## LBO Model Valuation

The **LBO valuation** is a central tool used to evaluate financial structure, return on investment and valuation of a potential target of a leveraged buyout.

A simple LBO model starts with free cash flow projections. To reduce leverage over time funds amortize on their debt. Commonly buyout funds use a 100% cash sweep, which means that all free cash flows after interest expense are used to repay repayable debt.

At the expected year of exit a terminal value using the Gordon growth formula is calculated. The terminal value is equal to the EV at the expected year of exit. To find the value of the equity at the expected year of exit simply deduct debt from EV. The IRR is calculated using the value of equity at entry and the value of equity at exit. While it is possible to use the Gordon growth formula for simplicity, practitioners would likely use an exit multiple based on comparable companies to find the terminal value.

### Financial structure of LBO Valuation

The financial structure takes a central role in a LBO model. Designing the financial structure involves assessing whether the target can support a given leverage under different assumptions. To manage credit risks lenders will want to analyze the targets ability to pay annual interest and to repay debt in time. The stakeholders in an LBO transaction will use a number of different leverage and coverage ratios to assess the capital structure. Common measures include: debt/Ebitda, debt/ total capitalization, ebitda/interest expense

In a typical **LBO valuation** the financial structure involves a mix of different types of debt and equity. Buyout funds use large amounts of leverage, on average debt comprise about 70% of the total enterprise value in buyouts. Debt is divided into tranches of different seniority. The term seniority refers to in which order debt holders receive payment.

### IRR method used in LBO Valuation

While LBO models used by practitioners are complex they boil down to one critical measure, it has to meet the hurdle IRR. Depending on the stage of investment, hurdle IRRs vary. IRR varies depending on the risk level, e.g. new ventures are more risky than well established companies and therefore venture capitalists require higher IRRs than managers of buyout funds.

Private Equity funds typically have hurdle rates in the region 20-30%. If the IRR proves to be too low it can have significant effect on the rest of the model. When this happens the fund will often reconsider their financial structure, in particular it will be of interest to adjust the equity contribution. Other common options are to try to adjust the purchase price or assumptions about the exit.

Building the LBO valuation the fund must decide on the use of free cash flows. It is common for buyout funds to employ a 100% cash sweep. Thus there will be no dividends to the buyout fund. Under the assumption of a 100% cash sweep the IRR is calculated as:

In practice there may also be other cash flows, e.g. to extract return prior to exit, the fund may want to do a dividend recapitalization which means that the company incurs new debt in order to pay a dividend to the private equity fund. With inter-temporal cash flows, IRR is calculated as:

How leverage enhances IRR, fictive example LBO transactions generate returns by taking on large debt followed by debt repayments and growth in enterprise value which is made possible by skilled management and strategic decisions. A larger debt level provides the additional benefit major tax savings, since tax is deductible. This is illustrated in the fictive example below.

When comparing the two different scenarios using 30% respective 70% debt, the annual free cash flow (FCF) is reduced in the latter due to the incremental annual interest expense. For year 1 the incremental annual interest expense is calculated by multiplying the additional debt (700-300 = 400. 400) with the assumed rd=8%, resulting in an incremental interest expense of 32 in year 1, after 26.3% corporate tax, the closing FCF is down to 36, which then is used to pay down debt. For each year of the projection period, the incremental interest expense can calculated as:

*Interest cost = (Scenario70%DebtoperningY1 – Scenario30%DebtopeningY1) * rd * (-t)*

By the end of year 5, the equity in the 70% debt scenario has grown from 300 to 917, resulting in an IRR of 25% and cash return multiple of 3.1. In the 30% debt scenario, FCFs are the same as for the 70% debt scenario. Each year’s FCFs after interest payments are used to amortize the debt (5*60=300), resulting in an all equity company in year 5. The equity stake has then grown from 700 to 1,410, resulting in an IRR of 15% and a cash return multiple of 2.0.

Clearly the higher debt level results in a higher return on equity for the investor. On the other hand higher leverage increases the risk which makes the firm potentially more vulnerable during economic downturns etc.