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What Is An LBO Model? Basics, Structure, Steps, FAQs, More

What Is An LBO Model? Basics, Structure, Steps, FAQs, More

LBO model

The word Leveraged Valuation model (LBO model) is a pretty dense word and there is a myriad of speculations hovering around it. Yeah, it’s a heavy and conceptual term. However, this term lies behind the billion-dollar deals companies are placing every year. As per the latest statistics, 30+ big, medium, and small LBO deals take place every year on average.

Read the guide till the end to understand how the LBO modeling words.

What Is An LBO Model?

According to WallStreetMojo’s LBO model definition, LBO modeling is used for valuing a leveraged buyout transaction. Here the target company is acquired using a huge amount of debt. This high leverage usage augments the long-run potential returns on the investors’ equity investments.

Excel allows for building an LBO model to help the investors evaluate the transaction. In addition, it’s possible to understand the highest risk-adjusted internal rate of returns (IRR).

How Does An LBO Model Work?

HOW DOES LBO MODEL WORK

Now that you know What Is An LBO Model, we are here with How Does An LBO Modelling Work.

  • LBO Model Template is somewhat similar to a DCF analysis with some common calculations like terminal value, cash flows, discount rate, and present value.
  • LBO analysis is basically about looking for the Internal Rate Of Returns (IRR). It also focuses on the cash flow, interest payments, and debt principal of the company.
  • The entire concept of this model is pretty simple: Purchase a firm > Fix It Up > Sell It. When a private equity firm targets a company, it buys, fixes it up, and mitigates the debt. Post that, it sells the company for gaining larger profits.

Steps In The LBO Analysis

Following are the crucial steps to building an insightful and detailed LBO model:

1. Assumptions

Before creating the LBO model, you must make an assumption about all forms of input. This includes sources, operating metrics, cash usage, operating scenarios, and purchase price allocation.

2. Financial Statements

After making all the assumptions, construct the different kinds of financial statements – Income statement, balance sheet, and cash flow statement. Moreover, depreciation schedules and working capital will calculate the line items.

3. Transaction Balance Sheet

A transaction balance sheet will depict the proforma balance sheet items after the recapitalization. It lays out the summative adjustments and the business capital structure after the completion of the LBO transaction.

4. Debt And Interest Schedules

As soon as the transaction balance sheet is complete, the debt and interest schedules model entails several layers. This consists of large or small business term loans, subordinated debt, line of credit, etc.

5. Credit Metrics

The credit metrics basically assess the repayment profile taking a look at how organizations can service the debt obligations. Actually, the line of credit includes the repayment of interest and principal.

6. DCF And IRR

Here, the step of creating a DCF model comes with a set of forecasted data. Calculate the free cash flows for every type of investor. Then using it, find out the IRR and Net Present Value (NPV) considering the types of investors.

7. Sensitivity Analysis

After the creation of the DCF model comes the sensitivity analysis. It will assess how the impacts of changes in the various independent variables will affect IRR.

Capital Structure In An LBO Model

Capital Structure in an LBO Model Excel refers to the financial components meant to purchase a targeted company. A typical capital structure in an LBO Valuation Model in focusing on lesser risky and cheapest options.

The structure involves:

1. Bank Debt

Bank debt is the cheapest financing Instrument. It acquires the targeted LBO company and accounts for 50-80% of the capital structure. 

2. High Yield Debt

High yield debt is a stacked debt carrying a high-interest rate compensating the investors for putting their money at risk.

3. Mezzanine Debt

Mezzanine debt lies in the middle in the simple Simple LBO Model capital structure. It’s a hybrid of equity and debt and subordinate to remaining debt financing options.

4. Equity

It accounts for 20-30% of the LBO Valuation Model based on the deal representing the private equity fund’s capital. Because of the risks involved, it attracts high-interest rates.

5. Credit Metrics

You’ll have to make sure that the debt covenants and the credit metrics are ideal for the deal. The primary credit metrics of an LBO model are: Interest Coverage Ratio, Debt/EBITDA, Debt Service Coverage Ratio, and Fixed Charge Coverage Ratio.

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6. Sponsor IRR

The final and last constituting element of the model is determining what IRR means for the sponsor. By calculating both the unleveraged and leveraged return rates, this model LBO Model Excel evaluates the benefits of leverage. In this regard, the alphabetization in excel comes into great use.

Principal Characteristics Of The Target Company (LBO Candidate)

Here are the features that the target company has to meet for becoming an LBO candidate:

  • It has to be from a strongly developed sector
  • The company must have a clean balance sheet with low or nil outstanding debt.
  • It must have strong cost-reduction measures and a steady management team.
  • There have to be feasible and non-complicated exit-options
  •  Low future CAPEX needs
  • A robust market position and strong competitive advantages
  • Selling some poor-performing non-core assets.

Frequently Asked Questions (FAQs):

Q1. How Does A LBO Work?

A Leveraged Buyout is the acquisition of one company using a large amount of the borrowed loans or bonds to meet the acquisition cost. 

Q2. What Is The Difference Between DCF And LBO?

A DCF model estimates the value of an investment on the basis of the expected future cash flows. On the other hand, the LBO model template is a specialized financial tool built-in Excel for evaluating an LBO transaction. 

Q3. Why Do LBOs Use Debt? 

In simple words, debt raises the possibility of expected returns to private equity firms or in other words, PE firms. 

Q4. How Does An LBO Create Value?

In LBO transactions, value is created in 3 different ways. Debt expansion, multiple expansion, and operational improvements. 

Summing It Up

To sum up, the LBO model is nothing but the perfect amalgamation of high debt and equity. If you are attempting to determine the purchase price of a flourishing business or company, go for a simple paper LBO model.

Any questions? Shoot them in the comment area below.

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