AN IN-DEPTH ANALYSIS ON

LBO MODEL
Linh Dao & Yifan Xu

PROFESSOR NICHOLAS CRAIN

OCTOBER 28, 2014
Owen Graduate School of Managment
 Fundamentals
I. Definition:

A leveraged buyout (LBO) is the acquisition of a company, division, business, or collection

of assets (target) using debt to finance a large portion of the purchase price.
The remaining portion of the purchase price is funded with an equity contribution by a
financial sponsor (sponsor).
LBOs are used by sponsors to acquire a broad range of businesses, including both public
and private companies, as well as their divisions and subsidiaries.
The sponsors ultimate goal is to realize an acceptable return on its equity investment upon
exit, typically through a sale or IPO of the target.

II. Typical Structure:

Investment exit within five years. In a traditional LBO, debt has typically comprised 60% to
70% of the financing structure, with equity comprising the remaining 30% to 40%.
The disproportionately high level of debt incurred by the target is supported by its
projected free cash flow and asset base, which enables the sponsor to contribute a small
equity investment relative to the purchase price.
The ability to leverage the relatively small equity investment is important for sponsors to
achieve acceptable returns.
The use of leverage provides the additional benefit of tax savings realized due to the tax
deductibility of interest expense.

III. Key Participants:

Financial Sponsors
Investment Banks
Bank and Institutional Lenders
Bond Investors
Target Management
 IV. Criteria for Successful LBO:

Mature industry and company: The stock price of the target company is preferably trading at a
lower multiple to FCF than others in the industry. Therefore, LBO purchasers can buy the
company at a relatively lower cost compared to the FCF it produces - key ingredient in
generating an attractive return for financial sponsors and investors.
Strong market position: If the company is well-positioned within its market (relative to other
competitors), it will be able to handle competitive pressures that might reduce profit margins
and will help provide potential growth opportunities for the business.
Strong management and substantial growth opportunity: Management is capable of running the
company effectively or creating a more efficient company (sustain competitive advantages
with lower costs or differentiation) and expanding into new profitable business segments or
products.
Balance sheet with little to no outstanding debt: Buyers prefer to use leverage as part of the
acquisition consideration. High amount of existing debt limit the companys ability to
withstand a higher level of new debt, and new debt is essential for the LBO. (Note that
existing debt, if any, will often need to be refinanced in an LBO in order to remove existing
financial limitations and covenants to fit the new capital structure).
Low future capital expenditure and working capital requirements: Part of the return LBO investors
seek will be generated from growing the business, and growth consumes cash in the short-
term in terms of reinvestment in new capital expenditures and working capital requirements
for the business.
Steady cash flows: Stable, recurring cash flows are critical to service the large new debt burden
for the LBO (especially in the first few years post-acquisition). Cyclical or highly seasonal
companies, therefore, can run into financial trouble in case of downturn. Debt pay-down is
also important to boost investor returns by increasing the equity/total assets ratio of the
company.
Possible divestitures of underperforming/non-core assets: Target companies often have divisions
or side businesses that are incurring losses and do not significantly contribute to the
companys total revenue. Often, these divisions can be sold to raise additional funds to pay
off outstanding debt more quickly.
Potential exit opportunities: Typically after 3-5 years, LBO investors would like to exit to realize
their target IRR. Holding the company beyond the optimal selling point will lower the
expected annual return on the investment since leverage decreases every year. Possible exits
include strategic sale to another company, an IPO, or sale to another LBO investor).
 Illustration
The case of Dells Privatization

Why this case: Silver Lake Partners $24B leveraged buyout of Dell. One of the largest LBO
transactions. Its an excellent example to learn from because of all the different elements:

Scenarios for revenue and expenses are very important because its a quasi-turnaround:
Dell needs to transition away from its declining desktop and laptop businesses and move
toward growing tablets, software, and services. And that may or may not work out.
Its not an acquisition of 100% of the company since Michael Dell is rolling over his equity
and contributing more cash.
The valuation and offer price are questionable, with Southeastern Asset Management
claiming that the company is worth $24.00 per share rather than $13.65 per share.
Microsofts participation via the $2 billion subordinated note its investing in.
Finally, post-transaction acquisitions will play a huge role here because Dell is unlikely to
achieve massive growth organically.

I. Transaction Assumptions
Answers to:
How much we actually pay for Dell?
What percentage of debt is optimal?
Steps:
1. Go to Investor Relations of Dell.com to pull out historical financial statements.
2. Go to 10-K for inputs of dilution calculation.
3. Go to 8-K Merger Agreement (most up to date if 10-K has not been released yet) for
capital structure.
Notes:
1. Interest rate should be modeled higher since their credit ratings have gone downhill
since the announcement.
2. Offer Price = Share price from the day before the rumor of Buyout and assume a
premium.
3. Equity Purchase Price = Diluted Shares * Offer Price.
4. Unlike traditional LBO that PE firm contributes equity and debt, here we have a lot of
other things: Michael Dell contributes personally, rolling over his own shares, cash
repatriated from offshore operations.
5. Funds required for the deal = Equity Purchase Price all other contribution.
6. Change the % of Debt used to determine the amount that SVP needs to contribute
(obviously needs to be a positive amount).
7. Refinancing debt would be an extra source of funds for the deal. Not in the base case.
 8. Dell has a lot of cash offshore, so when it takes cash back, it has to pay tax on the total
amount.

II. The Debt Assumption

Answers to:
How much to draw from revolver facilities?
What is the interest rate for each type of debt?
How much of principal to pay back annually?
Steps:
1. Information for the revolver facilities (undrawn initially from Merger Agreement)
2. The interest rate on revolver: LIBOR + 1% (currently is 97.5 bps but conservatively
assume a slight increase).
3. The interest rate on existing debt: the weighted average interest rates on all debt.
4. Work backward to get the % of each type of debt for flexibility of the model (ease of
changing the % of debt used in the Transaction Assumptions and updating the % of each
type of debt accordingly).
5. The amortization (principal repayment):
a. Term loan A has the highest: 20% principal repayment
b. Term Loan B & C has minimal to no principal repayment
c. High yield bonds: no principal repayment at all

III. Sources & Uses:

Answers to:
Where is funding coming from and going to?
Steps:
1. Uses:
a.Equity Value of company
b.Refinance Existing Debt: spend additional debt or equity pay off existing debt
c.Assume Existing Debt: have it on both sides just for clarification
d.Advisory Fees: based on the percentage of Equity Purchase Price
e.Financing Fees: based on the amount of debt used
f.Legal & Misc. Fees: fixed amount
g.Sum these up for Total Uses

2. Sources: very standard with different types of debt

a. Undrawn revolver
b. Term loans (B and C)
c. High yield notes: will be replaced by high yield bonds in the future
Bridge loans (1st and 2nd lien)
 ABL Facility
Microsofts Subordinated notes
d. Excess cash from Dell
e. Michael Dells own contribution and rollover equity

3. SPVs equity contribution is a plug (Uses Sources)

IV. Ownership Percentages & Purchase Price Allocation

Answers to:
What are the related parties ownership pre- and post-deal?
What is the amortization projection for the Purchase Price?
Steps:
1. Dell went from 15% to 75% post-deal.
2. SVP only owns 25% due to the amount of debt being used, Dells contribution and
rollover, SVPs relatively small contribution.
3. Goodwill Creation & Purchase Price Allocation: set up assumptions to amortize
goodwill created by the transaction and allocate the Purchase Price to Intangibles
Write-up.

V. Debt & Interest Schedule

Answers to:
How much cash flow does Dell actually generate each year after the buyout
takes place?
How much debt can they actually payout?
How are interest expenses calculated each year based on the debt initially and
existing debt balance?
How much does Dell pay off each year?
How much does the company have at the end of the transaction that goes to
silver lake company?
Steps:
1. Find and Enter Information on the Debts
a. Go through and search for terms such as interest rate, covenant, principal payment.
b. Go to table of content.
c. This case, the financing for the Merger (page 102): contribution of SLP, subordinated
debt, key terms on the debt, secured or unsecured, details of types of debt, drawn
or undrawn, first lien second lien, bridge loan
 d. Term facilities:
Interest rate
LIBOR based rate, floor (to protect debt investors and make sure they get an
interest rate of 4% or higher)
e. Bridge facilities: converted to normal term loan if they are not already converted
and swapped out and refinanced in the first place (standard term loan in this case).
Notes:
Inputs will go into the Assumptions section of the LBO model.
The percentage of each type of debt is back-calculated from the actual $ amount
for flexibility of the model.
There is mandatory payment for only term loan B and C (the amount needed to
repay each year), none for the rest.

2. Calculate Sources of Funding and Revolver Borrowing Required

a. Sources of funds: how much repaid each year.
b. Always start with beginning cash balance and also factor in any cash flow the
company generate over the course of the year and subtract all the minimum cash
balance needed to maintain at all time.
c. Beginning cash balance is directly linked to the Cash & Cash equivalents at the
beginning of the year
d. Cash flow generated is linked to cash flow available for debt repayment in CFF of
the SCF.
e. Minimum cash balance is the assumption at the top.
Notes:
Be aware that if the Subtotal before Revolver is not enough to meet the
minimum mandatory payment for the debt, then the shortage amount would be
drawn from the revolver (like a credit card for the company) and incur additional
interest expense and should be paid off over time.
Mandatory debt repayment: it never gets close to the Subtotal before Revolver.
The first few years interest expenses are high b/c of the beginning balance but
will eventually go away.
If we make the mandatory payment higher, for example, then the model would
reflect the amount needed to draw from the revolver (use Max function to get
the bigger of 0 or the difference).
Total Sources of Funds is the sum of Subtotal before Revolver (cash flow Dell
can put to pay off debt) plus any revolver borrowed.

3. Calculate Mandatory Debt Repayment:

a. Mandatory debt repayment: term B is calculated using the smaller of prior balance,
or the required repayment (the product of the total balance times the yearly
amortization).
 b. Be careful that the Total Existing Debt is not simply equal to the prior year balance.
In the CFF section of SCF, we notice the issuance of commercial paper, proceeds
from new debt, and repayments of debt that we need to account for.

4. Calculate Optional Revolver Debt Repayment

a. Optional Debt Repayment of Revolver: we are paying the smaller of Prior year
revolver balance, or how much cash left to pay (Subtotal before Revolver subtracts
how much being paid so far this year). Then we take the larger of 0 and the
difference (we only pay optionally if there is no need to borrow additionally from
the revolver in the first place). The main idea is if how much cash left is negative, we
always repay nothing; if how much cash left is positive, then we use all of the
remaining cash to make the optional payments.
b. The same logic is applied to other types of debt that come subsequently in order of
claims to assets.

5. Calculate Optional Existing Debt Repayment

a. Go to the 10K Note 5 Borrowings to see the details and aggregate future
maturities of long-term debt outstanding.
b. Total existing debt repayment is pretty much similar to the mandatory one, though
we make some adjustments for the changes in the CFS and all of the prior
mandatory repayments.
c. First take the smaller of the total existing debt balance at the end of the year after
the mandatory repayment (prior debt balance mandatory debt repayment on
existing debt + all changes in CFF of CFS) and the leftover cash (after we use
Subtotal before Revolver to pay the Mandatory Repayment Total and other above
optional repayments).
d. Take the bigger of the first and 0 to arrive at the optional repayment on existing
debt.
e. Apply the same logic to other types of debt that come subsequently in order of
claims to assets.

6. Link the Debt Schedules to Financial Statements

a. Cash generated from the balance Sheet: anything from the Subtotal before Revolver
remaining after making both the required and optional repayments.
b. Go to the CF avail. For Debt repayments section (next to CFF) of CFS and link the
total of debt repayments (both mandatory and optional) for each type of debt in the
Debt Schedule. At the end we show the Total Cash Flow used to repay Debt during
the course of the year.
c. Make sure Net Change in Cash formula actually reflect the actual cash used to repay
debt
d. Then we update the new balance for each type of debt under the Long-term
Liabilities section of BS (prior balance the amount repaid throughout the year).

7. Calculate Interest Expense (with Circular Reference)

 a. Take the higher of the LIBOR floor and the project LIBOR curve, then add it to the
LIBOR to get the interest rate for the respective type of debt.
b. Be aware that some of the debts are linked to the fixed interest rate (existing debt,
subordinated note), some have the floor and some do not. Need to double check
carefully.

8. Calculate Interest Income (Expense) and Link to Cash Flow Statement: last step because
of the circular reference
a. If the assumptions allow circular reference, then we average the balances (this year
and last year), if not then we use the current balance multiplied by the LIBOR rate.
b. Apply the same logic to other types of debt that come subsequently in order of
claims to assets. Due to the nature of debt, the interest expense would be more
negative in the first few years then becomes less negative.
c. Go to Income Statement once again, under Investment & Other Income, Net, we
link that to the Net Interest Income (Expense) of the Debt Schedule.

VI. Post-Buyout Add-On Acquisitions

Context:
Dell is in the midst of transforming itself from what was a very much PC-focused
company to one is more software and services-oriented.
As stated in the Merger Agreement, Dell is going to acquire companies in year 2
and year 4 (needs adjustment on BS, IC and SCF on year 2 and year 4).
Often seen as an effective way for company to generate cash flows for debt
repayments through organic growth of acquisition.
Answers to:
Can Dell achieve that?
Can Dell have higher valuation multiple? Can Dell be more valuable making such
changes?
If Dell keeps acquiring companies like in the past few years, what impacts will be
on the models?
How big should these companies be? What should their revenue growth and
margins look like? How much debt and equity to finance the acquisition?
How does that impact the models, returns and investment recommendation?
Required Adjustments:
Purchase price
Form of payment
Revenue & Expenses for each acquisition
 3 Statements changes
Tie EBIT to purchase price and assume an effective yield
Steps:
1. Overview of Changes to Model
a. Income Statement:
Revenue contribution from acquisition
Operating Expenses from acquisition
New intangibles from acquisition
b. Statement of Cash Flow:
Instead of Pro-formas, we model transaction adjustments
New intangibles from acquisition
Linking some items (Stock based compensation, depreciation) to the
combined revenue
c. Debt Schedule: for each acquisition we will add the corresponding
Interest Assumptions
Mandatory and Optional Debt Repayment

2. Find Information on Potential Acquisitions

a. Go to 10-K, Note 7 Acquisition (historical data): how much spent on each M&A
deal, purchase price allocation (to intangibles, cash, goodwill), the amount of net
sales and net income these acquired companies have contributed.
b. Go to Investor Presentation (projection estimates): total amount spent on
acquisition, number of deals, post-acquisition revenue, IRR Target for M&A Business
cases.

3. Check against Historical Results:

a. Negative Full-year Forward Net Income Contribution: pro forma net income is less
than the net income in Dells consolidated net income (these acquired companies
have low or negative margins), casting doubt on their 15% IRR very interesting
b. In SAMs letter sent to Dell few days after the announcement: the acquisitions since
2008 are worth even more than any single line of Dells businesses skeptical.

4. Make Assumptions for the Post-Buyout Acquisitions:

a. Calculate the average allocation of Total Amount Spent on All Acquisitions (given in
10-K)
Goodwill Created
Intangible Assets Created
Cash & Cash Equivalents
Account Receivable
Long-term Deferred Revenue
Other Long-term Liabilities
b. So we can estimate the allocation amount to each of these BS accounts based on the
new purchase price and how the combined BS would look like afterward.
 c. After calculating the Approximate Annual Amortization, we add it back to Full-year
Forward Net Income Contribution to get the Pre-tax Income before Amortization &
Merger Fees.
d. Yield = Pre-tax income/Total Amount Spent on Acquisitions -> compare to Target
IRR.
e. Make assumptions on & of Cash vs. Debt to finance the deal, interest rate, LIBOR
Floor, principal repayment Operating income yield, operating margin, revenue
growth rate.

5. Reflect on the Income Statement

a. Link all Revenue contribution from the acquisition assumption page and grow them
using the revenue growth
b. Link all Operating expense from the acquisition assumption page and use the proper
margin
c. Link New intangibles directly from the acquisition assumptions and divided by the
given useful lives.

6. Adjust Balance Sheet

a. Debit: Cash, AR, Goodwill, Intangibles created
b. Credit: Long-term deferred revenue, Other long-term liabilities, Debt raised and
Equity issued for the deal
c. Detailed Notes are posted next to each item.
d. Be aware to link the post-transaction columns.

7. Update the Cash Flow Statement

a. Link relevant items (Stock-based Compensation, CapEx, ) to the combined
revenue.
b. Make sure the years are properly linked together.

8. Update Debt Schedules and Interest Expense Calculations

a. First put No to Circular Reference on the Assumption to avoid having #REF!
error. Turn it back on after done.
b. The formula already take care of the change in LIBOR curve.
c. Re-link to the post-transaction columns for year 2 and year 4.
d. Update with the mandatory repayment on Acquisition 1 & 2 debt.

9. Verify and Check the Model

a. Balance Check.
b. Make sure cells in year after acquisition are properly linked to the previous years
cells.

10. Evaluate Effectiveness of Post-Buyout Add-On Acquisitions

a. Invest return: Exit Multiple, IRR.
b. Operating Sensitivity Analysis:
As the acquisition size gets bigger, the IRR for SVP actually goes down.
For lower yield and negative yield, as the size goes up, the IRR goes down.
 For positive yield then it flips -> sometime you spend more on acquisitions and
they are unprofitable, they much hurt the overall valuation.
Having a much higher yield and spending more can help. But its difficult to find a
good company with yield in that range that is still growing at a good cliff of 10%
annually, and can be acquired in this $ amount.
These types of acquisitions would not make huge impacts unless they are high
yielding, quickly growing companies, and therefore more expensive -> its
unclear the best way to achieve growth through acquisition.