Modelling equity structure in an LBO
The next stage of the LBO modelling course is to insert a preferred equity instrument (such as loan stock or preference shares) into the buyout structure. Download a copy of the spreadsheet used for this final section of the course: modelling equity.
- “Grab” the scroll bar with your mouse and start scrolling down. Look at what happens to the “private equity loan stock” box.
- Look at what happens to the % split of ordinary shares as loan stock increases. Look at what happens to private equity and management’s returns.
- By clicking in the cells in the spreadsheet, and examining the calculations, can you work out what is going on?
In this model (cell E10) we are assuming that a 10% dividend on the loan stock accumulates and is repaid on exit. As more loan stock is inserted into the structure management’s % of the ordinary shares increases, and management’s expected returns increase. Private equity investors are happy to see management rewarded because they want them motivated. In addition, because the loan stock ranks ahead of ordinary shareholders, the loan stock gives private equity some downside protection should the business not perform as anticipated, and sale proceeds not be as high as expected.
Time for your end of course LBO course modelling test:
- How big a stake can management ask for before private equity’s returns drop say to 30%?
Click here to download an Excel spreadsheet containing the answer: LBO modelling course answer. We have just developed some kind of framework for discussing management’s potential stake in an LBO! If you are now an expert, why don’t you try and work out what the impact would be on management’s stake if private equity were happy to accept a 25% return?
Of course in answer to the managing director’s question at the start of this case study, “How much could a management-led bid afford to pay for the business?”, he can pay what he likes! But the more he pays, the lower the return for everyone involved. He really wants to pay enough to secure the business and the opportunity against competing bidders, but buy in at a low enough price so that returns are still high.
Key learning points from the LBO modelling course
- Structuring the equity and introducing a preferred equity instrument helps get management’s equity stake up. For the private equity firm the structure helps motivate management.
- The structure means that the private equity firm gets a larger share of sale proceeds if exit occurs at an undervalue (private equity get some downside protection).
- The structure also encourages management towards exit once growth slows (e.g. if obligations on the preferred instrument keep on increasing at a high rate).
The difference between the simple Excel spreadsheet and full LBO modelling
A full LBO model would differ from this simple one, but the principles are the same. In a full LBO model you would expect to see sources and uses of funds and modelling of returns (equity in against equity out). The difference is that profits and cash flow available for debt paydown would be modelled much more accurately, through a full financial statement model.
Return to the start of the LBO training course
Please click here to return to the start of the LBO course training.
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