LBO Analysis Concept in simple terms
Let us consider the concept of LBO similar to buying a house. What will you do if you want to buy a new house? As we all know it is almost impossible to pay the entire amount of the house due to the rising real estate prices. Then what would you do? Of course, you will go for the loan. Loan acquires most of the entire process and similar is the LBO Analysis concept.
In a layman term if we break the LBO concept, Equity is known as the “down payment” and debt is known as the “mortgage”.
The acquisition or a segment of the company is known as leveraged buyout. But it is all common thing which you might have heard. What is different about this concept?
The answer is,
“The entire process is majorly funded by debt.”
LBO includes a private equity fund that uses a small amount of equity and majorly uses the leverage to fund the remaining consideration to the seller. The main purpose of LBO is to have major acquisitions without having committed to large capital.
The LBO analyses concept uses 90% debt and 10% equity. Due to high debt equity ratio the bonds are also referred to as junk bonds.
LBO Analysis example:
Ever wondered why companies opt for LBO Analyses? Is it beneficial for the companies to use debts and if not, then why companies go for LBO?
If you have $100 with you and at the same time if you borrow $900 more. You will have $1000.
Now, if you invest that $1000 and if you earn 10% interest on it. It goes up to $1100.
After repaying the debt of $900, you are left over with $200 (1100$ - 900$). It is 100% return on your money you initially put in. Remember you put $100? So, if at the end if you are left with $200 now, you have received 100% returns. Now, we can say that why companies opt for LBO Concept.
How LBO Analysis work?
- LBO Analyses has similar concept like DCF Analyses. It calculates cash flows, terminal values, present value and discount rate.
- However, DCF Analyses looks at the PV (Enterprise value) of the company whereas, LBO Analyses looks at the Internal rate of return (IRR).
- LBO focuses on whether there is enough projected cash flows to operate and pay debts and interests of the company.
Buy a company -> Fix it up -> Sell it.
Steps in LBO Analysis
Step 1: Transaction Assumptions:
- Make some transaction assumptions by analyzing the purchase price and financing the deal.
- With the above information, the table of sources and uses are created. The uses reflect the amount required to effectuate the transaction. The source refers from where the money is coming.
Step 2: Construction of the proforma balance sheet:
- Make changes in the existing balance sheet to highlight the transactions and capital structure. It leads to the existence of “Proforma” balance sheet. At this stage, intangible assets such as goodwill and capitalized financing fees are likely to be created.
Step 3: Create cash flow model:
The most crucial step is to project the company’s income statement, balance sheet, and cash flow statement for over a general period of five years. The balance sheet has to be projected based on the newly created proforma balance sheet. The post transaction debt must be considered while projecting the debt and interest.
Step 4: Calculate value of Private Equity firm’s equity stake:
The assumptions about the private equity firm’s exit from its investment can be made once the model is created. The company will be sold after 5 years at the same implied EBITDA multiple at which the company was purchased is the general assumption. We calculate the sale value because it allows us to analyze the IRR.
Key characteristics of LBO Candidate
- Matured industry
- Clean balance sheet with no or low outstanding debt
- Strong management team
- Cost-cutting measures
- Low working capital
- Steady cash flows
- Feasible exit options
- Possibility of selling under-performing non-core assets
Sources of funds in LBO Analyses
- Revolving credit facility
- Bank debt
- Mezzanine debt
- Subordinated or high-yield notes
- Seller notes
- Common equity
Conclusion
- LBO analyses helps in determining the purchase price of the company.
- It helps in developing the view of leverage, debt, and equity characteristics of the transaction.
- It helps in calculating the minimum valuation for the company.
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