Oftentimes, when companies are out for sale and the purchase price is to high for strategic buyers, Private Equity (PE) firms step in performing a Leveraged Buyout (LBO). The main idea behind that is to purchase the company with a mix of equity and debt and to sell it three to five years later at an improved price. During those years of ownership, the focus is on increasing the operational performance of the company to improve its value usually measured on multiples. Key characteristics of LBO candidates are a clean balance with minimum amount of debt, steady cashflows, feasible exit options and possibilities of improvement. The following aims to give a general overview of an LBO, to explain the key drivers for return on investment and finally to set up a simple model to calculate the IRR.
To start, we can compare an LBO to a house purchase using a combination of upfront payment and mortgage. Both transactions use a small amount of equity (upfront payment) and cover additional required assets (mortgage) by borrowing them. Having the general structure of an LBO, it’s still not clear why this is an attractive investment to PE firms. The reason for that is the fact that the returns on investment for the Private Equity Firms are increasing the more debt they use. To explain this better we look at the following example: Lets assume we buy a company at 1000$ and sell it five years after that at 2000$. The first picture shows us the return using 100% equity and the second one assumes a purchase which is 50% debt-financed. For this example, we assume that all debt is repaid when selling the company, which gives us sale price minus debt as the final cashflow.
You can now see the difference in the return multiple and the IRR, which indicates that a buyout at 50% is more valuable to the PE firm. In fact, in a real-life situation the company purchased would produce cashflows, which are used by the PE firm to repay the debt at a maximum level. This is boosting the returns even higher and shows the correlation between improved cashflows and the IRR. To sum it up the return of an LBO depends on three key factors:
- Operational Improvement, which leads to higher cashflows and better de-levering.
- Debt Structure and de-levering, which are crucial for the return.
- Exit Strategy, in terms of getting the maximum selling price after X years.
In the next steps we will successively extend the simple model to discuss the impact of the above-mentioned factors. First, we must extend it by information on the income, the cash flow and more details on the debt used. Make sure you enable iterative calculations in excel and set the basic information for our model as shown below.
Income and Cash Flow Statement
For our purpose we use the simplest Income Statement and Cash Flow Statement you can think of. We assume an EBITDA in Year 1 of 80$ whereas depreciation is fixed at 10$ per year and taxes are 25%. Further we put in a variable for EBITDA growth to see the effect of operational improvement on the IRR, but leave it a 0.00% for now. The interest expenses depends on the repayment, since we don’t have any information on it yet we leave them at 0. Looking at the Cash Flow statement we assume there is nothing like change in net working capital or capital expenditures, just to keep it nice and slim. We now end up with cash available for debt repayment and can continue with clarifying our debt situation a little bit more.
Debt information and repayment plan
Let’s assume that our interest rate is fixed at 6.00% over the 5 years and we use all our cash available to repay our initial debt of 500$. Implementing those assumptions gives us the repayment plan shown below. Please keep in mind that the interests should be calculated on the mean of beginning and ending debt.
One thing left to do now is to link the interests payed to the income statement created earlier. Here we come to the point where it is absolutely necessary to activate the iterative calculations, since the formula is based on a circular reference. Doing everything right should let you end up with the following table.
With all information on cashflow and debt repayment gathered, we can now calculate the IRR for our sample LBO. The purchase year cashflow is described by the amount of equity we had to invest initially and can be linked to our basic transaction information from the beginning. Since we use all cash available for repaying the debt our cashflow between purchase and exit year remains at zero. But of course the lowered debt has an effect on the exit year cashflow, which is described by
“Sale price – Ending debt in the exit year”.
Having this change implemented we can use the given Excel Formula IRR() to calculate the Internal Rate of Return. As you can see just by repaying debt the IRR increased from 25.00% to 28.09%.
We have now set up a model to analyse the impact of the three key drivers mentioned earlier. To recap those: we were looking at the debt structure, the operational improvement and the sales price. The tables below show you how a change in those factors affects the return on investment for the PE firm. To give you a better idea of where we are: the PE firms usually expect an IRR of 20.00 to 25.00% when performing a leveraged buyout.
Please keep in mind that the model above reflects a simple approach to calculate the returns of an LBO and to give you an idea of the general principles behind it. The model itself can be extended by various factors such as different types of debt, a more detailed income and cashflow statement and so on.
You can download it here: SimpleLBO_tumbusinessreview
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