rest can be used for debt servicing.

Debt and interest schedule

• This section simply keeps a tab on the debt that the company has paid down and how much interest is paid
• There are two types of repayment - mandatory and optional. Mandatory repayments have to be made each year, while optional repayments are made if you have some extra cash flow to pay down the debt. Its just like prepaying a loan even though it is not due.

Calculating investor Return

• This section that calculates how much return the PE firm will make over the years and whether it makes sense to enter into the investment
• Generally PE firms target a high IRR(>20%). There is another term called 'Money on Money' multiple. It simply calculates how many times the initial investment will be worth at exit. Ex: a 2x MoM means the PE firm doubled its money over the course of the investment.

 

Final Model and Presentation

• Presentation Link
• LBO Model Link