2. How to Build a LBO Model

 
Subtitles Enabled
Replay Lesson

Next lesson: Transaction Assumptions Part 1

Watch next lesson
100%

Overview

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 Notes

5-Step Process to Building a LBO Model

1. Enter Transaction Assumptions
2. Create Sources and Uses table
3. Build a Debt Schedule
4. Calculate Projected Cashflows
5. Analyse Key Metrics and Returns

1. Enter Transaction Assumptions

- Transaction assumptions help determine the actual funds required to complete the transaction
- Fees and Equity Rollovers can mean that the funds required are very different to the declared price
- Debt terms will also be entered in transaction assumptions

2. Sources and Uses Table

- Outlines all the sources of funding for the deal
- Total amount should balance against the total uses of cash

3. Build a Debt Schedule

- Calculates the amount of interest and principal due each year
- Can become complex when multiple debt instruments involved
- May often include optional early repayments

4. Calculate Projected Cashflows

- Debt schedule needs to be incorporated into existing cashflow calculations
- Interest will reduce income tax liability but principal payments will not
- Overall, a significant drop in cashflow expected due to new loans

5. Analyse Key Metrics and Returns

- Key metrics in this course will relate to ability to repay debt
- Returns will include both IRR and a Money-on-Money multiple
- We will also be performing some sensitivity analyses on these returns

Transcript

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.