LBO Modeling is used to value a leveraged buyout (LBO) transaction where a target company is acquired using a significant amount of debt. The use of high leverage increases the potential returns on investors’ equity investments in the long-run. An LBO model is usually built in Excel to help investors properly evaluate the transaction and realize the highest possible risk-adjusted internal rate of return (IRR).
The following steps are essential to building a thorough and insightful LBO model:
Before building the LBO model, assumptions need to be made on inputs, including financing, operating metrics of the business, sources, and uses of cash, purchase price allocation, and operating scenarios.
Excel functions and formulas can be used to set up a drop-down list so that different results will be reflected in the later sections (such as the DCF model), as different scenarios are chosen.
Before completing the full forecast on the financial statements, a transaction balance sheet needs to be built to show the pro forma balance sheet items after recapitalization. The transaction balance sheet lays out the total adjustments and capital structure of the business after the LBO transaction is completed. The closing pro forma balance sheet will flow back up to the balance sheet section to drive the forecasts.
4. Debt and Interest Schedules
The debt and interest schedules model the details of all layers of debt and interest payments associated with the LBO transaction, including line of credit, term loans, and subordinated debt. With the debt schedules completed, the rest of the linking can be done for the financial statements.
Following the creation of the DCF model, sensitivity analysis can be performed to assess how the IRR will be affected when different independent variables change, holding all other assumptions unchanged.
Finally, charts and graphs can be created to present the change in cash flows and the amount of leverage over time.
Thank you for reading CFI’s guide to LBO Modeling. Check out some of these resources below, including a course that can help you learn to model LBO transactions in more detail!