LBO Modeling Process

In any private equity transaction, the financial models used to evaluate an opportunity will evolve with the flow of information between the parties involved. Most of this information will come from the target company, but you will also have information come from third parties involved in due diligence as well as from providers of subordinated debt and senior debt.

For this reason I believe in building models via modular design. As more information is received, you can continue to update your model with more detailed schedules. (I find it is helpful to be aware of the relationships between the financial statements and the supporting schedules because it facilitates making these updates.)

SIMPLE LBO:

Initially limited financial data is provided by the company or the investment bank representing the company. The expectation is that the sponsor will respond with a range at which they would be interested in pursuing the acquisition (known as an Indication of Interest or IOI). For this reason you might start with a simple leveraged buyout model.

That said, many firms will not bother to build a model before submitting this range. If you are active in the market you generally know what a business will trade for. To provide some context, for every acquisition made an active firm may have evaluated ~300 opportunities. This process provides considerable feedback as it relates to valuation.

Note on LBO: This is often viewed as a complex process, but it shouldn’t be. A LBO model is nothing more than a three statement model that has been adjusted for the following:

  1. Balance Sheet Adjustments: At the date of acquisition the balance sheet is adjusted to reflect the new sources of capital. These inputs typically pull from what is known as a Sources and Uses table.
  2. Exit Analysis: This measures the performance of the investment. The outcome is displayed as both an Internal Rate of Return (IRR) and Multiple of Invested Capital (MOIC).

INCOME STATEMENT DETAIL:

If you are selected to move forward in the process, the next step is to work towards a Letter of Intent (LOI), which is effectively a more detailed IOI. At this stage the objective should be to better understand how the business generates cash flow on a monthly basis. I generally start by expanding upon the income statement with as much detail as the company will provide. As it relates to cost structure, the goal should be to identify which line items are fixed and which are variable. Incorporating this flexibility requires a schedule that permits identifying these line items accordingly. The information contained on this tab will be linked back to the income statement, which in turn drives the balance sheet and cash flow statement. This framework permits evaluating different scenarios and stress testing the business.

In this process I focus on cash flow generation as the business scales and as it declines. I also carefully evaluate working capital needs for potential volatility; a spike in working capital will consume the company’s cash, potentially leaving the management team in crisis.

Note: The purchase agreement typically calls for a working capital adjustment. If working capital at the date of close is outside of the company’s average working capital (determined by what is required to maintain current revenue levels), this will result in a direct change to purchase price. For this reason the associated calculation is extremely important.

DEBT SCHEDULES & CAPITAL STRUCTURE:

The transaction size will determine the stage at which lenders are engaged. Generally the larger the transaction the sooner you will engage lenders to provide terms sheets. For most transactions, however, you will not engage lenders until you are prepared to submit a letter of intent (LOI). At this stage you will need to update your model with debt schedules that reflect the terms provided by lenders.

If I have monthly financial information, then I will typically use a schedule that is horizontal to be consistent (see No. 1 below). If I am working with annual data then I might use a vertical schedule (see No. 2 below).

  1. Monthly Debt Schedule
  2. Preferred Equity Schedule

Note: The challenge is that financial models are built differently based on whether or not you are using monthly, quarterly or annual periods. As it relates to debt schedules specifically, in an annual model you generally use the average principal balance to calculate interest payments because it's possible that the value of the underlying principal will change each quarter.

DISTRIBUTION WATERFALL:

As the transaction works towards a close, conversations surrounding equity participation will become more detailed. A company’s certificate of incorporation [1] will describe how this works, but evaluating the outcome under multiple scenarios requires a distribution waterfall.

This is the part of the modeling exercise that can keep you at the office all night. While many distribution waterfalls are simple, I have seen (or built) examples that contemplate multiple classes of stock with a variety of IRR and / or MOIC hurdles (click on the link above if that doesn’t make sense).

I would also argue that this is where some operators are misled. Only recently I had a friend of mine reach out because a PE firm had offered him a 6% stake in a business with roughly $400 million in revenue. He provided the capital structure and I sent him back a schedule demonstrating that his equity would be of little value unless he could grow EBITDA by ~25% a year for the next two years. It goes without saying that it helps to understand the mechanics of how a company’s cash flows are distributed.

CONCLUSION:

This description focuses on the process of working towards a close. The only thing I would add is that this description assumes the business can generate the information described. You might be surprised to learn that businesses can achieve considerable scale without ever developing proper financial statements. In those instances the modeling gets highly creative.

Once the PE firm owns the asset it’s harder to say with any certainty which models will be used to make decisions during the hold period. But as it relates to this process, all of the schedules described above can be contained in a single model. For the majority of the exercise it’s just simple arithmetic and organization. If you can follow procedure and learn some new vocabulary you will realize it’s not as difficult as many make it out to be.

[1] See this link for a crude example: Qualified Small Business Stock and Private Equity

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