The short answer to "walk me through an LBO"
A leveraged buyout starts with buying a company mainly using debt to increase the returns of the sponsor equity. The PE firm will use the target company's cash flows for debt paydown. Only companies with stable and predictable cash flows are suitable for a leveraged buyout. After the holding period of around 5 years, the PE firm will sell the target company. The difference between entry and exit equity value is the return on investment.
What is an LBO?
An LBO, or a leveraged buyout, is a transaction in which a Private Equity fund (aka PE firm) acquires a company using debt to cover a significant part of the purchase price.
This acquisition process is similar to buying a home with a mortgage. The down payment is your equity investment and the remaining purchase price is financed with bank debt.
Using debt increases the overall return on investment for the PE firm when the company is being sold after a tenure of about 5 years.
Which companies are suitable for a leveraged buyout?
Before executing a leveraged buyout, we must find a suitable target company.
This kind of transaction only works with companies with solid financial performance. Cash flows need to be predictable and supported by revenue growth. We will be using a significant amount of debt. We will use the company's cash flow and excess cash for interest payments and debt repayment.
What private equity firms usually look for in the target company are the following points:
Stable, predictable and growing revenues
Low capital expenditures
High cash flows to pay interest expense and debt
Low entry purchase price
A strong management team for low monitoring needs
Visibility on the exit strategy (potential buyers after the holding period)
The target company needs to tick all the boxes before you even start to build an LBO model. You need to remember these points if the interviewer asks you how to find a target company suitable for a leveraged buyout.
Ideally, your leveraged buyout model shows a minimal internal rate of return (IRR) of 20%. That's the minimum return, called "hurdle rate", to continue the transaction process.
Why is "walk me through an LBO" such an important question?
"Walk me through an LBO" is a widespread interview question for Investment Management or Private Equity interviews. It is a less common question for Investment Banking interviews.
If you are serious about breaking into Private Equity, you need to know the LBO model like the back of your hand. Leveraged buyouts are what Private Equity firms look at daily.
If you get any technicals wrong, it's an automatic rejection. At this stage, technical questions are hygiene factors. More than simply memorizing the pure information is needed. You need to fully understand the concepts and do the work.
Common mistakes when answering "walk me through an LBO"
Like an Investment Banking interview, you need to come to the interviewer prepared beforehand. Keep your answers high-level, short and concise at first. The interview will then prompt you to elaborate further in detail. That's where you can show that you have done your homework.
Not being fully prepared and missing essential parts
Yes, it's difficult to break into Investment Banking and even harder to break into Private Equity. Even fewer seats are available on the buy-side, as it is a top-tier finance job.
If you thought Investment Banking interviews were competitive, Private Equity interviews will take you to the next level. Everyone who gets invited to a Private Equity firm knows the technical stuff. Only Investment Banking Analysts and Management Consultants usually get invited.
Losing yourself in minute details
If your answers are too long, you appear to not fully understand the concepts and can't get to the point. Yes, "walk me through an LBO" can be a long topic, but you can't ramble on forever. These are not traits of a promising Private Equity candidate.
How can you prevent this? Have your structure laid out, follow it and don't break it. Answer the question and wait to see whether the interviewer has further questions. Then, glance back at your structure and continue with it. This will give you an anchor point so you don't get lost in your stream of consciousness.
"Walk me through an LBO" in 5 steps
Step 1 - Entry enterprise value and equity value
Step 2 - Debt and equity financing
Step 3 - Project cash flows
Step 4 - Exit enterprise value and equity value
Step 5 - Returns for equity investors
Step 1 - Entry valuation
Entry enterprise value and equity value
How to calculate the proper entry price? The Enterprise Value to EBITDA (or EV/EBITDA) multiple is the most used valuation multiple. To derive this multiple, we use various valuation methods.
The peer group of comparable listed companies will indicate where larger publicly listed companies are currently trading. We will also look at multiples of recent comparable transactions to support the view developed by the multiples of comparable companies.
We can draft the entry multiple assumption for the LBO model based on both of these valuation methods. This will get us to the enterprise value.
We subtract net debt from the enterprise value to calculate the equity value (the actual purchase price). Net debt is calculated by subtracting outstanding debt from any excess cash.
Transaction and advisory fees
In addition to paying the purchase price to acquire the target company, the private equity firm must also pay for advisory fees, also known as transaction costs.
Here, we are talking about advisory fees, such as Investment Bankers, Management Consultants, Accountants and Lawyers and financing fees from the bank for providing debt to fund the deal.
The purchase price and fees paid to advisers and lenders are considered "uses of funds".
Step 2 - Debt and equity financing
Let's look at the "sources of funds". PE firms will use a combination of debt and equity to fund the transaction. A significant amount of the equity value will be paid with borrowed funds. This reduces how much equity the PE firm must use. The more leverage, the higher the returns on the sponsor equity.
How much leverage can be used is determined by how much EBITDA the target company generates. The typical debt to EBITDA ratio for a leveraged buyout is around 4 to 5.5x for smaller deals under $250 million in enterprise value and can go up to 7x for larger deals.
The sponsor equity share typically amounts to at least 40% or more of the equity value in a leveraged buyout transaction.
The primary source of funding for the majority of leveraged buyouts is bank loans.
On a simple level, there are two types of debt structure:
Senior debt – This type of debt tranche has the highest priority in repayment if the borrower defaults or goes bankrupt. It is usually secured by the assets or collateral of the borrower and carries a lower interest rate than subordinated debt
Subordinated debt – This type of unsecured loan ranks below senior debt. Debt repayment of subordinated debt happens only after senior debt holders are fully repaid. It is riskier for the lender and, therefore, offers a higher interest rate
Step 3 - Project cash flows and debt schedule
Typically, private equity firms aim to hold the target company for about 5 years. To execute the buyout, we need clear visibility of the financial performance and its cash flows.
With LBO modeling, we need to look at all the financial statements: the income statement, the cash flow statement and the balance sheet. All items are critical.
Here is how to derive the relevant cash flow:
EBITDA
(-) Investments in working capital
(-) Capital expenditures
(-) Interest expenses
(-) Taxes
(=) Cash flow available for debt repayment
(-) Debt repayments
(=) Net cash flow
You probably know how a DCF works and how to derive unlevered free cash flow. With an LBO model, the approach is similar, just that we need to add interest expense and debt repayments to the cash flows.
To properly build your LBO model, you need a debt schedule, which reflects how much debt the PE firm can use for its leveraged buyout.
Step 4 - Exit valuation
The typical holding period for a PE firm is around 5 years. After we have projected the cash flow for the next five years, we need to consider our LBO model's exit scenarios. In this part of the LBO model, we assume that the PE firm sells the target company to another buyer.
What is the right exit multiple assumption? A good and conservative starting point for the exit multiple assumption is to hold the EBITDA exit multiple constant. Generally speaking, a higher exit multiple can be justified by improved profitability, revenue growth or increased market share during the holding period.
Once the exit multiple assumption is fixed, we calculate the exit enterprise value. Then, we must subtract the expected net debt on the balance sheet to derive the exit purchase price. This is the cash inflow the PE firm receives after holding the target company for around 5 years.
Step 5 - Returns for equity investors
After calculating the exit equity value attributable to the PE firm, we need to look at the return on equity.
In an LBO model, there are two metrics that PE firms will look at: internal rate of return (IRR) and the multiple of invested capital (MOIC), aka money multiple.
The IRR number tells you the average compounded return on equity on a yearly basis. So, it's like the average return per year. It measures the return on equity to the investment time frame.
On the other hand, the money multiple tells you how many times your initial investment you've made. You simply divide the exit equity value by the entry equity value. Here, we are looking at the return on equity in absolute terms.
Both perspectives are essential, so PE firms look at IRR and money multiple.
This is the last step of the LBO model and we have come to the end of "walk me through an LBO".
What are the main drivers of an LBO model?
This could be a follow-up question after you describe how the LBO model works. In the end, the value created in a leveraged buyout comes down to these factors: entry valuation, leverage, EBITDA and cash flow expansion, as well as exit valuation.
Here are the main drivers of an LBO model:
Entry valuation
The entry purchase price is the first main driver of an LBO model. Suppose you pay too much to acquire the desired company, that already sets your entire LBO model on defense. A leveraged buyout's whole point is to acquire undervalued businesses with a solid financial performance using debt.
If you play around with your entry multiple assumption, you can see how quickly it can kill your internal rate of return and your entire case.
The lower the purchase multiples of the target company compared to the market, the better the LBO model works.
Leverage
How much debt you use is also a value driver. The more debt you use, the smaller the share of sponsor equity and the higher the return on equity. However, a higher debt burden goes hand in hand with a higher interest schedule and higher debt repayment.
This is inherently more risky and banks might not fund your acquisition. The more debt you take on, the more visibility and certainty you need for your income statement and cash flow statement.
EBITDA and cash flow expansion
EBITDA and, in turn, the company's cash flow are both major drivers of the LBO model. The company's future income statement and EBITDA development are critical assumptions of the LBO model. This is where PE firms often run different scenarios to see if they can still meet their minimum returns in case of a downside scenario.
The more EBITDA growth the PE firm can drive, the higher the exit enterprise value, assuming a constant exit multiple. The higher the exit valuation compared to the initial purchase price, the higher the return on equity.
On the cash flow side, the PE firm wants to see limited investments in working capital and little capital expenditures for the holding period. The additional cash flow can be used to serve interest expense and debt paydown. This means higher leverage or a faster debt paydown. Both increase the exit equity value.
Exit valuation
This is the final step of a leveraged buyout model: the sale of the company. This is where the PE firm makes its money. The higher the exit multiples, the higher the exit valuation and the higher the return on equity compared to the initial purchase price. Buy low, sell high.
Maybe the PE firm managed to increase profitability. Maybe demand increased due to some megatrends. Perhaps they pushed revenue growth so much that a higher EBITDA exit multiple applies to the bigger company. These are all factors that drive the exit valuation.
And, of course, the PE firm will hire Investment Banks to run a competitive sell-side M&A process to maximize competitive pressure.
Where does it leave us?
Let's recap "Walk me through an LBO"
It starts with the entry valuation and purchase price. Then, you take on the debt financing. You use the cash flow throughout the holding period to repay the outstanding debt. That's why a leveraged buyout only works with companies with a stable cash flow.
After a holding period of about 5 years, it is time to sell the company. Pushing EBITDA growth will increase the return on equity, increasing the exit valuation. After the PE firm sold the company, it's the difference between the entry and exit purchase price that the PE firm pockets.
Private equity firms make their investment decision based on their LBO model
After understanding how an LBO model works, knowing how much interest private equity firms express toward potential targets is easier. The financial performance must be solid, often supported by revenue growth and a strong competitive position.
The PE firm quickly build an LBO model and see whether the internal rate of return matches their minimum return requirements (hurdle rate). Private equity makes its decisions primarily based on its LBO model.
