The Challenge
A leveraged buyout of a North American business was under consideration. The company believed an LBO was achievable. The thesis depended on its cash flow carrying a meaningful debt package, and every stakeholder needed to know whether it could.
We were engaged to build the full LBO model: the operating forecast, the capital structure and the returns, in one integrated model the lenders and the equity could both interrogate.
Our Process
Operating model first. Before any debt went in, we built the company's operations from the drivers up: revenue by line, cost behaviour, working capital and capital expenditure, integrated into a three-statement model. In an LBO the debt is only as good as the cash flow underneath it, so this is where most of the effort went.
Transaction and capital structure. Sources and uses, the proposed debt tranches with their own terms, fees, and the opening balance sheet after the deal. Each tranche was modelled with its interest, amortisation and covenant package.
Coverage tested in every period. We calculated cash flow available for debt service and the debt service coverage ratio period by period, against the covenant levels in the term sheet, not as an annual average.
Returns and sensitivities. Equity returns under the base case and downside cases, with the operating and financing assumptions flexed to show where the structure stopped working.
Key Outcome
The model answered the question it was built for, and the answer was no.
The structure required DSCR of 1.20x. Most years of the forecast cleared it. One did not:
- ·Base case: 1.03x, barely covering debt service at all
- ·Best case: 1.19x, still short of the requirement
When even the best case misses, there is no operating plan that rescues the structure; only less debt does. The business generated healthy cash for an unlevered company. It did not generate enough to service that quantum of debt with the headroom lenders require. An average coverage figure across the term would have looked comfortable and hidden the problem; testing every year exposed it.
The company had gone in believing the LBO was possible. The model made it clear it was not, and the leveraged structure did not proceed. Finding that in a model, before anyone signed, is the cheapest place to find it.
The second engagement
Management had spent the engagement working with the operating model and saw something in it beyond the transaction. For the first time they had their business laid out as a set of drivers they could change and immediately see the effect of on profit and cash.
They asked us to turn it into their budgeting model. We stripped out the transaction layer, restructured the drivers around how the business is managed and reported, and added the budget-versus-actual structure they needed. We then supported the team through the budget cycle itself as their FP&A partner.
Results
- ·Full integrated LBO model delivered: operating forecast, three statements, debt schedule, coverage and returns
- ·Coverage shortfall identified before any commitment: 1.03x base case and 1.19x best case against 1.20x required, in one year of the forecast
- ·Transaction work repurposed rather than discarded: the operating model became the company's budgeting model
- ·Ongoing budgeting support engagement following on from the original mandate
Why this matters
A good LBO model is not built to make a deal work. It is built to show whether it does. When the answer is no, the operating model underneath still has value, because it is the clearest description of how the business makes money that the company has ever had.
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