Thursday, December 9, 2010

LBO Model and Valuation Basics

Background
A leveraged buyout (LBO) is a type of business acquisition in which a buyer (typically a private equity partnership) acquires a company and uses debt to finance a significant percentage of the purchase price. 

The proportions of debt and equity capital used to finance LBO transactions depend on a number of factors, including:
  • Credit market and general economic conditions.
  • The historical and forecasted operating performance and management expertise of the company to be acquired.
  • The ability of the acquired company to meet forecasted interest and principal repayment requirements.
  • The market value of the tangible assets to be acquired.
  • The buyer’s appetite for financial risk.
In an LBO transaction, the assets of the acquired company are pledged as collateral for debt, and the acquired company (or a newly formed company containing the assets of the acquired company) is the borrower.  The debt is usually in the form of secured bank loans and, if the acquisition is of sufficient size, subordinated debt provided by investment partnerships.

LBO debt is almost always non-recourse to the business buyer, meaning the buyer is not liable if the debt is not repaid by the borrower.  If the borrower defaults on the debt, the lender(s) may seize the pledged collateral, and debt recovery is limited to the amount realized from the disposal of the collateral.

The LBO form of business acquisition is attractive to business buyers because they need to fund only a fraction of the acquisition purchase price.  This funding strategy reduces the buyer’s at-risk equity investment, and enhances his return on investment, if the acquired company performs as expected. 

If the acquired company does not perform as expected, the debt service requirements of a leveraged capital structure can range from very challenging, to a situation in which the buyer’s equity investment is worthless.

LBO Valuation
LBO valuations use the financial structure and analyses techniques employed by LBO buyers to estimate the value a business.  The valuation presumes the business buyer is a “financial buyer” (for example, a private equity partnership) that owns no other company in the acquired company’s industry and, therefore, expects all of its investment return to result solely from the forecasted performance of the acquired company.   

An LBO valuation is typically built on a five year financial forecast of the acquired company’s operations.  The valuation analysis forecasts the operations of acquired company during the forecast period, the debt and other liabilities repaid during the ownership period, and contains an assumption about the multiple of earnings a business will be sold for at the end of the ownership period.  By targeting pre-tax annual rates of returns on equity and subordinated debt investments consistent with those sought by private investment funds, an LBO valuation estimates  the purchase price a financial buyer should be willing to pay for a business to achieve those returns. 

In general, an LBO valuation estimates the minimum current value of a business since buyers who already own similar businesses, and would benefit from operational synergies with the acquired company, will usually pay more for a given business than will a financial buyer.  These synergistic buyers are also known as "industry buyers". 

An LBO valuation model can emulate industrial buyer pricing by adjusting the financial forecast of the acquired company to fit its revised ownership - generally by increasing forecasted sales and/or reducing costs and expenses of the acquired company due to its ownership by a complementary enterprise. 

Building an LBO Model
For those interested in creating their own LBO model, eHow.com provides a helpful narrative titled “How to Build an LBO Model” (http://www.ehow.com/how_5106647_build-lbo-model.html).  eHow.com is an online community (80 million visitors per month) dedicated to providing practical solutions to completing a huge variety of task.

The eHow instructions indicate “the key elements of an LBO model are the three major financial statements (income statement, cash flow statement and balance sheet) as well as assumptions regarding debt levels, repayment periods and interest rates.”

The narrative suggests the following steps to create an LBO model, using Excel as the software platform:
  • Enter an outline of the company’s capital structure.
  • Build the company’s income statement to the EBITDA level, entering at least three years of historical data for the income statement and then use this data to create five years of projected income statements.
  • Enter three years of historical balance sheet data.
  • Calculate historical balance sheet ratios, and use these ratios to calculate five years of projected balance sheet information.
  • Build the cash flow statement.
  • Create a debt pay-down schedule to determine interest expense.  Link the interest expense figure back to the cash flow statement.
  • Calculate the exit value for the business based on a multiple of year five EBITDA.
  • Use the XIRR formula in Excel to calculate the annual return on investment.  Compare the return on investment to the desired rate of return based on the riskiness of the investment.
  • Make sure that the circular references setting in Excel is enabled. Linking the interest expense back to the cash flow statement will create a circular reference, which Excel will not be able to execute unless it is set to manual calculation.
The instructions indicate that a “basic knowledge of finance and accounting will be very helpful in building an LBO model”... and that the difficulty encountered will be “moderately challenging.”

Corpfin.Net LBO Model
If your objective is to generate LBO valuations, rather than spend your time creating and debugging your own Excel model, our LBO model may be a good fit for you. 

How does our LBO model differ from the (bare-bones) Excel model described above?
  • Our LBO model is one of three applications nested within our five-year financial forecast models.  This “nested” design feature means that once you have completed a five year forecast, you are just a few moments and assumptions away from creating an LBO valuation, supported by 8 comprehensive reports.
  • Our software creates an LBO valuation from the perspective of both a buyer and a seller.  We call these perspectives Cases.  Case 1, the most usual analysis, views the business acquisition from the point of view of the business buyer and solves for the purchase price of the business acquisition, given the buyer’s required pre-tax return on its equity investment.  Case 2 views the business acquisition from the point of view of the seller and computes buyer’s return on its equity investment, given the seller’s target selling price of the business.  In instances where parties disagree about valuation, we find that looking at a transaction from both points of view leads to constructive discussions and negotiations. 
  • Our LBO model makes it easy to create and save multiple valuation scenarios, with different operating forecasts, investment returns and capital structure assumptions, for a same purchase and sale transaction.
  • Our LBO model reports cover not only the business valuation and the details of the estimated purchase and sale transaction, but also the financial performance of the business before and after the sale.  Reports, in both HTML and PDF formats, are as follows:  
    •  A multi-page narrative report that organizes and provides an interpretation of the valuation results.  The report is organized in a manner to help the user logically present and describe the key elements and results of the valuation to a third party. 
    • A comprehensive statistical report that depicts the valuation result and the outcomes achieved by the seller and buyer of the business.
    • The primary financial statements - annual income statements, balance sheets and cash flow statements showing the financial performance of the business prior to and after the purchase by the financial buyer.  We forecast information at approximately the same level of account detail as an accountant’s standard year-end report.
    • A financial assumptions report.  Our LBO valuation model contains 183 assumptions in total (that’s 35 income statement and balance sheet assumptions for each of the five forecast years, plus 8 assumptions relating to the valuation and rate of return objectives of the buyer).
    • Two financial metric and performance reports.  The first report is organized into six management sections (working capital; assets; liabilities; profitability; debt; and bank borrowings).  It contains 43 different metrics for each of historical and forecast years.  The second report is a subsection of the first report, and focuses on debt service metrics that are particularly important to lenders.
If you are looking for an easy-to-use, sophisticated, presentation-oriented LBO model, please consider using ours.  You will save a lot of time vs. creating your own model - you will probably complete your first draft of a valuation, with all of our automatically generated reports, in about the time it takes to format the spreadsheet for a bare-bones Excel model. 

Please see our LBO model tutorial at http://www.corpfin.net/newsite/models/tutorial3.shtml for additional information. 

If you have any questions about our LBO or other corporate finance applications, please feel free to contact me at tgf@corpfin.net. 

If you have a friend who is thinking about buying or selling a business, please send her/him the link to this post.

1 comment:

  1. Knowledgeable information shared by you about LBO Model and Valuation Basics. Get Result Oriented Financial Modeling Examples In Excel from efinancialmodels.com.

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