- What is an LBO Model?
- How to Create an LBO Model?
- What is the Difference Between LBO and DCF?
The acquisition of a company can be carried out in multiple ways. Very often, it is accomplished using borrowed money. Acquiring a company by using a considerable amount of debt is known as a leveraged buyout. This kind of transaction is inherently risky, so the entire process is modeled beforehand. A leveraged buyout (LBO) model can become very complex depending on the transaction details and the parties involved. Usually, LBO models are created using Microsoft Excel to estimate the returns for all parties involved in the transactions.
In this article, you will learn about leveraged buyouts, how they are modeled, and the difference between LBO and Discounted Cash Flow (DCF) models. You will also learn about the main components of an LBO model so you can build one using Microsoft Excel. To learn more about company valuations, take a look at this article: How to Calculate the Value of a Company.
What is an LBO Model?
A leveraged buyout consists of the acquisition of a company using significant amounts of debt. An LBO model is a financial tool used to assess these potential transactions, usually built using Microsoft Excel. Cash flows to and from the different parties involved are modeled to determine their rate of return.
Depending on the circumstances of the transaction, the model can become quite complex, with multiple relationships and dependencies between variables. However, some essential components and steps are common to any LBO model.
How to Create an LBO Model?
As mentioned above, a leveraged buyout is a complex process. More importantly, since it depends on multiple factors and assumptions, the model will vary according to the decisions that are made for each choice. In other words, the details of the model will vary depending on the specifics of the transaction. However, some general components and stages need to be considered in any case. The steps below describe the main components required to construct an LBO model.
Step 1. Purchase Price, Debt, & Equity
To start building the LBO model, you’ll need a purchase price for the target company. This involves a company valuation, which can be carried out using different valuation methods. Since it is a leveraged buyout, once the price is determined, you need to find the right mix of debt and equity. The mix and the type of debt will need to be considered carefully.
A Scenario Analysis is a powerful tool to examine possible future business outcomes. Here’s everything you need to know about performing a Scenario Analysis.READ MORE
Step 2. Sources of Finance & Types of Debt
A leveraged buyout uses two types of funding: equity and debt. However, there are many types of debt available. The acquiring company has to decide what kinds of debt to use, and this will depend on the terms available: interest rate, repayment schedule, etc.
Step 3. Build Financial Projections
After the previous steps have been completed, it’s time to start projecting financial statements. Specifically, you’ll have to model projections for the target company’s future balance sheet and income statement. This will require multiple future metrics, which will also have to be estimated.
Step 4. Calculate Cash Flows & Cash Repayments
Once you have the projections for the balance sheet and income statement, it’s time to project cash flows so you can calculate the cash available for repayment.
Step 5. Analyze Repayment Structure
Depending on your chosen type of debt, the debt repayment structure will vary. However, there will be mandatory payments on specific dates. The acquiring company has to be reasonably sure that the mandatory payments will be made in a timely fashion. It’s crucial that the repayment structure and schedule be realistic and manageable.
Discounted Cash Flow (DCF) Analysis (Complete Guide)
The Discounted Cash Flow Analysis is a valuation method that helps to estimate the value of an investment. Here’s everything you need to know.READ MORE
Step 6. Exit Strategy
As this is a leveraged buyout, you need to have an exit strategy. The acquiring company has to decide the time and manner in which to sell the target company. It is usually understood that when this happens, the acquiring company repays the target company’s debt. However, the acquiring company also gets to keep the remaining cash at the end of the ownership period.
Step 7. Calculate IRR on Initial Investment
The main aim of a leveraged buyout is to maximize the return on your initial investment. Based on the model constructed in the previous steps, you can calculate the Internal Rate of Return (IRR).
What is the Difference Between LBO and DCF?
In an LBO, all cash flows between the parties involved are modeled to estimate each party's rate of return. In DCF analysis, cash flows are also modeled, but the rate of return is estimated based on risk to provide an estimated value for that particular investment. To learn more about the discounted cash flow method, check out this article on Discounted Cash Flow (DCF) Analysis.
As you have seen, a leveraged buyout is a complex process. In addition to the calculations involved, many assumptions must be made to build the projections. Each LBO model is different, as the specific steps and formulas depend on multiple factors, including debt/equity mix, type of debt, discount rate, etc.
You now know about leveraged buyouts and the difference between LBO and DCF analysis. You also know the steps involved in building an LBO model and the main assumptions and estimates needed. Since there are multiple variables and relationships to consider, it’s common to use what-if techniques, like sensitivity and scenario analysis. Layer can help you by synchronizing your data across multiple formats and locations, automating data flows, and managing all aspects of your data.