Leveraged Buyout (LBO) Model for Private Equity Firms

When it comes to growing your firm, sometimes it helps to have a bit of leverage, and we’re not talking about having the right people on your side (although that always helps!). Instead, we’re talking about leverage in the form of debt, known in the industry as a leveraged buyout (LBO). 

An LBO is a phrase that refers to the use of “leverage” to buy out a business. Acquirers are usually private equity firms, although LBOs can also apply to companies, as well as a business’ current management. They occur for either strategic and growth reasons, financial reasons, or all three.

For PEs, leveraged buyouts mean borrowing as much as possible from various lenders and then funding the remaining balance with their own equity, usually at a 90%-10% ratio, respectively. By incorporating LBOs into the firm’s growth strategy, PEs can expect to see greater returns within a shorter time frame. How, exactly? Read on as we dive into the PEs role in an LBO, and the model and metrics to measure to help your firm navigate a successful acquisition. 

The PEs Role in an LBO

More often than not, PEs serve as the initiators of any LBO. In contrast to VCs, who typically opt to invest in startups and do not have majority control, the PEs main goal in an LBO is quite the opposite. When purchasing a majority stake of a company they see growth potential in, PEs enter an LBO to be more hands-on and take control. 

From management guidance and innovative growth ideas to deep industry expertise, PEs bring new insights and the ability to shift the strategic direction of the newly acquired organization. When pairing that invaluable expertise with the financial leverage to acquire even more resources, PEs can drive rapid expansion for the company, usually within three to five years. This growth would not have been possible otherwise, and due to a fast exit rate, LBOs serve as a time-tested way for PEs to build corporate value over an accelerated time frame.  

The LBO Model

Before making an acquisition, PE firms conduct their due diligence through a series of steps, including analyzing a potential company’s assets, cash flows, and capital expenditures. If the deal seems to have potential, the PE firm negotiates a price and outlines a deal structure. Next, they source capital to take ownership of the business, then implement strategic changes and cost-cutting measures to accelerate growth (and revenue). 

To determine if a deal is worth pursuing, firms use an LBO model for evaluation, which, as the Corporate Finance Institute explains, can get pretty complicated due to the unique factors that go into such a deal. These include:

  • A high degree of leverage
  • Multiple tranches of debt financing
  • Complex bank covenants
  • Issuing of Preferred shares
  • Management equity compensation
  • Operational improvements targeted in the business

Once evaluating those factors, PEs need to measure key metrics to ensure the deal is favorable, such as:

  • Debt/EBITDA
  • Interest Coverage Ratio (EBIT/Interest)
  • Debt Service Coverage Ratio (EBITDA – Capex) /  (Interest + Principle)
  • Fixed Charge Coverage Ratio (EBITDA – Capex – Taxes) / (Interest + Principle)

When analyzing these metrics, PEs should also conduct what’s called a sensitivity analysis. This analysis forecasts LBO outcomes based on different assumptions and scenarios, such as changing the EV/EBITDA acquisition multiple, the EV/EBITDA exit multiple, and the amount of leverage (ie: debt) used.

If using a templated LBO model, it’s essential to keep in mind that certain models use specific assumptions. In Firmex’s templated LBO model, for example, it assumes 100% acquisition of the target company, that the most recent year-end balance sheet is the closing balance sheet, that there are no step-ups in asset values, and that there will be no amortization of goodwill from an acquisition. If these assumptions don’t apply to your deal, factor that in during your analysis. 

Put Your Acquisitions on Autopilot

From due diligence tracking and contract negotiations to compiling traditional and alternative data together to determine if a deal will be favorable for your firm, many moving parts go into an LBO. 

To centralize the data and communications into one hub, a PE-designed CRM like Altvia can be a differentiator in optimizing your LBO process. To learn how we can help your firm, set up a time to chat with a member of our team. 

A traditional crm was built for general ‘customer’ scenarios

Software platforms have made the world a better place by making work a better place. Indeed the world is better off when people enjoy their jobs even marginally more, and workplace applications on big CRM platforms like Salesforce.com have done that and much more.

But the potential that platforms like these offer presents diminishing returns: once the platform provider has engineered too many industry specific components into its platform, its usefulness for other industries begins to be threatened, and with that so do the usefulness of the component tools built into the platform.

So it is with the CRM category that Salesforce.com has defined: it is generic enough to work for many industries, and yet still offers the potential for others to round off the edges and nail more vertically-oriented and extremely tailored software solutions.

Private capital markets are actually a great demonstration of this dynamic. Where generic CRM platforms simplify — appropriately so — to assume there’s a business, a customer, a sale, and service of that customer, there are a few industry-specific pieces that are missing.

Take for example, that investors become customers by investing through legal entities the GP raises. It’s a subtle but important nuance that just doesn’t make sense at a platform-as-a-service level (because it’s overly complicated for a simple one-time sale that many industries require), but which can easily be added without 10 years or software engineering. Once provided, the rest of the platform’s components become tremendously powerful again and you’re set to take over the world.

As a traditional CRM in our pillars methodology, these nuances must be present to properly account for investors in these legal entities, potential target companies and which are owned by these entities, the context of all interactions with these parties (as well as the appropriate overlap, ie co-investments), and how you’re arriving at finding these opportunities on both sides of the equation, such that you’re able to piece together what’s effective and what’s not. Not just because we say so, but because these are the very relationships and data that are key to the motivation behind a CRM in any industry.

It’s critical, too, that the valuable publicly-available information that helps to enrich CRM systems and save users painful steps of entering it themselves is fully-integrated at the platform level.

Again, look no further than the 3,000+ pre-built integrations that Salesforce.com — the creator of the CRM platform concept — has at a platform level to do so, and which only exists by way of holding just short of overly-specifying certain industry workflows that would present challenges to properly integrate.

Stakeholder reporting and communication (investor relations) draws on a range of datasets

The traditional “customer service” model of CRM systems once again makes overly-simplified assumptions about the customer relationship when applied to private capital markets.

In fifteen years I personally have yet to hear the terms “warranty” or “service call” in this market because it’s just not the same. But make no mistake, as uncomfortable as it may be to say aloud, customer service is more important now than ever and it’s constantly happening; the industry is, after all, considered to be a financial “service”.

As it turns out, that service is primarily information-based — it’s driven by data and takes the form of reports and analysis that drive decisions, and then end up again in investor-facing reports and analysis.

The foundational elements of a private capital markets CRM must be built such that they accommodate this data (like we discussed above), but so too that it can accommodate additional supporting data that investors (customers!) need in the context of service.

Oftentimes this supporting data — financial metrics and time-based values, for example — is believed not to meet the traditional definition of CRM and the natural thought is “well, better do this in Excel!”.

While I happen to believe Excel is still the greatest software application ever built, its introduction to this value chain we’ve discussed herein actually creates the problem many firms suffer from: key data needed to provide customer service (again: effectively the entirety of a firm’s reports and analysis) is now in disparate systems and detached.

Both of those dynamics are important and distinct: not only is this supplemental data disparate, but when brought together there is no logical association that can be made between the two data sets.

Allow me, then, to make the point very simply: not only can this financial and time-based value data (you may be thinking about is as “portfolio monitoring” or “accounting”) be a part of a CRM, it is arguably the most important part of a CRM because it’s at the core of what providing service to the customer entails — information that comes out of data!

Firms need a digital method to engage stakeholders (ie investor portals)

Investor portals are not new; in fact, for many of us — including myself — they conjure up horrifying nightmares in which we’re aimlessly guessing at folders to find the newest document we need.

So in lies the opportunity: not only have the portals we’ve come to hate not simplified the process of acquiring information, they’ve failed to create an entirely new experience that is “customer service” driven.

To be fair, this is not a B2C market where you’d be long out of business for not having focused on customer service and thus the customer’s technology-driven experience. But don’t expect to be around too much longer if you aren’t thinking about this shift.

Today’s institutional investors increasingly expect this same consumer-like experience, and a massive opportunity is being missed by not providing it. It’s not about providing them the experience they desire; it’s more about the ability to measure engagement that is had in return.

Put simply: what’s keeping the market from providing this experience is the availability of the information that’s required to create the service that provides the experience.

If you’ve hung in this long, you know that by focusing on your CRM, you have the data that’s required to manage the customer relationship and the technology-driven experience through which that information is shared to create a differentiated and opportunistic customer experience.