Creating a Revenue Model
February 12, 2025
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Just like mergers and acquisitions, modeling for leveraged buyouts (LBOs) also requires special skill and knowledge. In this article, we will have a closer look at how leveraged buyouts work as well as how financial modeling techniques need to be adopted to meet the needs of investors indulging in LBO’s.
A leveraged buyout is a special type of acquisition. As the name suggests, this type of acquisition involves the extensive use of leverage i.e., debt. Hence, if a company takes over another company using large amounts of debt to fund the process, then the transaction is called leveraged buyout. There is no standard definition of how much debt constitutes a leveraged buyout. However, if more than 50% of the purchase price is funded using debt, then the acquisition is generally referred to as a leveraged buyout.
Over the past years, leveraged buyouts have polarized the investment community. There are some people in the industry who swear by the usefulness of leveraged buyouts. On the other hand, there are other people who believe that leveraged buyouts benefit nobody except the people financing them. This is because leveraged buyouts are like a high stakes gamble wherein the company obligates itself to making large debt payments over several years. If they are able to increase their cash flows in order to pay back the loans, then all works out well. Otherwise, even established companies end up in bankruptcy because they lose large amounts of equity value to debt payments.
A financial modeler must have a clear understanding of how leveraged buyouts create value. This understanding is important because it is the financial modeler’s job to highlight the value drivers in the model clearly. The decision-makers should not have to spend much time understanding how the proposed value will be created. Instead, the model should be intuitive and easy to understand. Usually, LBO’s are known to create value in one of the two ways mentioned below.
Generally, firms only take on short term and long term debt. Hence, their cash flow is easy to predict. The modeler only needs to multiply the outstanding debt with an interest rate. Later, adjustments are made for new debt raised and existing debt repaid. However, the complexity is low. Hence, modeling is not very difficult.
However, this is not the case with leveraged buyouts. Since firms require a lot of debt, they usually take it from different sources on very different terms and conditions. Hence, predicting cash flow becomes a challenging task. Some of the types of debt commonly used in a leveraged buyout have been explained below.
It is important to understand that only the types of debt have been mentioned above. For each type of debt, the firm has many tranches, and there are different terms and conditions attached to each tranche. This is what makes financial modeling for leveraged buyouts mind-bogglingly complex.
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