LBO analysis
Also known as: Buyout model, Ability-to-pay analysis
The same cash flows run backwards. Not what is it worth, but what can be paid at a target return.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat actually happens?
Every other method on this desk asks what a business is worth. This one asks a different question: given that a buyer needs to make a certain return, what is the most it can pay?
You work backwards. Start with the return the fund needs. Decide how much debt the business can carry, because that is most of the purchase price. Forecast the cash flows over five years, work out how much debt gets repaid, and assume the business is sold at the end. Then solve for the one number that makes the return come out right.
That number is not a valuation. It is what one particular kind of buyer can afford. A strategic buyer that can cut duplicate costs can pay more; a market with tighter lending means every financial buyer can pay less.
Which is exactly why the analysis is useful. In an auction, it tells a seller what the financial bidders can reach, and therefore what a trade buyer has to beat. It sets the floor.
- 1
Return target1 day
The sponsor states what it needs to make, which is an input rather than a conclusion.
- 2
Debt capacity2–5 days
How much the business can borrow, from lenders rather than from a model.
- 3
The operating case1–2 wks
Cash flows through the hold period, with the debt paydown that follows from them.
- 4
Exit assumption1–2 days
The multiple at which it is sold years later, usually assumed equal to entry because assuming otherwise is a market call.
- 5
Solving for price1–2 days
The equation is inverted: given the return and the financing, what can be paid today.
What will lenders lend — The debt market decides. This is the constraint that actually binds, and it changes quarter to quarter with nothing about the business changing.
Is the exit assumption honest — Whoever reads the model decides. A case that relies on selling at a higher multiple than was paid is a case that relies on the market, and it should say so.
Who is on the deal
| Who | Side | What they are actually for |
|---|---|---|
| The sponsor | Buy side | States the return it needs, which is an input to the model rather than a conclusion from it. |
| The lenders | Neither | Decide the debt capacity, which is the constraint that actually binds the answer. |
| The analyst | Neither | Inverts the model: given the return and the financing, what can be paid. |
| The seller | Sell side | Sees only the bid, and can infer a great deal about the assumptions behind it. |
- Desk
- Valuation & Deal Analysis
- Answers
- What a financial buyer can pay and still make its return
- Sets
- A floor for the price, not a value
- Binding constraint
- What lenders will lend, which changes quarterly
- Assumption to test
- The exit multiple
What decides whether it completes
Not how hard this is, and not a rating — there is deliberately no total. It says which of five blockers decides whether this transaction happens at all, in the same order on all 70 transaction types so they can be compared. This publication's own reading; see the notice below.
- Pricematters
- Financingdecides it
- Approvalbarely applies
- Diligencematters
- Executionmatters
What decides it here. This method does not value anything; it inverts a return requirement, so the debt market sets the answer. The assumption to test is the exit multiple: a case that relies on selling higher than it bought is a case about the market rather than about the business.
3 · IntermediateHow it runs in practice
The mechanics
- Sources and uses. What is being paid for, and where the money comes from: debt, sponsor equity, management rollover.
- The operating case. Revenue, margins, capital expenditure and working capital over the hold period.
- The debt schedule. Interest paid, cash swept into repayment, covenants tested.
- The exit. Earnings in the final year, multiplied by an exit multiple, less remaining debt.
- The return, expressed as a multiple of money and an annual rate.
The three sources of return, separated
- Debt paydown — cash flow repays borrowings, and every unit repaid becomes equity value. Arithmetic, and it requires nothing of the business except that it keeps generating cash.
- Earnings growth — the business is made bigger or better. This is the part that is actually work.
- Multiple expansion — sold at a higher multiple than was paid. This is the market, not the buyer.
Splitting a modelled return into these three is the single most useful thing to do with one of these models, and it takes ten minutes.
Why the exit is usually assumed flat
Assuming you sell at a higher multiple than you bought is assuming the market will be kinder to you than it was to the seller. Conventional practice is to assume the exit multiple equals the entry multiple, so that the return comes only from the first two sources. A case that needs expansion to work should say so on the page.
Where it is used
By sponsors to decide what to bid, and by sell-side advisers to work out what the sponsors will bid — see the auction, where knowing the financial floor shapes how the process is run.
4 · AdvancedThe numbers & the documents
Why leverage raises the return
Buy a business for 100 with 40 of equity. Suppose it is worth 130 five years later and debt has fallen from 60 to 40. Equity is 90 against 40 invested: 2.25 times. The enterprise grew by 30%; the equity grew by 125%.
Now suppose it is worth 85 and debt is still 55. Equity is 30 against 40: a loss of a quarter, on an enterprise that fell by 15%. Same mechanism, both directions — see leverage.
The cash sweep, which is where models differ most
How much surplus cash is compelled to repay debt rather than sitting on the balance sheet. A structure with a full sweep deleverages faster and produces a better modelled return; one with a partial sweep leaves cash available for acquisitions. The sweep is negotiated in the credit agreement and it drives the answer, so a model that assumes one the documents do not permit is wrong in a way nobody will notice.
What the model cannot tell you
- Whether the operating case is achievable. The model does what it is told.
- Whether an exit will exist. Five years out, in a market nobody can see.
- Whether the leverage is survivable in a downturn — which is what a downside case is for, and it is the case people run last and read least.
How to read somebody else's
Three questions, in order. What is the exit multiple relative to entry. What proportion of the return comes from paydown rather than growth. And what happens in a case where earnings fall for two years — because a structure that cannot survive that is not conservative, however good the base case looks.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow people on the deal think about it
Now say it back
Close the page and give LBO analysis in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — name both sides and what each one is actually trying to get.
- What has to happen, in order — the three or four stages, not the whole timetable.
- Where the money comes from — cash, new shares, or borrowed; somebody has to fund it.
- What kills it — the ordinary way, not the dramatic one.
Where this transaction shows up elsewhere
- EasyFairness opinionDealA narrow statement, on a stated date, about one specific offer
- EasyLeveraged buyoutDealA company bought largely with borrowed money, secured on the company itself
- EasyPrecedent transactionsDealWhat was actually paid for similar businesses, control premium included
- MediumValuationDeskThe arithmetic underneath every transaction: discounted cash flow, comparables, precedent transactions, the buyout…
- HardCost of capitalDealThe rate everything is discounted at, assembled from inputs that are mostly estimates of things nobody can observe
- HardLevfinDeskHow a buyout is funded: the commitment, the flex, syndication, covenants and the exit that has to exist before the…