Notwithstanding the recent LBO boom where nearly all companies were considered to be possible LBO candidates, characteristics of a good LBO target include steady cash flows, limited business risk, limited need for ongoing investment (e.g. capital expenditures or working capital), strong management, opportunity for cost reductions and a high asset base (to use as debt collateral). The most important trait is steady cash flows, as the company must have the ability to generate the cash flow required to support relatively high interest expense.
Some of the key ways to increase the PE firm’s return (in theory, at least) include:
- – reduce the purchase price that the PE firm has to pay for the company
- – increase the amount of leverage (debt) in the deal
- – increase the price for which the company sells when the PE firm exits its investment (i.e. increase the assumed exit multiple)
- – increase the company’s growth rate in order to raise operating income/cash flow/EBITDA in the projections
decrease the company’s costs in order to raise operating income/cash flow/EBITDA in the projections
By using significant amounts of leverage (debt) to help finance the purchase price, the private equity firm reduces the amount of money (the equity) that it must contribute to the deal. Reducing the amount of equity contributed will result in a substantial increase to the private equity firm’s rate of return upon exiting the investment (e.g. selling the company five years later).
First, we need to make some transaction assumptions. What is the purchase price and how will the deal be financed? With this information, we can create a table of Sources and Uses (where Sources equals Uses). Uses reflects the amount of money required to effectuate the transaction, including the equity purchase price, any existing debt being refinanced and any transaction fees. The Sources tells us from where the money is coming, including the new debt, any existing cash that will be used, as well as the equity contributed by the private equity firm. Typically, the amount of debt is assumed based on the state of the capital markets and other factors, and the amount of equity is the difference between the Uses (total funding required) and all of the other sources of funding.
The next step is to change the existing balance sheet of the company to reflect the transaction and the new capital structure. This is known as constructing the “proforma” balance sheet. In addition to the changes to debt and equity, intangible assets such as goodwill and capitalized financing fees will likely be created.
The third, and typically most substantial step is to create an integrated cash flow model for the company. In other words, to project the company’s income statement, balance sheet and cash flow statement for a period of time (say, five years). The balance sheet must be projected based on the newly created proforma balance sheet. Debt and interest must be projected based on the post-transaction debt.
Once the functioning model is created, we can make assumptions about the private equity firm’s exit from its investment. For example, a typical assumption is that the company is sold after five years at the same implied EBITDA multiple at which the company was purchased. Projecting a sale value for the company allows us to also calculate the value of the private equity firm’s equity stake which we can then use to analyze its internal rate of return (IRR). Absent dividends or additional equity infusions, the IRR equals the average annual compounded rate at which the PE firm’s original equity investment grows (to its value at the exit).
While the private equity firm’s IRR is usually the most important piece of information that comes out of an LBO analysis, the analysis also has other uses. By assuming the PE firm’s required IRR (amongst other things), we can back into a purchase price for the company, thus using the analysis for valuation purposes. In addition, we can utilize the LBO model to analyze the trend of credit statistics (such as the leverage ratio and interest coverage ratio) which is especially important from a lender’s perspective.