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2. How to Build a LBO Model
To build the financial model for our LBO transaction, we're going to follow a simple 5-stage process that I'll explain in this lesson.
Lesson Goal (00:00)
The goal of this lesson is to learn about the steps involved in building an LBO model.
Steps in Building an LBO Model (00:04)
This course follows a five-step process for building a leveraged buyout model. These steps are as follows:
- Enter transaction assumptions
- Create a Source and Uses table
- Build a Debt Schedule
- Calculate projected cashflows
- Analyze key metrics and returns
1. Enter Transaction Assumptions (00:32)
In an LBO, the funds required are often different to the purchase price, due to the impact of items like fees and equity rollovers. In this step, we identify all these relevant items to determine the funds required to complete the transaction. We also include the debt terms in this step.
2. Create a Sources and Uses Table (01:02)
A Sources and Uses table identifies all the different sources of funding for the deal, such as equity providers, debt providers, and different forms of debt. It then identifies what these funds will be used for. The total sources and total uses should balance in this table.
3. Build a Debt Schedule (01:34)
A debt schedule identifies the interest payments and principal payments due each year on the debt. This can be complex when multiple forms of debt are involved. The debt schedule may include optional payments, such as early repayments of some loans.
4. Calculate Projected Cashflows (01:58)
Debt repayments will significantly affect projected cashflows. As a result, we need to modify the projected Income Statement and Statement of Cashflows to include debt repayments. This will reduce the company’s cashflows substantially. We will need to monitor projected cash balances closely to ensure the transaction is viable.
5. Analyze Key Metrics and Returns (02:23)
Finally, we calculate various key metrics for the transaction and the company. We want to analyze the company’s ability to repay debt while maintaining liquidity, and we want to analyze the return from the LBO to the investors. We also want to perform a sensitivity analysis on our findings.
In this course, we're going to adopt a five-step process in building our leveraged buyout model. The first step is entering the transaction assumptions. We'll then create a sources and uses table, build a debt schedule for our different types of debt, calculate the projected cash flows given this new debt on the Balance Sheet and then analyze the key metrics and returns for the investor. Let's start with entering our transaction assumptions.
The key point to bear in mind when entering transaction assumptions is that the funds required to complete a deal are often different to the headline purchase price. Items such as fees and equity rollovers can have a significant impact in creating this difference. In addition to these items, we'll also include the debt terms in this part of the model. Once we've entered our transaction assumptions, we can create a sources and uses table, and this table outlines all the different sources of funding for the deal. This could include multiple equity providers and multiple debt providers using various types of instruments, from subordinated debt to revolving loans.
In all cases, the total amount of sources should balance against the total uses of cash.
Next up is the debt schedule. The debt schedule simply calculates the amount of interest and principal due each year for the target.
As you can imagine, this can become quite complex when multiple debt instruments are involved and it may often include optional early repayments on some of this debt. Once the debt schedule has been created, we can project our new cash flows, and as you'd expect, the debt schedule needs to be incorporated into the Income Statement and the statement of cash flows.
In LBOs, large amounts of debt will always reduce cash flows substantially, and the overall cash balance in the company will also need to be monitored. Lastly, once our projected cash flows have been calculated, we can analyze the key metrics and returns for the business over the projected period.
In this course, the key metrics will relate to the ability to repay debt and will focus on liquidity ratios, such as the debt service coverage ratio. When analyzing returns, we will look at both IRR and a money-on-money multiple, which is very popular among private equity firms. And needless to say, we'll also be performing some sensitivity analysis on these returns.
Let's get started now in the next lesson on the first stage of building our buyout model with entering transaction assumptions.