Financial Training Associates makes a small sample of its LBO modelling course material available online free of charge. This course extract explains how private equity firms structure LBOs and provides a very high level overview of how LBO models are structured. You can either click on and play the video below, or read the transcript for the course.
LBO modelling course trainer: OK, let’s try and summarise some of that then. What we’ve seen is that we can use algebra to calculate IRR; we know that money multiple is another key measure of return for our private equity friends. And David, one more time, we’ve worked it out; we know that if somebody’s looking for a three times money multiple, what’s that translate to in terms of an IRR?
Delegate: Over five years it’ll be twenty-five percent.
LBO modelling course trainer: Over five years it will be twenty-five percent, absolutely right, OK. So two… two main ways of calculating return, and of course there’s a neat little function in Excel which will help us with those IRRs, and hopefully we understand now a little bit more what it’s about. I want to try and summarise this up. I was encouraging you to think, and I started by asking how do private equity firms make money? Matt told me buy low, sell high, and I think we’ve unpacked that a little bit now. Buy low, sell high. I was encouraging you to think in terms of a model with your returns, and I was asking you to imagine a model that showed, in Excel – this is not an Excel modelling course, but I was asking you to imagine a model which showed a private equity firm putting twenty into its investment, getting sixty out; and what we’ve looked at is all the different ways you could measure return on that. All right, so I’m encouraging you now, again, to think about how… how a model might be put together. And some of you have seen this already, I think; how a model might be put together. So what I’ve got on the board here, or I’m starting to put together, is a… a framework for our model. And our framework in… for our Excel model, it’s just, it’s just to show you the structure and how it might be mapped out. And what I’m going to start with is, in my model, is modelling entry. So I’m going to look at entry and exit, and I think you guys know – or some of you know, this is how private equity firms do it in their models; we’re modelling entry and we’re modelling exit. And what we’re going to think about for our valuation is we’re thinking about a hundred million business; and I’m thinking that that business – again this is the good old days – might have generated EBITDA, one of our profit measures, of ten million; might have been valued at a ten-times multiple. What do you think of that multiple, Matt?
Delegate: Pretty punchy!
LBO modelling course trainer: Pretty… pretty punchy. It is pretty high. And our valuation on the business, of course, is the same one hundred million that we’ve got on our previous chart up there at the back of the room: a hundred million. Now just so we know, we’ll talk about valuation later in the programme; it’s not the subject for now. EBITDA times the multiple; what kind of value is that one called in corporate finance speak?
LBO modelling course trainer: It’s enterprise… it’s something called enterprise value, or EV, isn’t it? OK, so we’re looking at a business, we’re looking at an asset which is valued at a hundred million. Initially we’re thinking about a house, now we’re thing about a business. And again we were in the good old days – we’re going to imagine that the amount of debt that that business could raise would be eighty million, which is… which again is ridiculously high in today’s market but the numbers work. We’re going to subtract off that debt. The equity in, of course, is going to be twenty, all right? No prizes for guessing what it’s going to look like on the exit – there’s room in your pack just to… just to write that down, that little framework what we’re doing here is just taking it a step further, looking at how you’d model this in practice and on the exit I’ll ask you some questions. EBITDA times our multiple equals, again, enterprise value when we sell. We’re going to subtract off the debt, and here we go we’re going to have our sixty million equity out – you know that’s a three times money multiple. All right?
So at… you… you’re just getting a record of that; that’s brilliant. How we’d model this; how we’d put this together in a model. I’ll just give you a couple of minutes to do that; so keep writing; just get that framework into your packs. And then next thing I’m going to ask you is to brainstorm. What I’d like you to do is use these Post-It Notes that we’ve got; and what I’d like you to do is tell me, as many answers as possible – there’s normally about five or six out there – in terms of driving returns, what are all the sorts of things – looking at that framework, what are all the sorts of things that might drive return. Matt’s already got part of it for us – buying low, selling high – we’ve talked about some of it on the way through. I reckon there’s probably about five or six Post-It Notes out there, probably, per person. How are we going to make money out of this deal that we’ve just modelled? Ready for some Post-It note action, Ollie? Yeah? All right.
See if you can get it; I know, you’ll be exercising your brain; see if you can get five or six. If there was a competition here – there’s no competition and there’s certainly no prize – but if there was a competition – as many Post-It Notes as possible looking at that chart, what’s going to drive return. Ready for Post-It Note action?
LBO modelling course trainer: Excellent. All right. Let’s do that. Just write… just… just write down on the Post-It Notes as many ideas as… as you can: what’s going to drive returns.
Initial leverage, and subsequent debt pay-down, both drive private equity returns in LBO modelling
LBO modelling course trainer: All right, I’m really interested to hear what you guys are thinking; I’m really interested to hear that. This is how I’m looking at this little model framework here. There’s a bunch of things that are driving the increase of money multiple. One of those things is how much debt I can get in from the start. How much debt I can get in. We already saw that that was going to have an impact on return; the more debt that we could get in to start with, the… the higher the money multiple or the IRR. So we saw that early on today. Paying debt down along the way; obviously if we could… if we could pay some debt down along the way our equity proceeds would be higher; and I think there’s a few other sort of broad categories here.
In an LBO model, selling at a higher valuation multiple than we bought at is another driver of returns
LBO modelling course trainer: Maybe we could sell at a higher multiple than we bought at; maybe we could sell at a higher multiple than we bought at – sometimes people call that multiple arbitra… absolutely right; thank you: multiple arbitrage. Not to be confused with the money multiple. The money multiple, of course, is a measure of return. When we’re talking about multiple arbitrage, what we’re talking about is selling at a higher multiple than we would buy in at.
Business growth drives LBO returns
LBO modelling course trainer: And I suppose the other thing that I can see on here, if you like there’s a few broad categories driving the equity return – the return on our money multiple – a few broad categories; debt pay down, how much debt I can get in to start with, multiple arbitrage and general business growth. Could you guys come up with your Post-It Notes please? And stick them up here and let’s see if they fit into some of these categories. General business growth was the other one.
Come up here and stick them up, and we’ll see whether they slot in there neatly or not. OK, so what have we got coming up? Yeah, reduction in debt. EBITDA growth, well done. Yeah, expanding the business. Comes in under growth. Selling at a high multiple. Exit multiple. EBITDA growth. Multiple arbitrage. Early debt repayment. Well done, you guys did well. All right. Excellent.
More course material on private equity and LBO modelling
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