Walk me Through an LBO Model – Interview Question
Building a Leveraged Buyout (LBO) model is a fundamental skill in private equity. It is highly likely that candidates being interviewed for a role in this sector will be asked to explain some of the concepts within an LBO model. Here’s a structured guide to the mechanics of constructing an LBO model, which covers the modelling steps succinctly and in order.
Step 1: Calculate the Implied Entry Valuation
The first step to building an LBO model is to calculate the implied entry valuation based on the entry multiple and the last 12 months (LTM) EBITDA of the target company.
Example Calculation:
Entry Multiple: 5.0x EV/EBITDA
Last 12 Months EBITDA: $756m
The implied entry valuation is calculated by multiplying the entry multiple by the EBITDA. This gives you the initial valuation of the company at the time of acquisition.
In this case 5.0 EV/EBITDA x $756 EBITDA = $3,780 Enterprise Value.
The entry valuation will form the basis for the analysis of cash flow generation, returns and exit strategy.
Step 2: Create the Sources and Uses Section
Next, the sources and uses section will lay out the proposed transaction structure highlighting firstly where funds will come from to support the deal (Sources) and secondly what it will be spent on (Uses).
Sources
The sources side will detail how the deal will be funded. This includes the equity contribution, debt financing, and any other financial instruments.
Most importantly, the key question being answered here is: What is the size of the equity stake that the financial sponsor must contribute once you’ve got the sources and uses table?
Uses
The uses element will calculate the total amount of capital required to make the acquisition. This includes the purchase price, transaction fees, and any refinancing of existing debt.
In our example it would be the $3,780 EV plus any other costs such as corporate finance and legal fees plus any debt refinancing set-up costs.
Step 3: Project Free Cash Flows (FCFs)
The next step will be to create operating forecasts for the company and derive how much FCF is generated which can then be used to service debt. Analysts will need to include the revenue growth rate, operating margins, interest rates on debt, and tax rates.
The FCFs generated are central to an LBO as they determine the amount of cash available for debt pay down and the interest expense due each year. Analysis and forecasting must be prudent and look at maximising the cash available to service debt once other obligations have been paid.
Step 4: Determine Exit Assumptions
In the final step, the exit assumptions of the investments are made. This includes the exit multiple and the date of exit. Some investment funds will have a target time-period such as a 5-year exit, but this may change depending on the finances of the purchased company. Ideally exits are well-planned and swiftly executed to that deals and expected returns remain on target. The exit multiple will be based on peer group performance and multiples or any companies similar in size and operations.
The total proceeds received by the private equity firm are then used to calculate the IRR and cash-on-cash return with a variety of sensitivity tables. It is important to look at upside and downside sensitivity to the exit multiple and cash flows to determine if the deal is attractive or not.
Conclusion
This question is typically asked to ensure that any candidate seeking to join a private equity firm understands how a buyout works. Essentially, this explanation should link the purchase price with the returns expected. It can be explained in many ways to highlight this relationship.
The candidate must be able to concisely summarize the mechanics of an LBO model without getting lost in detail. If interviewees are looking to go an extra step, they can explain some more about where their assumptions came from and the use of debt in the capital structure. However, this may make the answer overly long.
Understanding these steps ensures that you can succinctly describe how an LBO model is put together and what the important parts are, demonstrating a clear understanding of the process and its components.
Common Pitfalls to Avoid
1. Overcomplicating the Explanation
While it’s important to show a deep understanding, overloading the explanation with excessive details can be counterproductive. Keep it concise and to the point.
2. Ignoring Assumptions
Assumptions are the backbone of your projections. Be clear about your assumptions regarding revenue growth, margins, interest rates, and tax rates. Unclear or unrealistic assumptions can undermine the credibility of your model.
3. Neglecting Sensitivity Analysis
Failing to include sensitivity analysis can be a major pitfall. Sensitivity tables help in understanding how changes in key assumptions affect the returns, which is crucial for assessing the investment’s risk and potential.
4. Misunderstanding Debt Structure
An LBO heavily relies on debt. Misunderstanding the types of debt, interest rates, and repayment schedules can lead to inaccurate projections and unrealistic models. Ensure you have a firm grasp of how debt is structured in an LBO.
5. Forgetting the Big Picture
It’s easy to get lost in the details and forget the overarching goal: linking the purchase price with the expected returns. Always keep the big picture in mind to ensure your explanation remains focused and relevant.
By understanding these steps and avoiding common pitfalls, you can confidently walk through an LBO model, demonstrating your capability to evaluate and communicate investment opportunities effectively.
Additional Resources
Financial Modeling Interview Questions