Building a Full LBO Model
We discuss the theory behind the LBO and also how to build one in other posts. All our readers should know how to put together a basic and bare bones LBO – but in reality an LBO model can be very functional for any situation that the private equity firm or financial sponsor can look at.
A full fledged LBO can be fed by a full operating model instead of a couple quick and dirty assumptions. Debt schedules can be enormous and multiple capital tranches can be layered in to see what returns look like with additional debt, preferred shares, cash sweeps, minimum cash balances, working capital assumption changes, synergies from portfolio companies and bolt-on acquisitions.
LBO structuring is also important for investment bankers and leveraged finance teams in order to figure out what features the loan and bond package should have where returns still make sense for private equity investors as well as what is possible before bond and bank covenants are breached (with some contingency cushion built in).
So what do we need to know beyond the purchase multiple, EBITDA margin, revenue growth assumptions, exit multiple, initial leverage and revolver interest rate?
Here are some other common LBO modeling features that can be built in.
Capital Assumptions for LBO
The simplest LBO is constructed using term loans/bank debt. To be extremely simple, a private equity associate can just build in a revolving credit line as a substitute for term debt/revolver.
However a more realistic LBO will have a revolver, repayable and amortizing term loan and some form of bullet debt – possibly two forms of bullet debt.
This will come in the form of a revolving credit facility, term loan A with prepayment options, term loan B with mimimal amortization (bullet) and high yield bonds (bullet).
Now how does this affect your IRR? There are two dynamics at play here – coupon and debt paydown.
Capital Stack and LBOs
All things equal, the coupon on bank debt or the interest on TLB will be much higher than revolver and bank term loans.
So if there is no need to sweep the cash into paying down debt, the IRR will be higher if you have a higher proportion of bank debt versus high coupon bullet debt (TLB actually is floating rate debt such as LIBOR + 500 – but this will often be swapped back to fixed by the private equity firm, which also means more fees for banks from their sales and trading division).
Of course, you cannot do an entire LBO with bank debt (senior debt) because banks are hesitant to have so much risk outstanding and also have so much debt pari passu with them if anything goes wrong. Banks are looking to get paid back easily and quickly, so they will want the rest of the debt to be subordinated to them whether secured (second lien or 2L) or unsecured.
There can even be subordinated debt, which is even higher cost of capital. All things equal, this being in the debt mix makes the cost of capital more expensive leaving less for equity (IRR down), but if they are incremental to the capital structure (for example there is 70% leverage but you can add 15% subordinated debt) it will likely increase the IRR.
Preferred shares are very expensive capital and are not tax deductible, so if they are in the financing mix using the same equity cheque IRR will fall. However if it is incremental and reduces the equity cheque it will increase the IRR.
Amortizing Debt and Mandatory Prepayment of Debt
Now let’s assume the debt all has the same coupon in a theoretical world. So the coupon for an amortizing term loan equals the high yield bond. All things equal, the IRR when you use more bullet debt/HYB is higher – think of the levered free cash flow formula free cash flow to equity = unlevered free cash flow – debt repayments + debt issuance. So repayments early on reduce free cash flow (although this is partially offset by lower interest on lower debt balance).
Now for cash sweeps and debt paydown, this means the banks want the company to use all excess cash generated to pay down debt. This decreases the IRR versus having the debt maturing at the end. However, it is normal for banks to expect a cash sweep especially for a firm that is quite levered, so make this your base case.
If there is no cash sweep, we are assuming the cash generated is dividended out to equityholders. This is partially offset by a higher debt payment to pay off at exit.
The converse is allowing for a dividend recapitalization later on during the LBO where the company relevers and offers a special dividend to the private equity firm.
Mid-Year Convention for LBO
You may be asked to build a toggle for mid-year or year-end payments to equity.
If you discount cash flows to be paid to equity halfway through the year instead of at year end (which is easier), the IRR will go up as the discount timing is shorter (time value of money).
PE firms usually assume they will exit in 5 years. Sometimes this does not pan out and investments are underwater. They have to plan for these contingencies.
However, the longer out you go, the less you get the benefits from leverage. The later the exit, the more the investment looks like an unlevered IRR.