Leverage Buyout Models (LBO)
yedlu, Winter 2024
Overview
Definition: Acquisition of a company primarily using debt, with the remaining portion funded by equity from financial sponsors (e.g., private equity firms).
Goal: Generate high returns (IRR > 20%) upon exit, typically within 5-7 years, via sale or IPO.
Drivers of Success:
- Effective use of leverage to amplify equity returns.
- Operating improvements, cost reductions, and strategic repositioning.
- Effective use of leverage to amplify equity returns.
Sources and Uses of Funds Table
- Purpose: Tracks how the deal is financed and where the funds are allocated.
- Structure:
| Sources | Uses |
|---|---|
| Senior debt | Equity purchase price |
| Subordinated debt | Refinancing of target debt |
| Sponsor equity contribution | Transaction fees |
| Revolving credit facility | Financing fees |
Key Considerations:
- Ensure that sources = uses.
- Include all transaction costs (e.g., financing fees at 1% of debt, transaction fees at 1.5% of equity purchase price).
- Ensure that sources = uses.
Post-Closing Balance Sheet
Adjustments:
- Write off target’s existing equity accounts.
- Record new debt and equity contributions.
- Add goodwill and intangible asset write-ups.
- Capitalize financing fees and amortize them over debt maturity.
- Write off target’s existing equity accounts.
Example:
For a $1,000M transaction with $600M debt and $400M equity:- Add $600M debt (senior + subordinated).
- Reduce retained earnings for transaction fees.
- Record goodwill:
\[\text{Goodwill} = \text{Equity Purchase Price} - (\text{Net Assets} + \text{Write-Ups})\]
- Add $600M debt (senior + subordinated).
Debt Schedule and Cash Flow Assumptions
Debt Hierarchy:
- Senior Debt: Includes term loans and revolvers. Priority repayment with lower interest.
- Subordinated Debt: Higher interest, paid after senior debt. Often includes Payment-In-Kind (PIK) features.
- Senior Debt: Includes term loans and revolvers. Priority repayment with lower interest.
Key Concepts:
- Cash Sweep: Excess cash flow is used to repay debt, starting with revolvers.
- Revolver Mechanics: Borrow to cover shortfalls; repay first when cash becomes available.
- Debt Plug: Balances cash flow using revolving credit or excess cash.
- Cash Sweep: Excess cash flow is used to repay debt, starting with revolvers.
Formulas:
- Revolver Drawdown:
\[\text{Revolver Borrowing} = \max(0, \text{Cash Deficit})\]
- CADR (Cash Available for Debt Repayment):
\[\text{CADR} = \text{CF from Operations} + \text{CF from Investing} - \Delta \text{Cash}\]
- Revolver Drawdown:
Internal Rate of Return (IRR) Analysis
Definition: Measures the annualized return on equity investment, accounting for cash inflows and outflows.
Calculation: \[\text{IRR} = \text{Discount Rate such that } \sum_{t=0}^n \frac{\text{CF}_t}{(1+\text{IRR})^t} = 0\]
Drivers of IRR:
- Entry and Exit Multiples: The purchase price and selling price relative to EBITDA.
- Leverage: Amplifies returns by minimizing equity contribution.
- Operational Performance: EBITDA growth and cost efficiencies.
- Entry and Exit Multiples: The purchase price and selling price relative to EBITDA.
Example:
Entry price = $500M, exit price = $800M, equity contribution = $200M.
IRR = 25% over 5 years with positive cash flows annually.
Key Financial Metrics and Benchmarks
- Leverage Ratios:
- Senior Debt/EBITDA ≤ 3.0x.
- Total Debt/EBITDA ≤ 5.5x.
- Senior Debt/EBITDA ≤ 3.0x.
- Coverage Ratios:
- EBITDA/Interest Expense ≥ 2.0x.
- (EBITDA - CAPEX)/Interest Expense ≥ 1.6x.
- EBITDA/Interest Expense ≥ 2.0x.
- Other Constraints:
- Equity Contribution/Total Capital ≥ 25%.
Sensitivity Analysis
Purpose: Assess how changes in key variables affect IRR.
Key Drivers:
- Exit multiples and timing.
- Leverage levels.
- Revenue growth and margins.
- Exit multiples and timing.
Example:
Analyze IRR for exit multiples ranging from 6x to 8x EBITDA and exit years from 4 to 6 years.