Investment Banking: How to Create a Pro Forma Model for an LBO Analysis
In investment banking, the first step in an LBO analysis is to project the cash flows of the firm over the expected time frame of the LBO — generally six to eight years. The specific cash flow definition generally used in the LBO market is earnings before interest, taxes, depreciation, and amortization (EBITDA).
Akin to real estate agents looking at the prices that comparable homes have sold for in the area to set an asking price for a home just being listed, investment bankers will look at comparable LBOs that have recently been transacted in the marketplace to determine the debt levels that the market will likely support to fund the LBO.
These debt levels are generally referred to as multiples of EBITDA. For instance, the likely level of total debt may be four times EBITDA or six times EBITDA. The level of debt that the market will likely support for an LBO is a function of both the risk of the particular LBO and current market conditions.
Risk of the LBO
LBOs are high-risk, high-return operations. Investors too often fixate on the enormous returns they might enjoy if everything works out according to plan. But in business, things don't always work the way they're supposed to.
The risk of an LBO refers to the variability or volatility of the EBITDA projections and how likely they are to be reached. The less variability in the EBITDA projections — that is, the more certain the analyst is that there won't be negative surprises in EBITDA in the foreseeable future — the higher the multiples of EBITDA that the LBO will support.
That is why simple businesses with stable cash flows (such as firms that produce consumer staples like food) are the best targets for LBOs, because their cash flows are more stable and less vulnerable to surprises due to downturns in the economy or technological innovations.
Some markets are simply better for LBOs than others. When credit conditions are loose and the risk appetite of market participants is strong, the multiples of EBITDA that an LBO will support expand and it's an opportune time for private equity sponsors to participate in the LBO market. Investment bankers often refer to these kinds of markets as easy money periods.
Alternatively, when credit conditions tighten and the risk appetite of market participants is weak, it's a poor time for private equity sponsors to participate in the LBO market.
In the wake of the recent financial crisis of 2008 and 2009, the LBO market basically disappeared for a period of time due to tight money and the freezing of the credit markets. Firms that had LBOs planned around the time of the outbreak of the credit crisis had to cancel their plans because credit was simply not available.
Market conditions can make a huge difference in the level of debt that an LBO deal will support. For example, according to S&P Capital IQ, during the fourth quarter of 2009, the average leverage of large corporate LBOs was slightly less than four times EBITDA. In the third quarter of 2012, the average leverage of LBOs expanded to nearly six times EBITDA.
Over less than a three-year time period, the amount of debt supported by large corporate LBOs had expanded by nearly 50 percent! Now, remember, these numbers are averages. Some deals command much higher multiples based upon the specific circumstances of the firm. However, timing related to market conditions is extremely important when considering an LBO.
As you may expect, there is a direct relationship between how attractive the market values LBOs and the volume of LBOs that are brought to market. Given poor market conditions, the volume of LBOs fell substantially in 2009, because the terms of LBOs were simply not attractive.
Volume has picked up as the multiples of EBITDA have increased, but LBO volume as of late 2013 still had not returned to the pre–financial crisis levels of 2006 and 2007.