WSP Paper LBO (Answer)

Overview of Paper LBO Model Steps Before we begin, the steps to build a paper LBO can be found below. Step 1: Input Transaction and Operational Assumptions Step 2: Build “Sources & Uses" Table Step 3: Project Financials Step 4: Calculate Free Cash Flow (FCF) Step 5: LBO Returns Analysis Step 1: Input Transaction and Operational Assumptions The first step is to lay out the operational assumptions that were provided in the prompt, and to calculate the total amount paid to purchase the target company as shown below: Step 1. Input Transaction and Operational Assumptions Eutry Valuation Operational Assumptions LTWM EBITDA $20 LTWM Reveuue $100 Eutry WMultiple 10.0x Anaual Revewue Growth $10 Purchase Euterprise Value $200 EBITDA WMargin 7o 207 DéA “To of Revenne 10%% Capex (Enter as "-") (4$5) Aw NWC $0 Leverage Wattiple 5.0 Tuterest Rate 5% TaxRate 407 Formulas Used in Step 1 « Purchase Enterprise Value = LTM EBITDA x Entry Multiple EBITDA Margin % = LTM EBITDA + LTM Revenue Step 2: Build “Sources & Uses” Table Next, we will build out the Sources & Uses table, which will be a direct function of the transaction structure assumptions. In this particular example, the purchase multiple used was 10.0x EBITDA and the deal was funded using 5.0x leverage. More specifically, the objective of this section is to figure out the exact cost of purchasing the company, and the amount of debt and equity financing that would be required to complete the acquisition. The amount of debt used will be calculated as a multiple of LTM EBITDA, while the amount of equity contributed by the private equity investor will be the remaining amount required to “plug” the gap and make both sides of the table balance. Ultimately, the main goal of an LBO model is to determine how much the firms' equity investment has grown, and to do so — we need to first calculate the size of the initial equity check by the financial sponsor. Step 2. Build "Sources & Uses” Table Sources & Uses Sources Uses Debt Financing 4100 Equity Purchase Price $200 Spovsor Equity 100 Total Sources $200 Total Uses $200 Formulas Used in Step 2 « Debt Financing = Leverage Multiple x LTM EBITDA « Sponsor Equity = Total Uses — Debt Financing In a real LBO model, the Uses of Funds Section will likely include transaction and financing fees, among other uses. In addition, other more complex concepts like management rollover will be reflected in both the sources and uses of funds. However, these nuances are unlikely to show up here, so unless you were explicitly provided with additional data in the prompt, focus exclusively on the data provided. Step 3: Project Financials ‘We have completed filling out the Sources & Uses section of our model, so now we will project the financials of JoeCo down to net income (the “bottom line"). The operational assumptions that will drive the projections were provided in the first step. Step 3. Project Finaucials JoeCo Finawcials Vear 1 Year 2 Vear 3 Year 4 Year 5 (% in millions) Revene $10 $120 $130 $140 $150 EBITDA 22 24 26 26 30 Less: D&A 1) “12) (3) 14) “15) €BIT 1 $12 493 14 415 Less: Interest 5) (5) ) ) ®) BT 46 $7 40 $a $10 Less: Taxes (2) ®3) 3) (4) “) Net Income $4 $4 $5 45 6 As a side note, for interview purposes, it is reasonable to round your calculations to the nearest whole number for convenience Formulas Used in Step 3 * Revenue = Prior Period Revenue + Annual Revenue Growth EBITDA = EBITDA Margin % x Current Period Revenue * D&A Expense = D&A % of Revenue x Current Period Revenue « Interest = Debt Financing Amount x Interest Rate % Step 4: Calculate Free Cash Flow Next, we will project JoeCo's free cash flows (FCFs) throughout the five-year holding period. The FCF generation ability of an LBO target will determine the amount of debt that can be paid down during the holding period — however, there will be no principal paydown assumed. Step 4. Caleulate Free Cash Flow Free Cash Flow Mear 1 Mear 2. Year 3 Year 4 Vear 5 Net Income $4 $4 $5 45 46 Plus: D&A " 12 13 14 15 Less: Capex () ) ) (5) () Less: A in NWC 0 0 0 0 0 Free Cash Flow $10 M1 3 14 16 Formulas Used in Step 4 * Free Cash Flow = Net Income + D&A — Capex — Change in NWC Step 5: LBO Returns Analysis In the last step, we will assess the returns of the investment based on the cash-on-cash return and the internal rate of return (IRR). Recall from earlier, the prompt stated that the PE firm exited the investment at the same multiple as entry (i.e. no “multiple expansion”). Since you will likely not have access to a calculator, calculating the IRR requires some back-of-the-envelope work. The LBO holding period assumption is usually 5 years, so we recommend memorizing the IRRs based on the most common cash-on-cash-returns. TRR Approximations Holding Period 5 Years Cash-on-Cash Return Actual TRR Roumded TRR 1.5x 2.4 10.0%% 2.0x 14.9%% 15.0% 2.5% 204 20.0%% 3.0% 246 25.0% 3.5% 29.5% 30.0% The Rule of 72 (and 115) Forgot your IRRs? No problem — in most cases, the return should be even easier to approximate under the Rule of 72, which estimates the time that it takes to double an investment as 72 / rate of return. For example, over a 5-year horizon, the approximate IRR required to double the investment is 72/ = ~15%. There's also the lesser-known Rule of 115, which estimates the time it takes to triple an investment as 115 / rate of return. If you are facing difficulty estimating the IRR, there is a high likelihood that you may have made a mistake in a previous step. As for this example, the cash-on-cash return is around 2.5x — as calculated by dividing the exit equity value by the initial sponsor equity contribution. Using either the table above or the Rule of 72 and 115, we can approximate the IRR of this investment to be marginally in excess of ~20%. Step 5. Returus Avalysis Exit Valuation Return Wetrics Vear 5 EBLTDA $20 Cash-on-Cash Returns 2.6x Exit Mutiple 10.0¢ Tnterval Rate of Return (TRR) 21.4% Exit Enterprise Value 4300 Tuitial Debt Amount $100 Less: Camulative FCF (©4) Final Year Net Debt $36 Exit Equity Value $264 Formulas Used in Step 5 o Exit Enterprise Value = Exit Year EBITDA x Exit Multiple Final Year Net Debt = Initial Debt Amount — Cumulative FCFs Exit Equity Value = Exit Enterprise Value — Ending Year Net Debt Cash-on-Cash Return = Exit Equity Value = Initial Sponsor Equity Internal Rate of Return (IRR) = Cash-on-Cash Return * (1/t) — 1 Paper LBO in Private Equity Interviews Paper LBOs are used by private equity firms — and in some cases, headhunters - to quickly vet a potential candidate and take place at fairly early stages of the PE Interview Process (i.e. first round). As candidates progress to subsequent rounds, private equity firms often ask interviewees to complete a far more detailed LBO Modeling Test. By contrast, other LBO modeling tests are longer, with candidates usually given between 1 to 3 hours or even as a take-home case study. * Basic LBO Model Test * Standard LBO Model Test * Advanced LBO Model Test Paper LBO vs. "On-the-Job" Modeling On the job, you will build two types of LBO models most frequently: « Short-Form LBO Models: These are usually similar to the level of complexity you'll encounter in an LBO Modeling Test and are used at the pre-letter of intent (LOI) stage of a deal when the PE firm has received a Teaser, signed an NDA and received a confidential information memorandum (“CIM") from the investment banker which contains high-level financial data. « Fully Integrated LBO Model with Operating Model: At later stages of the deal process, LBO models become far more advanced and contain fully integrated financial statements, as well as a variety of accounting, tax, and transaction adjustments not usually tested in the recruiting process. These are the models that private equity firms hire us to train their associates on. = -3