Step II(a): Build Historical and Projected Income Statement through EBIT

The banker typically begins the pre-LBO model by inputting the target's historical income statement information for the prior three-year period, if available. The historical income statement is generally only built through EBIT, as the target's prior annual interest expense and net income are not relevant given that the target will be recapitalized through the LBO. As with the DCF, historical financial performance should be shown on a pro forma basis for non-recurring items and recent events. This provides a normalized basis for projecting and analyzing future financial performance.

Management projections for sales through EBIT, as provided in the CIM, are then entered into an assumptions page (see Exhibit 5.52), which feeds into the projected income statement until other operating scenarios are developed/provided. This scenario is typically labeled as “Management Case.” At this point, the line items between EBIT and earnings before taxes (EBT) are intentionally left blank, to be completed once a financing structure is entered into the model and a debt schedule is built (see Exhibit 5.29). In ValueCo's case, although it has an existing $1,000 million term loan and $500 million of senior notes (see Exhibit 5.5), it is not necessary to model the associated interest expense (or mandatory amortization) as it will be refinanced as part of the LBO transaction.

From a debt financing perspective, the projection period for an LBO model is typically set at seven to ten years so as to match the maturity of the longest tenured debt instrument in the capital structure.² A financial sponsor, however, may only use a five-year projection period in its internal LBO model so as to match its expectations for the anticipated investment horizon. As a CIM typically only provides five years of projected income statement data,³ it is common for the banker to freeze the Year 5 growth rate and margin assumptions to frame the outer year projections (in the absence of specific guidance). As shown in ValueCo's pre-LBO income statement (Exhibit 5.4), we held Year 5 sales growth rate, gross margin, and EBITDA margin constant at 3%, 40%, and 21%, respectively, to drive projections in Years 6 through 10.

Step II(b): Input Opening Balance Sheet and Project Balance Sheet Items

The opening balance sheet (and potentially projected balance sheet data) for the target is typically provided in the CIM and entered into the pre-LBO model (see Exhibit 5.5, “Opening 2012” heading).⁵ In addition to the traditional balance sheet accounts, new line items necessary for modeling the pro forma LBO financing structure are added, such as:

• financing fees (which are amortized) under long-term assets
• detailed line items for the new financing structure under long-term liabilities (e.g., the new revolver, term loan(s), and high yield bonds)

The banker must then build functionality into the model in order to input the new LBO financing structure. This is accomplished by inserting “adjustment” columns to account for the additions and subtractions to the opening balance sheet that result from the LBO (see Exhibits 5.5 and 5.15). The inputs for the adjustment columns, which bridge from the opening balance sheet to the pro forma closing balance sheet, feed from the sources and uses of funds in the transaction (see Exhibits 5.14 and 5.15). The banker also inserts a “pro forma” column, which nets the adjustments made to the opening balance sheet and serves as the starting point for projecting the target's post-LBO balance sheet throughout the projection period.

Prior to the entry of the LBO financing structure, the opening and pro forma closing balance sheets are identical. The target's basic balance sheet items—such as current assets, current liabilities, PP&E, other assets, and other long-term liabilities—are projected using the same methodologies discussed in Chapter 3. As with the assumptions for the target's projected income statement items, the banker enters the assumptions for the target's projected balance sheet items into the model through an assumptions page (see Exhibit 5.53), which feeds into the projected balance sheet. Projected debt repayment is not modeled at this point as the LBO financing structure has yet to be entered into the sources and uses of funds. For ValueCo, which has an existing $1,000 million term loan and $500 million of senior notes, we simply set the projection period debt balances equal to the opening balance amount (see Exhibit 5.5). At this stage, annual excess free cash flow⁶ accrues to the ending cash balance for each projection year once the pre-LBO cash flow statement is completed (see Step II(c), Exhibits 5.9 and 5.10). This ensures that the model will balance once the three financial statements are fully linked.

Depending on the availability of information and need for granularity, the banker may choose to build a “short-form” LBO model that suffices for calculating debt repayment and performing a basic returns analysis. A short-form LBO model uses an abbreviated cash flow statement and debt schedule in place of a full balance sheet with working capital typically calculated as a percentage of sales. The construction of a traditional three-statement model, however, is recommended whenever possible so as to provide the most comprehensive analysis.

Operating Activities

Income Statement

Links In building the cash flow statement, all the appropriate income statement items, including net income and non-cash expenses (e.g., D&A, amortization of deferred financing fees), must be linked to the operating activities section of the cash flow statement.

Net income is the first line item in the cash flow statement. It is initially inflated in the pre-LBO model as it excludes the pro forma interest expense and amortization of deferred financing fees associated with the LBO financing structure that have not yet been entered into the model. The amortization of deferred financing fees is a non-cash expense that is added back to net income in the post-LBO cash flow statement. Certain items, such as the annual projected D&A, do not change pro forma for the transaction.

As shown in Exhibit 5.6, ValueCo's 2013E net income is $345.2 million, which is $160.3 million higher than the pro forma 2013E net income of $184.9 million after giving effect to the LBO financing structure (see Exhibit 5.31).

Balance Sheet Links

Each YoY change to a balance sheet account must be accounted for by a corresponding addition or subtraction to the appropriate line item on the cash flow statement. As discussed in Chapter 3, an increase in an asset is a use of cash (represented by a negative value on the cash flow statement), and a decrease in an asset represents a source of cash. Similarly, an increase or decrease in a liability account represents a source or use of cash, respectively. The YoY changes in the target's projected working capital items are calculated in their corresponding line items in the operating activities section of the cash flow statement. These amounts do not change pro forma for the LBO transaction. The sum of the target's net income, non-cash expenses, changes in working capital items, and other items (as appropriate) provides the cash flow from operating activities amount.

As shown in Exhibit 5.7, ValueCo generates $520.1 million of cash flow from operating activities in 2013E before giving effect to the LBO transaction.

Investing Activities

Capex is typically the key line item under investing activities, although planned acquisitions or divestitures may also be captured in the “other investing activities” line item. Projected capex assumptions are typically sourced from the CIM and inputted into an assumptions page (see Exhibit 5.52) where they are linked to the cash flow statement. The target's projected net PP&E must incorporate the capex projections (added to PP&E) as well as those for depreciation (subtracted from PP&E). As discussed in Chapter 3, in the event that capex projections are not provided/available, the banker typically projects capex as a fixed percentage of sales at historical levels with appropriate adjustments for cyclical or non-recurring items.

The sum of the annual cash flows provided by operating activities and investing activities provides annual cash flow available for debt repayment, which is commonly referred to as free cash flow (see Exhibit 5.25).

As shown in Exhibit 5.8, we do not make any assumptions for ValueCo's other investing activities line item. Therefore, ValueCo's cash flow from investing activities amount is equal to capex in each year of the projection period.

Financing Activities

The financing activities section of the cash flow statement is constructed to include line items for the (repayment)/drawdown of each debt instrument in the LBO financing structure. It also includes line items for dividends and equity issuance/(stock repurchase). These line items are initially left blank until the LBO financing structure is entered into the model (see Step III) and a detailed debt schedule is built (see Step IV(a)).

As shown in Exhibit 5.9, prior to giving effect to the LBO transaction, ValueCo's projected excess cash for the period accrues to the ending cash balance in each year of the projection period.

Cash Flow Statement Links to Balance Sheet

Once the cash flow statement is built, the ending cash balance for each year in the projection period is linked to the cash and cash equivalents line item in the balance sheet, thereby fully linking the financial statements of the pre-LBO model.

As shown in Exhibit 5.10, in 2013E, ValueCo generates excess cash for the period of $353.3 million, which is added to the beginning cash balance of $250 million to produce an ending cash balance of $603.3 million.⁷ This amount is linked to the 2013E cash and cash equivalents line item on the balance sheet.

At this point in the construction of the LBO model, the balance sheet should balance (i.e., total assets are equal to the sum of total liabilities and shareholders' equity) for each year in the projection period. If this is the case, then the model is functioning properly and the transaction structure can be entered into the sources and uses.

If the balance sheet does not balance, then the banker must revisit the steps performed up to this point and correct any input, linking, or calculation errors that are preventing the model from functioning properly. Common missteps include depreciation or capex not being properly linked to PP&E or changes in balance sheet accounts not being properly reflected in the cash flow statement.

Step III(a): Enter Purchase Price Assumptions

A purchase price must be assumed for a given target in order to determine the supporting financing structure (debt and equity).

For the illustrative LBO of ValueCo (a private company), we assumed that a sponsor is basing its purchase price and financing structure on ValueCo's LTM 9/30/2012 EBITDA of $700 million and a year-end transaction close.⁸ We also assumed a purchase multiple of 8.0x LTM EBITDA, which is consistent with the multiples paid for similar LBO targets (per the illustrative precedent transactions analysis performed in Chapter 2, see Exhibit 2.35). This results in an enterprise value of $5,600 million (prior to transaction-related fees and expenses) and an implied equity purchase price of $4,350 million after subtracting ValueCo's net debt of $1,250 million.

For a public company, the equity purchase price is calculated by multiplying the offer price per share by the target's fully diluted shares outstanding.⁹ Net debt is then added to the equity purchase price to arrive at an implied enterprise value (see Exhibit 5.13).

Step III(b): Enter Financing Structure into Sources and Uses

A sources and uses table is used to summarize the flow of funds required to consummate a transaction. The sources of funds refer to the total capital used to finance an acquisition. The uses of funds refer to those items funded by the capital sources—in this case, the purchase of ValueCo's equity, the repayment of existing debt, and the payment of transaction fees and expenses, including the tender/call premiums on ValueCo's existing bonds. Regardless of the number and type of components comprising the sources and uses of funds, the sum of the sources of funds must equal the sum of the uses of funds.

We entered the sources and uses of funds for the multiple financing structures analyzed for the ValueCo LBO into an assumptions page (see Exhibits 5.14 and 5.54).

Sources of Funds

Structure 1 served as our preliminary proposed financing structure for the ValueCo LBO. As shown in Exhibit 5.14, it consists of:

• $2,150 million term loan B (“TLB”)
• $1,500 million senior notes (“notes”)
• $2,100 million equity contribution
• $250 million of cash on hand

This preliminary financing structure is comprised of senior secured leverage of 3.1x LTM EBITDA, total leverage of 5.2x, an equity contribution percentage of approximately 35%, and $250 million of ValueCo's cash on hand (see Exhibit 5.2).

We also contemplated a $250 million undrawn revolving credit facility (“revolver”) as part of the financing. While not an actual source of funding for the ValueCo LBO, the revolver provides liquidity to fund anticipated seasonal working capital needs, issuance of letters of credit, and other cash uses at, or post, closing.

Uses of Funds

The uses of funds include:

• the purchase of ValueCo's equity for $4,350 million
• the repayment of ValueCo's existing $1,000 million term loan and $500 million senior notes
• the payment of total transaction fees and expenses of $150 million (consisting of financing fees of $90 million, tender/call premiums of $20 million, and other fees and expenses of $40 million)

The total sources and uses of funds are $6,000 million, which is $400 million higher than the implied enterprise value calculated in Exhibit 5.12. This is due to the payment of $150 million of total fees and expenses and the use of $250 million of cash on hand as a funding source.

Step III(c): Link Sources and Uses to Balance Sheet Adjustments Columns

Once the sources and uses of funds are entered into the model, each amount is linked to the appropriate cell in the adjustments columns adjacent to the opening balance sheet (see Exhibit 5.15). Any goodwill that is created, however, is calculated on the basis of equity purchase price and net identifiable assets¹⁰ (see Exhibit 5.20). The equity contribution must also be adjusted to account for any transaction-related fees and expenses (other than financing fees) as well as tender/call premium fees that are expensed upfront.¹¹ These adjustments serve to bridge the opening balance sheet to the pro forma closing balance sheet, which forms the basis for projecting the target's balance sheet throughout the projection period.

Exhibit 5.16 provides a summary of the transaction adjustments to the opening balance sheet.

Sources of Funds Links

The balance sheet links from the sources of funds to the adjustments columns are fairly straightforward. Each debt capital source corresponds to a like-named line item on the balance sheet and is linked as an addition in the appropriate adjustment column. For the equity contribution, however, the transaction-related fees and expenses as well as the tender/call premiums must be deducted in the appropriate cell during linkage. Any cash on hand used as part of the financing structure is subtracted from the existing cash balance.

Term Loan B, Senior Notes, and Equity Contribution

As shown in Exhibit 5.17, in the ValueCo LBO, the new $2,150 million TLB, $1,500 million senior notes, and $2,100 million equity contribution ($2,040 million after deducting $20 million tender/call premiums and $40 million of other fees and expenses) were linked from the sources of funds to their corresponding line items on the balance sheet as an addition under the “+” adjustment column.

Cash on Hand

As shown in Exhibit 5.18, the $250 million use of cash on hand was linked from the sources of funds as a negative adjustment to the opening cash balance as it is used as a source of funding.

Uses of Funds Links

Purchase ValueCo Equity

As shown in Exhibit 5.19, ValueCo's existing shareholders' equity of $3,500 million, which is included in the $4,350 million purchase price, was eliminated as a negative adjustment and replaced by the sponsor's equity contribution (less other fees and expenses and tender/call premiums).

Goodwill Created

Goodwill is created from the excess amount paid for a target over its net identifiable assets. For the ValueCo LBO, it is calculated as the equity purchase price of $4,350 million less net identifiable assets of $2,500 million (shareholders' equity of $3,500 million less existing goodwill of $1,000 million). As shown in Exhibit 5.20, the net value of $1,850 million is linked to the adjustments column as an addition to the goodwill and intangible assets line item.¹² The goodwill created remains on the balance sheet (unamortized) over the life of the investment, but is tested annually for impairment.

Repay Existing Debt

ValueCo's existing $1,000 million term loan and $500 million of senior notes are assumed to be refinanced as part of the new LBO financing structure, which includes $3,650 million of total funded debt. As shown in Exhibit 5.21, this is performed in the model by linking the repayment of the existing term loan and senior notes directly from the uses of funds as a negative adjustment.

Tender/Call Premiums

As part of the transaction, we assumed ValueCo's existing senior notes have a change of control provision and are required to be refinanced as part of the LBO. For illustrative purposes, we assumed that ValueCo's existing $500 million 8% 8-year senior notes were issued approximately four years ago and, therefore, the call price after the first call date would be 104% of par (par plus ½ the coupon, see Chapter 4). As a result, ValueCo's existing senior notes require a premium of $20 million ($500 million × 4%) to be paid to existing note holders.

Financing Fees

As opposed to M&A transaction-related fees and expenses, financing fees are a deferred expense and, as such, are not expensed immediately. Therefore, deferred financing fees are capitalized as an asset on the balance sheet, which means they are linked from the uses of funds as an addition to the corresponding line item (see Exhibit 5.22). The financing fees associated with each debt instrument are amortized on a straight line basis over the life of the obligation.¹³ As previously discussed, amortization is a non-cash expense and, therefore, must be added back to net income in the operating activities section of the model's cash flow statement in each year of the projection period.

For the ValueCo LBO, we calculated financing fees associated with the contemplated financing structure to be $90 million. Our illustrative calculation is based on fees of 1.5% for arranging the senior secured credit facilities (the revolver and TLB), 2.25% for underwriting the notes, 1.00% for committing to a bridge loan for the notes, and $5.3 million for other financing fees and expenses.¹⁴ The left-lead arranger of a revolving credit facility typically serves as the “Administrative Agent”¹⁵ and receives an annual administrative agent fee (e.g., $150,000), which is included in interest expense on the income statement.¹⁶

Other Fees and Expenses

Other fees and expenses typically include payments for services such as M&A advisory (and potentially a sponsor deal fee), legal, accounting, and consulting, as well as other miscellaneous deal-related costs. For the ValueCo LBO, we estimated this amount to be $40 million. Within the context of the LBO sources and uses, this amount is netted upfront against the equity contribution.

Step IV(a): Build Debt Schedule

The debt schedule is an integral component of the LBO model, serving to layer in the pro forma effects of the LBO financing structure on the target's financial statements.¹⁷ Specifically, the debt schedule enables the banker to:

• complete the pro forma income statement from EBIT to net income
• complete the pro forma long-term liabilities and shareholders' equity sections of the balance sheet
• complete the pro forma financing activities section of the cash flow statement

As shown in Exhibit 5.27, the debt schedule applies free cash flow to make mandatory and optional debt repayments, thereby calculating the annual beginning and ending balances for each debt tranche. The debt repayment amounts are linked to the financing activities section of the cash flow statement and the ending debt balances are linked to the balance sheet. The debt schedule is also used to calculate the annual interest expense for the individual debt instruments, which is linked to the income statement.

The debt schedule is typically constructed in accordance with the security and seniority of the loans, securities, and other debt instruments in the capital structure (i.e., beginning with the revolver, followed by term loan tranches, and bonds). As detailed in the following pages, we began the construction of ValueCo's debt schedule by entering the forward LIBOR curve, followed by the calculation of annual projected cash available for debt repayment (free cash flow). We then entered the key terms for each individual debt instrument in the financing structure (i.e., size, term, coupon, and mandatory repayments/amortization schedule, if any).

Forward LIBOR Curve

For floating-rate debt instruments, such as revolving credit facilities and term loans, interest rates are typically based on LIBOR¹⁸ plus a fixed spread. Therefore, to calculate their projected annual interest expense, the banker must first enter future LIBOR estimates for each year of the projection period. LIBOR for future years is typically sourced from the Forward LIBOR Curve provided by Bloomberg (see Appendix 5.1).¹⁹

As shown in the forward LIBOR curve line item in Exhibit 5.24, LIBOR is expected to increase incrementally throughout the projection period from 35 bps in 2013E to 250 bps by 2022E.²⁰ The pricing spreads for the revolver and TLB are added to the forward LIBOR in each year of the projection period to calculate their annual interest rates. For example, the 2013E interest rate for ValueCo's revolver, which is priced at L+425 bps would be 4.6% (35 bps LIBOR + 425 bps spread). However, since we contemplate a LIBOR floor of 1.25%, the TLB bears interest at 5.5% until 2018E when LIBOR is expected to increase above 1.25% (see Exhibit 5.26).

Cash Available for Debt Repayment (Free Cash Flow)

The annual projected cash available for debt repayment is the sum of the cash flows provided by operating and investing activities on the cash flow statement. It is calculated in a section beneath the forward LIBOR curve inputs. For each year in the projection period, this amount is first used to make mandatory debt repayments on the term loan tranches.²¹ The remaining cash flow is used to make optional debt repayments, as calculated in the cash available for optional debt repayment line item (see Exhibit 5.25).

In addition to internally generated free cash flow, existing cash from the balance sheet may be used (“swept”) to make incremental debt repayments (see cash from balance sheet line item in Exhibit 5.25). In ValueCo's case, however, there is no cash on the pro forma balance sheet at closing as it is used as part of the transaction funding. In the event the post-LBO balance sheet has a cash balance, the banker may choose to keep a constant minimum level of cash on the balance sheet throughout the projection period by inputting a dollar amount under the “MinCash” heading (see Exhibit 5.25).

As shown in Exhibit 5.25, pro forma for the LBO, ValueCo generates $371.8 million of cash flow from operating activities in 2013E. Netting out ($166.9) million of cash flow from investing activities results in cash available for debt repayment of $204.9 million. After satisfying the $21.5 million mandatory amortization of the TLB, ValueCo has $183.4 million of cash available for optional debt repayment.

Revolving Credit Facility

In the “Revolving Credit Facility” section of the debt schedule, the banker inputs the spread, term, and commitment fee associated with the facility (see Exhibit 5.26). The facility's size is linked from an assumptions page where the financing structure is entered (see Exhibits 5.14 and 5.54) and the beginning balance line item for the first year of the projection period is linked from the balance sheet. If no revolver draw is contemplated as part of the LBO financing structure, then the beginning balance is zero.

The revolver's drawdown/(repayment) line item feeds from the cash available for optional debt repayment line item at the top of the debt schedule. In the event the cash available for optional debt repayment amount is negative in any year (e.g., in a downside case), a revolver draw (or use of cash on the balance sheet, if applicable) is required. In the following period, the outstanding revolver debt is then repaid first from any positive cash available for optional debt repayment (i.e., once mandatory repayments are satisfied).

In connection with the ValueCo LBO, we contemplated a $250 million revolver, which is priced at L+425 bps with a 1.25% LIBOR floor and a term of six years. The revolver is assumed to be undrawn at the close of the transaction and remains undrawn throughout the projection period. Therefore, no interest expense is incurred. ValueCo, however, must pay an annual commitment fee of 50 bps on the undrawn portion of the revolver, translating into an expense of $1.25 million ($250 million × 0.50%) per year (see Exhibit 5.26).²² This amount is included in interest expense on the income statement, together with the annual administrative agent fee of $150,000.

Term Loan Facility

In the “Term Loan Facility” section of the debt schedule, the banker inputs the spread, term, and mandatory repayment schedule associated with the facility (see Exhibit 5.27). The facility's size is linked from the sources and uses of funds on the transaction summary page (see Exhibit 5.46). For the ValueCo LBO, we contemplated a $2,150 million TLB with a coupon of L+450 bps, LIBOR floor of 1.25%, and a term of seven years.

Mandatory Repayments (Amortization)

Unlike a revolving credit facility, which only requires repayment at the maturity date of all the outstanding advances, a term loan facility is fully funded at close and has a set amortization schedule as defined in the corresponding credit agreement. While amortization schedules vary per term loan tranche, the standard for TLBs is 1% amortization per year on the principal amount of the loan with a bullet payment of the loan balance at maturity.²³

As noted in Exhibit 5.27 under the repayment schedule line item, ValueCo's new TLB requires an annual 1% amortization payment equating to $21.5 million ($2,150 million × 1%).

Optional Repayments

A typical LBO model employs a “100% cash flow sweep” that assumes all cash generated by the target after making mandatory debt repayments is applied to the optional repayment of outstanding prepayable debt (typically bank debt). For modeling purposes, bank debt is generally repaid in the following order: revolver balance, term loan A, term loan B, etc.²⁴

From a credit risk management perspective, ideally the target generates sufficient cumulative free cash flow during the projection period to repay the term loan(s) within their defined maturities. In some cases, however, the borrower may not be expected to repay the entire term loan balance within the proposed tenor and will instead face refinancing risk as the debt matures.

As shown in Exhibit 5.27, in 2013E, ValueCo is projected to generate cash available for debt repayment of $204.9 million. Following the mandatory TLB principal repayment of $21.5 million, ValueCo has $183.4 million of excess free cash flow remaining. These funds are used to make optional debt repayments on the TLB, which is prepayable without penalty. Hence, the beginning year balance of $2,150 million is reduced to an ending balance of $1,945.1 million following the combined mandatory and optional debt repayments.

Interest Expense

The banker typically employs an average interest expense approach in determining annual interest expense in an LBO model. This methodology accounts for the fact that bank debt is repaid throughout the year rather than at the beginning or end of the year. Annual average interest expense for each debt tranche is calculated by multiplying the average of the beginning and ending debt balances in a given year by its corresponding interest rate.

As shown in Exhibit 5.27, in 2013E, ValueCo's TLB has a beginning balance of $2,150 million and ending balance of $1,945.1 million. Using the average debt approach, this implies interest expense of $117.7 million for the TLB in 2013E (($2,150 million + $1,945.1 million)/2) × 5.75%). The $117.7 million of interest expense is linked from the debt schedule to the income statement under the corresponding line item for TLB interest expense.

Senior Notes

In the “Senior Notes” section of the debt schedule, the banker inputs the coupon and term associated with the security (see Exhibit 5.28). As with the TLB, the principal amount of the notes is linked from the sources and uses of funds on the transaction summary page (see Exhibit 5.46). Unlike traditional bank debt, high yield bonds are not prepayable without penalty and do not have a mandatory repayment schedule prior to the bullet payment at maturity. As a result, the model does not assume repayment of the high yield bonds prior to maturity and the beginning and ending balances for each year in the projection period are equal.

For the ValueCo LBO, we contemplated a senior notes issuance of $1,500 million with an 8.5% coupon and a maturity of eight years.²⁵ The notes are the longest-tenored debt instrument in the financing structure. As the notes do not amortize and there is no optional repayment due to the call protection period (standard in high yield bonds), annual interest expense is simply $127.5 million ($1,500 million × 8.5%).

The completed debt schedule is shown in Exhibit 5.29.

Step IV(b): Complete Pro Forma Income Statement from EBIT to Net Income

The calculated average annual interest expense for each loan, bond, or other debt instrument in the capital structure is linked from the completed debt schedule to its corresponding line item on the income statement (see Exhibit 5.30).²⁶

Cash Interest Expense

Cash interest expense refers to a company's actual cash interest and associated financing-related payments in a given year. It is the sum of the average interest expense for each cash-pay debt instrument plus the commitment fee on the unused portion of the revolver and the administrative agent fee. As shown in Exhibit 5.30, ValueCo is projected to have $246.6 million of cash interest expense in 2013E. This amount decreases to $128.9 million by the end of the projection period after the bank debt is repaid.

Total Interest Expense

Total interest expense is the sum of cash and non-cash interest expense, most notably the amortization of deferred financing fees, which is linked from an assumptions page (see Exhibit 5.54). The amortization of deferred financing fees, while technically not interest expense, is included in total interest expense as it is a financial charge. In a capital structure with a PIK instrument, the non-cash interest portion would also be included in total interest expense and added back to cash flow from operating activities on the cash flow statement. As shown in Exhibit 5.30, ValueCo has non-cash deferred financing fees of $12 million in 2013E. These fees are added to the 2013E cash interest expense of $246.6 million to sum to $258.6 million of total interest expense.

Net Interest Expense

Net interest expense is calculated by subtracting interest income received on cash held on a company's balance sheet from its total interest expense. In the ValueCo LBO, however, until 2019E (Year 7), when all prepayable debt is repaid and cash begins to build on the balance sheet, there is no interest income as the cash balance is zero. In 2020E, ValueCo is expected to earn interest income of $1.1 million,²⁷ which is netted against total interest expense of $135.7 million to produce net interest expense of $134.6 million.

Net Income

To calculate ValueCo's net income for 2013E, we subtracted net interest expense of $258.6 million from EBIT of $556.9 million, which resulted in earnings before taxes of $298.2 million. We then multiplied EBT by ValueCo's marginal tax rate of 38% to produce tax expense of $113.3 million, which was netted out of EBT to calculate net income of $184.9 million.

Net income for each year in the projection period is linked from the income statement to the cash flow statement as the first line item under operating activities. It also feeds into the balance sheet as an addition to shareholders' equity in the form of retained earnings.

The completed pro forma income statement is shown in Exhibit 5.31.

Step IV(c): Complete Pro Forma Balance Sheet

Liabilities

The balance sheet is completed by linking the year-end balances for each debt instrument directly from the debt schedule. The remaining non-current and non-debt liabilities, captured in the other long-term liabilities line item, are generally held constant at the prior year level in the absence of specific management guidance.

As shown in Exhibit 5.32, during the projection period, ValueCo's $2,150 million TLB is completely repaid by 2019E. ValueCo's $1,500 million senior notes, on the other hand, remain outstanding. In addition, we held the 2012E deferred income taxes and other long-term liabilities amount constant at $300 million and $110 million, respectively, for the length of the projection period.

Shareholders' Equity

Pro forma net income, which has now been calculated for each year in the projection period, is added to the prior year's shareholders' equity as retained earnings.

As shown in Exhibit 5.33, at the end of 2012E pro forma for the LBO, ValueCo has $2,040 million of shareholders' initial equity (representing the sponsor's equity contribution less other fees and expenses). To calculate 2013E shareholders' equity, we added the 2013E net income of $184.9 million, which summed to $2,224.9 million.

The completed pro forma balance sheet is shown in Exhibit 5.34.

Step IV(d): Complete Pro Forma Cash Flow Statement

To complete the cash flow statement, the mandatory and optional repayments for each debt instrument, as calculated in the debt schedule, are linked to the appropriate line items in the financing activities section and summed to produce the annual repayment amounts. The annual pro forma beginning and ending cash balances are then calculated accordingly.

In 2013E, ValueCo is projected to generate $204.9 million of free cash flow. This amount is first used to satisfy the $21.5 million mandatory TLB amortization with the remaining cash used to make an optional repayment of $183.4 million. As shown in Exhibit 5.35, these combined actions are linked to the TLB line item in the financing activities section of the cash flow statement as a $204.9 million use of cash in 2013E.

As we assumed a 100% cash flow sweep, cash does not build on the balance sheet until the bank debt is fully repaid. Hence, ValueCo's ending cash balance line item remains constant at zero until 2019E when the TLB is completely paid down.²⁸ As shown in Exhibit 5.10, the ending cash balance for each year in the projection period links to the balance sheet.

The completed pro forma cash flow statement is shown in Exhibit 5.36.

Step V(a): Analyze Financing Structure

A central part of LBO analysis is the crafting of an optimal financing structure for a given transaction. From an underwriting perspective, this involves determining whether the target's financial projections can support a given leveraged financing structure under various business and economic conditions. The use of realistic and defensible financial projections is critical to assessing whether a given financial structure is viable.

A key credit risk management concern for the underwriters centers on the target's ability to service its annual interest expense and repay all (or a substantial portion) of its bank debt within the proposed tenor. The primary credit metrics used to analyze the target's ability to support a given capital structure include variations of the leverage and coverage ratios outlined in Chapter 1 (e.g., debt-to-EBITDA, debt-to-total capitalization, and EBITDA-to-interest expense). Exhibit 5.38 displays a typical output summarizing the target's key financial data as well as pro forma capitalization and credit statistics for each year in the projection period. This output is typically shown on a transaction summary page (see Exhibit 5.46).

For the ValueCo LBO, we performed our financing structure analysis on the basis of our Base Case financial projections (see Step II) and assumed transaction structure (see Step III). Pro forma for the LBO, ValueCo has a total capitalization of $5,690 million, comprised of the $2,150 million TLB, $1,500 million senior notes, and $2,040 million of shareholders' equity (the equity contribution less other fees and expenses). This capital structure represents total leverage of 5.2x LTM 9/30/2012 EBITDA of $700 million, including senior secured leverage of 3.1x (5.0x 2012E total leverage and 3.0x senior secured leverage). At these levels, ValueCo has a debt-to-total capitalization of 64.1%, EBITDA-to-interest expense of 2.7x and (EBITDA – capex)-to-interest expense of 2.2x at close.

As would be expected for a company that is projected to grow EBITDA, generate sizeable free cash flow, and repay debt, ValueCo's credit statistics improve significantly over the projection period. By the end of 2019E, ValueCo's TLB is completely repaid as total leverage decreases to 1.5x and senior secured leverage is reduced to zero. In addition, ValueCo's debt-to-total capitalization decreases to 27.8% and EBITDA-
to-interest expense increases to 6.5x.

This steady deleveraging and improvement of credit statistics throughout the projection period suggests that ValueCo has the ability to support the contemplated financing structure under the Base Case financial projections.

Step V(b): Perform Returns Analysis

After analyzing the contemplated financing structure from a debt repayment and credit statistics perspective, the banker determines whether it provides sufficient returns to the sponsor given the proposed purchase price and equity contribution. As discussed in Chapter 4, sponsors have historically sought 20%+ IRRs in assessing acquisition opportunities. If the implied returns are too low, both the purchase price and financing structure need to be revisited.

IRRs are driven primarily by the target's projected financial performance, the assumed purchase price and financing structure (particularly the size of the equity contribution), and the assumed exit multiple and year (assuming a sale). Although a sponsor may realize a monetization or exit through various strategies and timeframes (see Chapter 4, “Primary Exit/Monetization Strategies”), a traditional LBO analysis contemplates a full exit via a sale of the entire company in five years.

Return Assumptions

In a traditional LBO analysis, it is common practice to conservatively assume an exit multiple equal to (or below) the entry multiple.

As shown in Exhibit 5.39, for ValueCo's LBO analysis, we assumed that the sponsor exits in 2017E (Year 5) at a multiple of 8.0x EBITDA, which is equal to the entry multiple. In 2017E, ValueCo is projected to generate EBITDA of $929.2 million, translating into an implied enterprise value of $7,433.7 million at an exit multiple of 8.0x EBITDA. Cumulative debt repayment over the period is $1,386.1 million (2012E TLB beginning balance of $2,150 million less 2017E ending balance of $763.9 million), leaving ValueCo with projected 2017E debt of $2,263.9 million. This debt amount, which is equal to net debt given the zero cash balance, is subtracted from the enterprise value of $7,433.7 million to calculate an implied equity value of $5,169.7 million in the exit year.

IRR and Cash Return Calculations

Assuming no additional cash inflows (dividends to the sponsor) or outflows (additional investment by the sponsor) during the investment period, IRR and cash return are calculated on the basis of the sponsor's initial equity contribution (outflow) and the assumed equity proceeds at exit (inflow). This concept is illustrated in the timeline shown in Exhibit 5.40.

The initial equity contribution represents a cash outflow for the sponsor. Hence, it is shown as a negative value on the timeline, as would any additional equity investment by the sponsor, whether for acquisitions or other purposes. On the other hand, cash distributions to the sponsor, such as proceeds received at exit or dividends received during the investment period, are shown as positive values on the timeline.

For the ValueCo LBO, we assumed no cash inflows or outflows during the investment period other than the initial equity contribution and anticipated equity proceeds at exit. Therefore, we calculated an IRR of approximately 20% and a cash return of 2.5x based on $2,100 million of initial contributed equity and $5,169.7 million of equity proceeds in 2017E.

Returns at Various Exit Years

In Exhibit 5.41, we calculated IRR and cash return assuming an exit at the end of each year in the projection period using the fixed 8.0x EBITDA exit multiple. As we progress through the projection period, equity value increases due to the increasing EBITDA and decreasing net debt. Therefore, the cash return increases as it is a function of the fixed initial equity investment and increasing equity value at exit. As the timeline progresses, however, IRR decreases in accordance with the declining growth rates and the time value of money.

IRR Sensitivity Analysis

Sensitivity analysis is critical for analyzing IRRs and framing LBO valuation. IRR can be sensitized for several key value drivers, such as entry and exit multiple, exit year, leverage level, and equity contribution percentage, as well as key operating assumptions such as growth rates and margins (see Chapter 3, Exhibit 3.59).

As shown in Exhibit 5.42, for the ValueCo LBO, we assumed a fixed leverage level of 5.2x LTM 9/30/2012 EBITDA of $700 million and a 2017E exit year, while sensitizing entry and exit multiples. For our IRR analysis, we focused on entry and exit multiple combinations that produced an IRR in the 20% area, assuming an equity contribution comfortably within the range of 25% to 40%.

For example, an 8.0x entry and exit multiple provides an IRR of approximately 20% while requiring a 35% equity contribution given the proposed leverage. Toward the higher end of the range, an 8.25x entry and exit multiple yields an IRR of 18.9% while requiring an equity contribution of 36.8%. Toward the low end of the range, a 7.25x entry and exit multiple provides an IRR of 23.2% while requiring a 28.8% equity contribution.

It is also common to perform sensitivity analysis on a combination of exit multiples and exit years. As shown in Exhibit 5.43, we assumed fixed total leverage and entry multiples of 5.2x and 8.0x LTM 9/30/2012 EBITDA, respectively, and examined the resulting IRRs for a range of exit years from 2015E to 2019E and exit multiples from 7.0x to 9.0x.

Step V(c): Determine Valuation

As previously discussed, sponsors base their valuation of an LBO target in large part on their comfort with realizing acceptable returns at a given purchase price. This analysis assumes a given set of financial projections, purchase price, and financing structure, as well as exit multiple and year. At the same time, sponsors are guided by the other valuation methodologies discussed in this book.

LBO analysis is also informative for strategic buyers by providing perspective on the price a competing sponsor bidder might be willing to pay for a given target in an organized sale process. This data point allows strategic buyers to frame their bids accordingly. As a result, the banker is expected to employ LBO analysis as a valuation technique while serving as an M&A advisor in both buy-side and sell-side situations.

Traditionally, the valuation implied by LBO analysis is toward the lower end of a comprehensive analysis when compared to other methodologies, particularly precedent transactions and DCF analysis. This is largely due to the constraints imposed by an LBO, including leverage capacity, credit market conditions, and the sponsor's own IRR hurdles. Furthermore, strategic buyers are typically able to realize synergies from the target, thereby enhancing their ability to earn a targeted return on their invested capital at a higher purchase price. However, during robust debt financing environments, such as during the credit boom of the mid-2000s, sponsors have been able to compete with strategic buyers on purchase price. The multiples paid in LBO transactions during this period were supported by the use of a high proportion of low-cost debt in the capital structure, translating into a relatively lower overall cost of capital for the target.

As with the DCF, the implied valuation range for ValueCo was derived from sensitivity analysis output tables (see Exhibit 5.42). For the ValueCo LBO, we focused on a range of entry and exit multiples that produced IRRs in the 20% area, given an equity contribution comfortably within the range of 25% to 40%. This approach led us to determine a valuation range of 7.25x to 8.25x LTM 9/30/2012 EBITDA, or approximately $5,075 million to $5,775 million (see Exhibit 5.44).

Step V(d): Create Transaction Summary Page

Once the LBO model is fully functional, all the essential model outputs are linked to a transaction summary page (see Exhibit 5.46). This page provides an overview of the LBO analysis in a user-friendly format, typically displaying the sources and uses of funds, acquisition multiples, summary returns analysis, and summary financial data, as well as projected capitalization and credit statistics. This format allows the deal team to quickly review and spot-check the analysis and make adjustments to the purchase price, financing structure, operating assumptions, and other key inputs as necessary.

The transaction summary page also typically contains the toggle cells that allow the banker to switch among various financing structures and operating scenarios, as well as activate other functionality. The outputs on this page (and throughout the entire model) change accordingly as the toggle cells are changed.