Leveraged Buyout and LBO Model Bonus Videos: Simple LBO Model – Case Study and Tutorial

Hello and welcome to another tutorial video. This time around we’re going to go through a
quick LBO modeling test or, as it's sometimes called, a “Paper LBO Model.” Now these are very,
very common in private equity interviews and really in all types of finance interviews where this
topic could come up. And what they'll often do is instead of having you sit down and create a
full Excel model with a lot of complicated detail that takes you several hours or a week or
something like that.

They may give you a very simple scenario and say, “Here is our scenario. Here's where the
company’s EBITDA is, here's how much debt we're using. Here's what we expect for capital
expenditures. Here's what you should assume for the debt repayment and the cash. Here's the
multiple that we're aiming for. And then based on this, what should we be paying for this
company upfront in the beginning?" So they could easily give you a scenario like this and it tests
not only your understanding of these modeling concepts and how an LBO works, but also if you
can condense and simplify information and if you can figure out from the clues they give you,
what different line items should be.

[01:02]

So let's go to our Excel file for this. As you can see it's going to be very, very simple because it is
a very simple scenario, intended to test in a few minutes whether or not you can figure this out.
So what we're going to do here is pretty much start at the top and start filling out our EBITDA
and some of the other metrics up here. Then go down to the cash flow section and see if we
can use this to perhaps flesh out some more of the items at the top.

Then we are going to look at the exit at the end and then based on some of the numbers here,
we're going to calculate what the initial price for this company should be. In this case the
private equity firm ABC Capital is targeting a 3.0x multiple of invested capital and plan to sell
the company after five years at an enterprise value of the EBITDA multiple of 6.0x. So we're
going to go through this exercise and see what's required to do that.

Now the first two parts here are actually irrelevant to the fact that the company has poor
operating results – Revenue and EBITDA have declined. That doesn't matter because with LBO
models you're only worried about future periods. You can sort of ignore these first two
paragraphs here.

[02:03]

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The first relevant part they tell you is that OpCo, the company that they’re going to be acquiring
has an EBITDA of $250 million and they expect EBITDA to stay flat for the next five years. What
does that mean in terms of our model? What it means is that in Year 0, we have EBITDA of $250
million and each year after that it stays flat.

Notice how we're not even bothering with formatting or anything else like that to make this
look pretty. We just want to get to the correct answer because of the speed test here.

What else is relevant? They're also telling us that ABC Capital has obtained debt financing of
$750 million and they expect working capital to be a source of funds at $6 million per year.

So let's going into these assumptions. The beginning debt balance is going to be $750 million,
the interest rate going to be 10% and then working capital they said source of funds at $6
million per year, that means that the change in working capital, I have actually just labeled it
"Working Capital." I should really call it "Change in Working Capital." It's going to be a positive
and it's going to add to our cash flow each year because they say source of funds right here.

[03:04]

There's a lot of confusion about this topic, but in this case it's very, very simple. So this might be
a company where for example, they collect a lot of deferred revenue upfront and so they're
getting more cash than what you'd expect from just looking at their income statement. It could
be something like that. It could be that they're taking a while to pay suppliers, but they're
collecting cash from customers very quickly. So there are a number of reasons why working
capital could be a source of funds, but those are some guesses in this case.

So I’m going to say six in each year here of Year 1 through Year 5. We have that assumption
entered right here. Let's keep going down. So OpCo requires capital expenditures of $35 million
per year and has a tax rate of 40%. So let's think about those assumptions going into them. Now
the capital expenditure assumptions are going to be on the cash flow statement, or really this
mini cash flow area that we have.

[03:53]

Really all we're doing is starting with our net income. And then we're making some of the usual
adjustments you see on the cash flow statement like adding back non-cash charges, subtracting
CapEx. But we're not going through a full cash flow statement because it's not required by the
question and it would make it way too long to do this.

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So for CapEx it's going to be a use of cash because they're spending money on that. So we're
going to take this, copy this across. That's ($35 million) per year.

We also know the tax rate as they stated was 40%, so we have that information. Let's go back
to the case study and see what also we can enter. So we should assume no transaction fees,
zero minimum cash required that simplifies some of this treatment. And that PP&E on the
Balance Sheet remains constant for the next five years. That is very important because what
that tells you is that depreciation must equal capital expenditures if the net PP&E number is
staying constant for the next five years.

So they're not telling us directly what depreciation here should be, but we know from the
question prompt that it has to be equal to the CapEx. As I say over here, CapEx has to equal
D&A which equals $35 million because the PP&E stays constant.

[04:57]

For it to stay constant, depreciation will have to be a positive of course. CapEx will be a negative
and so they'll cancel each other out. So for the depreciation, I'm going to link to our CapEx and
just flip the sign for this one, so we have that.

And then I'm also going to go back to the income statement and enter our depreciation figures
right here. And remember, these are going to be negative on the income statement because
when you subtract D&A from EBITDA, you get to your EBIT, your operating income, then when
you subtract interest from that you get to your pre-tax income or earnings before taxes, EBT
down here. So we have that.

Now let's go back and keep going through these assumptions. Assume that excess cash is not
used to repay debt and instead simply accumulates in the Balance Sheet. In real life you
wouldn't necessarily do this, but I'm just trying to give you some round numbers here that you
can work with. With these numbers, the advantage is that these are so simple and such clean
numbers, that you could conceivably do this in your head or write out on paper, which is why
it's called a Paper LBO model sometimes. And that's why we’re making this assumption here.

[05:52]

So let's think about this, what does this actually mean? So to figure out how much cash actually
accumulates and what our Debt Balance is over time, we have to do a couple things. So first off
for the Debt Balance, what we're going to do here is link to our beginning Debt Balance up at
the top. And then for the debt and each year after that, if we actually had cash that was

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generated that we can use for debt repayment, we could use it to repay that debt. But in this
case we don't. So this cash is just going to build up on a Balance Sheet over time.

How do we figure out what this cash flow is and then what the Debt Balance is? Well the Debt
Balance is easy because they're telling us that nothing is repaid. So the $750 million is going to
stay the same through all five years here in this model. Now the Cash Generated, to get this we
have to figure out what the company's Net Income is and some of these other metrics.

Now we already have our D&A, so we can take that and our EBITDA and get to our Operating
Income or EBIT. But we need to get to the interest first. To do that, we can take our Interest up
here and I'm going to anchor this with F4 and then we're going to multiply by the beginning
Debt Balance. In other words, the Debt Balance from the prior year, Year 0 here. This is what's
going to determine our interest in Year 1.

[07:00]

We have and let's copy this across. We have $75 million in interest. Now we get to our Pre-Tax
Income. So I’ll take our EBITDA and our D&A and our Interest, those all have negative signs, so
we can just add these. So our EBT, our pre-tax income, is $140 million each year.

What about the taxes? Well, for these we can take our Tax Rate, I'm using a negative sign here.
We can take our Tax Rate and anchor this with F4, multiply by EBT and then copy this across.
Then for our Net Income, just take our Pre-Tax Income and our Taxes, so we get to Net Income
of $84 million per year right here.

Now what about the cash that's generated? Remember how the cash flow statement works.
We start at the top with Net Income and then we adjust for Non-Cash Charges, Working Capital
and then subtract Capital Expenditures. That gets us to our free cash flow, technically our
levered free cash flow or something like that, because we are including Interest Expense here.

[07:52]

So for the cash generated, we're going to take our net income and then we're going to add our
Depreciation. Our Working Capital is going to add to our cash flow here because they its source
of funds here and then our Capital Expenditures, we're adding that because it’s already
negative. That, of course, is going to reduce our cash flow.

So we have this. Let's copy it across and you can see that they generate $90 million of cash each
year here because we're assuming no debt repayment. What really happens is that we have our

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Net Income of $84. The D&A and the CapEx cancel each other out and so all that really happens
here is that our Change in Working Capital boosts our Net Income of $84 million and takes that
up to $90 million instead. So we have that. And now with this done, we can move into the last
step of this process which is figuring out the required purchase price to get a 3.0x multiple of
invested capital, add an EV/EBITDA multiple of 6.0x. So let's work backwards and think about
how you do this.

We know what our EBITDA at the end of this period is, it's just the $250 million we had from
the start. We also know that they're telling us to some assume a 6.0x Exit Multiple, so we have
that. What is the Exit Enterprise Value then? We take our Exit Multiple of 6.0x and we multiply
it by our EBITDA of $250 million.

[09:00]

Now, to figure out how much actually goes to the private equity firm, you pretty much always
assume that they have to repay any outstanding debt. And then any excess Cash Generated can
be put toward that debt, so it's going to increase how much they get back at the end, the Cash
Generated is going to increase that. The debt remaining that they have to repay is going to
decrease that amount. So that's one way to think about it.

You can also think about it like this, that to go from Equity Value to Enterprise Value you have
to subtract Cash and add Debt. If you're going from Enterprise Value to Equity Value you do the
opposite. So you would subtract Debt and add Cash instead. So there are a couple of ways to
think about it, but that is what you do in this case.

Now for the Debt, we want to take the remaining balance at the end. So I'm going to use a
negative sign and have this negative for the $750 million right here. And then for the Cash
Generated, so what we can say for this is we can just add up the cash flow each year because
remember, we assume that this just stays on the company's Balance Sheet. We assume
basically that they didn't have any cash to begin with or that the cash they had was the bare
minimum they needed. So we’re just going to have this for our total Cash Generated. It comes
out to $450 million.

[10:04]

The Equity Proceeds. Let's add up all these numbers. So we have our Exit Enterprise Value
minus our Debt plus our Cash. This gets us to $1.2 billion for the Exit Proceeds. Now to figure
out what the initial investment was. This part is a little bit tricky. Remember, per the case study
instructions, that they are targeting at 3.0x multiple of Invested Capital and they plan to sell this

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company after five years. So let's enter this 3.0x multiple right here and what we can then do is
take our Equity Proceeds, this is what goes to the private equity firm at the end, divide by our
multiple of invested capital and that will give us the Initial Equity Investment that the PE firm
made.

Now this is not the total amount that they paid for the company, because, remember, they
used the $750 million of debt in the beginning as well. But this is going to get us the equity
portion of what they contributed in the beginning. Let's take this, divide by the multiple
invested capital right there. So we have that.

[10:56]

And then for the initial price, what I'm going to say is that we will take the $400 million that
they must've contributed in the beginning. And then we're going to add the Debt, which gives
us the total price they paid there. Equity Contribution plus the Debt they used to buy the
company, $1.15 billion.

What is this as a multiple of EBITDA? We can just take that price and divide by the Year 0
EBITDA here or the Year 1 EBITDA. It doesn't even matter because they stay the same each year
in this case. And so we get to a multiple of 4.6x. And so that is really it.

You can see some of the logic over here. I've just written out in words that the initial
investment is $400 million. To get to a 3.0x multiple of Invested Capital, they use $750 million
of debt. So the total price is $1.15 billion, representing a 4.6x EBITDA purchase multiple. So
that's it. This gets you to the correct answer now and in most cases that's it, you're done.

One other quick thing to point out is that in this case, one conclusion we might draw is that,
on the surface this doesn't necessarily seem like a great deal because to get the multiple of
invested capital they’re targeting, we actually need multiple expansion.

[12:01]

We need the Exit Multiple to go up from the 4.6x in the beginning up to 6.0x here at the end
which is expansion of about 30%, 33%, 35%, something like that. So that is one quick conclusion
we can draw based on this very, very simple math.

But that is really it for our Paper LBO model tutorial, or quick LBO model tutorial. Hope you
understand some more about this concept now and are better prepared to do this in case study

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interviews. It is really not that difficult. You just need to work quickly, forget about formatting
and get to the math and the final answers as quickly as possible.

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