WSP Red Book: LBO Modeling

Walk me through the mechanics of building an LBO model.

1. Entry Valuation based on ltm EBITDA and entry multiple. or, price per share for a public

2. Sources and Uses table including fees, equity that needs to be bought out, and debt that needs refinancing. Then, the amount of sources needed to meet this obligations will be determined

3. FCF Build: forecast operations over the 5-7 year expected holding period and a complete 3-stmt model so that LBO debt assumptions properly impact IS and CFS. Must build an accurate debt schedule

4. Exit valuation and returns based on the exit multiple, calculate IRR and MOIC

5. Sensitivity Analysis: one common one is to back into the implied pre-LBO equity value based on explicit sponsor hurdle rates and operating assumptions.

What is the purpose of the “Sources & Uses” section of an LBO model?

This shows how much capital the sponsor needs in order to make the deal possible and where they will get it from. It is critical to determining financing needs and how those will impact the statements going forward.

How would you measure the credit health of a pre-LBO target company?

Look at leverage and interest coverage ratios both pre-LBO and then what you think they will be post LBO to determine if the company can support the leverage.

• Ratios depend bust post LBO ranges between 5x-7x, with senior debt ratio around 3x

• Rule of thumb is that a higher interest coverage ratio is better, and you want at least 2x post-LBO first year

Why is LBO analysis used as a floor valuation when analyzing company value using several valuation methodologies?

It is used as a floor because it determines the MAXIMUM a sponsor would pay to achieve a specific IRR. Meaning, the return they expect is already embedded, so it isn’t about intrinsic or implied value, just what they would have to pay to get the return they seek.

These hurdle rates are usually higher than the cost of equity capital on the same business without those LBO-specific risks. Thus, the present value (or valuation) implied, given those higher hurdle rates, will be lower than the valuation of the company when analyzed through the traditional DCF and comps approaches.

When analyzing the viability of undertaking an LBO, how do private equity firms estimate the company's value in the exit year?

They estimate the value based on a final year financial metric, usually EBITDA, and tend to apply a similar multiple to where they entered so that the investment case doesn’t hinge too much on expansion.

This assumption will be sensitized to show IRRs across a spectrum.

If you had to choose two variables to sensitize in an LBO model, which ones would you pick?

Exit multiple and entry multiple since they have the greatest impact on returns.

Other possible variables include:

• revenue growth

• leverage multiple at purchase

• EBITDA margin

What are the capex and net working capital requirement considerations for a private equity firm looking at a potential investment?

Ideally low CapEx and low NWC requirements so that as much cash can go towards paying down principal as possible. You would prefer most of the CapEx to be maintenance. If a mature company has high numbers for both of these metrics, then the cost structure is probably just very unfavorable.

Higher CapEx could be a positive if it is an element of maintaining the business’ moat, though.

If management decides to rollover equity, how would you calculate their new ownership stake and proceeds received at exit?

Rollover equity would be included as a Source of capital on the Sources and Uses table. So, the new stake would be equal to the Rollover Equity Amount/(Rollover Equity Amount + New Equity).

At exit, the amount of proceeds received by multiplying the exit equity value by the implied ownership by the management team that rolled over their equity.

Alternatively, this could be based on a percentage of the excess value creation over the initial equity investment or structured with a liquidation preference in which management doesn't receive any proceeds unless a returns threshold is met.

What are the two most common return metrics used by private equity firms?

IRR and MoM

If you're given the multiple of money (MoM) of an investment and the number of years the investment was held, what is the formula to calculate the internal rate of return (IRR)?

IRR = MoM^(1/t) - 1

What levers have a positive/negative impact on the IRR of an investment?

Higher IRR:

• payouts throughout

• Lower entry, higher exit multiple

• more debt paid down

• more leverage (less initial equity)

• EBITDA growth

• Shorter holding periods

Lower IRR

• opposite of the above

When measuring returns, why is it necessary to look at both the IRR and MoM?

The MoM cannot be a standalone metric as it doesn't consider the time value of money, unlike the IRR calculation. For instance, a 3.0x multiple may be impressive if achieved in five years, but the multiple remains the same, whether it took five years or thirty years to receive those proceeds.

IRR is an imperfect standalone measure because it's highly sensitive to timing. For example, a private equity firm issuing itself a dividend soon after the acquisition increases the IRR, but the MoM may have been sub-par (making the IRR misleading in this case).

Tell me how you would calculate IRR in Excel

Record initial investment as a negative amount. Project out cash flows over the time period, record exit value, use XIRR function.

What is the difference between gross IRR and net IRR in private equity?

Gross IRR is the return on the equity as a whole. Net IRR is the return to LPs after accounting for management and performance fees in the 2/20 structure.

Tell me about the J-curve in private equity returns.

For the first few years of a fund, returns are low because there is dry powder, investments are getting closed

Early in the fund lifespan, the J-curve begins with a steep, negative slope as the initial investments represent capital outflows and the annual management fee paid to the PE firm. But gradually, as the fund exits its portfolio companies after each holding period, the downward trajectory will reverse course and ascend upward.

If a business that underwent an LBO has been operating as intended, why does the private equity firm not hold on to the investment for a longer duration (e.g., 10+ years)?

Their investments are time-bound by the fund structure that they operate. They need to return capital to LPs before they can raise the next fund.

Also, longer holding periods decrease IRR, and that looks worse on marketing materials that help those future fundraisings.

In the situation when a private equity firm has the option to exit within a 1 to 2-year time frame, why might the firm be reluctant to proceed with the sale?

They may be reluctant to proceed because this creates reinvestment risk for LPs and GPs since a new investment needs to be sourced in the fund.

Also, transaction fees could weigh on the return anyways.

How would you calculate the levered free cash flow yield for private equity investment, and when would it be used?

Although used far less often than the IRR and MoM, the levered free cash flow yield (FCFY) can be a useful metric for assessing a private equity investment's performance. 1. The first step to calculating the levered FCFY is to calculate the levered free cash flow. Recall, this investment is from a private equity firm's perspective, so we must deduct interest payments and mandatory debt pay down. Levered FCF = EBITDA –Taxes –Interest –Capex –Increase in NWC −Mandatory Debt Amortization 2. Now that we have the levered FCF, the only remaining calculation is to divide the levered FCF by the initial equity investment amount. Levered Free Cash Flow Yield (FCFY) = Levered Free Cash Flow Initial Equity Investment There is no set levered FCFY that PE firms target since it'll vary not only by industry but by other factors such as the financing mix, total ownership percentage, and required amortization by debt. However, the higher the levered FCFY, the better since this implies the company is generating cash that can be used to reinvest into the business or payout a special dividend. If a private equity firm wanted to see how its investment was performing, then the levered FCF yield is one metric they could use. So rather than the percentage amount, what matters more is the year-over-year growth (YoY). If the levered free cash flow becomes a larger proportion than the firm's initial equity contribution, it's a positive sign as that would signify downside protection above all else.

If we had not deducted interest and the mandatory debt amortization in calculating the levered free cash flow, what metric would we be measuring?

We would be measuring unlevered free cash flow, which is the cash flow available to all investors, not just the equity holders.

it can tell us how much FCF remains to reinvest into the business and pay a dividend to equity holders, as well as the amount that can be used to paydown debt.

How does the accounting treatment of financing fees differ from transaction fees in an LBO?

Financing fees are amortized over the life of the bond while transaction fees are a one-time expense.

If an acquirer writes-up the value of the intangible assets of a target, how are goodwill and amortization impacted?

Goodwill decreases because assets make up more of the purchase price.

Publicly traded companies cannot amortize goodwill under US GAAP – however, private companies can opt to amortize goodwill for tax reporting purposes. This question is specifically regarding the purchase accounting on the closing date of the transaction.

What does a cash sweep refer to in LBO modeling?

A cash sweep refers to a percentage allocation of free cash flows to paying off debt at different tranches based on cash flows left over after making mandatory principal repayments. Any revolver balance must be paid off first.

In most cases, this optionality to repay debt early comes with a prepayment penalty fee since the lender receives reduced interest payments.

What is the purpose of the minimum cash balance in an LBO model?

The minimum cash balance reflects the need for a business to have working capital in order to run its day-to-day operations.

The debt schedule will contain logical functions that ensure the cash balance never dips below this specified amount. The minimum cash balance will increase the amount of funding required since this cash on the company’s balance sheet cannot help fund the transaction.