LBO Model Concept: Leveraged Buyout and Buying a House Video Lecture | Leveraged Buyouts and LBO Models : Startup Valuation - Finanace & Accounting

hello and welcome to another of our free
youtube financial modeling tutorials
this time around we're going to be going
through the concept of a leveraged
buyout lvo
an LBO model how it works and
specifically we're going to be
addressing one of the most common
analogies used to explain an LBO which
is as I say right here buying a house
with a down payment and a mortgage and
the basic idea there is that a lot of
people use this analogy and say that an
LBO
is just like when you buy a house
because when you buy a company and a
leveraged buyout use a combination of
equity in other words cash that the
private equity firm has on hand and then
debt that they raise to put toward the
purchase price and then over time they
pay off the debt and then eventually
they sell the company at the end repay
the debt and then the proceeds after
they repay the debt or what goes to them
and the analogy that's often used is as
I said before buying a house because
once again you have a down payment cash
in the beginning plus debt the mortgage
that you use and then you own the house
for oil and then you sell it at the end
of the period now that's a common
analogy but we don't think it's the best
way to understand how a leveraged buyout
works because what happens is when you
just buy a house personally you are not
earning rental income from it but when
you buy a company you are earning not
rental income but you're earning cash
though you're earning profits you're
earning something on that investment
because you are not living there and
just like when you buy a house if you
buy a house to rent it out to other
people you buy it as an income
generating asset which you may then sell
in a couple years so we think that's a
better analogy to use to understand an
LBO model and how a leveraged buyout
actually works it is less confusing
versus thinking of it as if you bought a
house to live in personally so we're
going to go through that analogy here
and go through why and how the math
behind an LBO model actually works so
the basic reason the math here works is
that when you use debt to buy a house
that you rent out to other people and
make an income from or use it to buy a
company which generates free cash flow
which generates after-tax profits that
also goes to you if you're the 100%
owner of that company then when you use
debt you can use it to reduce the
upfront purchase price and that is the
main reason why a leveraged buyout or
using debt to buy real estate actually
works the way it does think about it
this way if you invest $150 versus five
hundred dollars well it's going to be
much easier to get a high return on the
smaller amount invested the 150 then is
on the 500 and certainly on a larger
scale if you have say five hundred
thousand dollars versus ten million
dollars well it's going to be a lot
easier to get a high return on five
hundred thousand dollars versus ten
million dollars and even on an even
larger scale once you get up to the
billions or tens of billions well it's
really hard to earn high return on that
because you have to find ideas that are
not only profitable but also big and
profitable whereas if you are working on
a smaller scale it's much easier to find
these smaller opportunities to double
your money to triple your money and so
on and so forth so to illustrate this
let's take a look at this example here
of first buying a house with 100% cash
and then using 70% debt and 30% cash to
buy that same house and let's look at
happens here so it's scenario 1 we're
using a hundred percent cash so that
equates to five hundred here I haven't
specified the units but this is
presumably something like five hundred
thousand dollars so we buy it upfront
for $500,000 and then the selling value
we're going to assume is five hundred
and fifty thousand that equates to
roughly two percent increase in prices
per year over this five year period that
we have and we're assuming that we get a
rental income and annual rental income
of thirty five here and if you run the
numbers 35 divided by five hundred that
is about a seven percent yield which is
roughly in line for real estate
especially residential real estate
you'll often see a yield in that range
of between five and ten percent now the
debt interest rate debt principal
repayment those don't come into play yet
those we'll look at in our second
example but let's just go through our
first example first and see what happens
here so we have a purchase of the
property for five hundred at the
beginning so we spend that five hundred
and cash and then each year we get
thirty five and rental income now we're
assuming this doesn't grow in real life
it would probably grow by say 2% 3% 4%
per year but this is just for
this example we get that run telling him
at the end and your five and then
finally we sell it at the end in your
five for 550 so how much have we
invested well we invested the 500 now
how much do we get back total total we
got back 725 so you might look at that
and think okay well that seems
reasonable I mean we get roughly 1.5 X
if you do the math here as I did with
the sum formula so 1.5 X and the IRR the
internal rate of return so the effective
compounded interest rate on this
investment is around 9% which is pretty
typical for real estate to see returns
in that range because you have a 7%
yield and then the exit price grows over
the purchase price so do the rough math
and you can see how the internal rate of
return would be slightly above the 7%
yield we calculated so this is an OK
scenario 9 percent is nothing to sneeze
at it certainly beats inflation in most
cases maybe not as good as the stock
market overall but what happens if you
now use leverage so now what happens if
you use 70 percent debt and 30 percent
cash so you have 150 in your down
payment and then you have 350 in debt or
the mortgage you use to buy this house
and then rent it out to other people
well in this case take a look at this
now our purchase price gets reduced from
500 up here down to 150 down here now
that may seem like a small difference
but that actually makes a really big
difference in the model because as we'll
see it is much much easier to get a high
return on 150 than it is on 500 so what
happens here well we still have this
rental income above 35 but we are also
paying interest and we're paying debt
principle each year so that reduces our
cash flow each year that's true but in
general if you think about these numbers
and think about the way about the way
this works
yes our cash flow is down by about 25 or
so each year here however our purchase
price in the beginning is down by 350 so
which do you think makes more of a
difference reducing the purchase price
by 350 or reducing our cash flows in
between over these four or five years by
let's run the numbers say five times
twenty-five so lots of percentage but
five times twenty-five about 125 you can
tell intuitively that
deucing the purchase price by 350 is
going to make way more of a difference
than reducing our cash flows by 125
because first off money today is worth
more than money tomorrow meaning that
this upfront purchase price reduction is
worth more in net present value terms
and also just numerically 350 is bigger
than 125 so you look at this and you
realize why and how the math works the
way it does now when we go and sell the
property at the end we still sell it for
550 up here but we also have to repair
our debt now how much debt do we have to
repay at the end well we had 350
initially and then throughout this
buyout period we had paid off so we're
down to around 306 at the end because we
paid off around 45 44 or so of this over
the course of these four or five years
so we do have to repay debt here but
even after that you've been taking that
into account look at this our returns
multiple here is 1.9 X versus 1.5 X
above so our returns multiple gets
boosted by about 30% here and then our
internal rate of return goes from 9% up
to 15% so look at that it's an increase
of over 50% all because we use this debt
we use the 70% in the beginning and the
reason it works again is because
reducing the purchase price has a
disproportionate effect on this entire
transaction structure on this entire
scenario it makes much more of a
difference than not having as much cash
flow good to you in between and it
certainly makes more of a difference to
reduce the purchase price in the
beginning versus reducing the exit value
at the end because of the time value of
money money today is worth more than
money five years from now due to
inflation and the compounding effect of
money you could put it somewhere else
and earn something on that money so as a
result this means that it's almost
always in your best interest when buying
a company like this if you're a private
equity firm to use as much leverage as
you can reasonably use without
bankrupting the company or putting it to
serious financial difficulty and as I
say right here PE firms usually aim for
an IRR of around 20% or higher so they
roughly want to double what the stock
market in the US has returned over the
past hundred years or so
so in this case it doesn't quite meet
the threshold to be a good leveraged
buyout candidate but if they were able
to increase the selling price at the end
make it go up from 550 to 600 or 650 or
something else maybe that would improve
it maybe they can increase the yield
somehow by improving the property by
increasing rent something like that by
getting better terms on the debt they
might be able to claim more cash flow
for themselves maybe they can increase
the amount of debt that's used in the
beginning from 70% to 80% so there are a
lot of ways to increase the return here
but those are some of the key factors
that impact a model and also why in
general leveraged buyouts work and also
as you can see here why any type of debt
used to purchase an asset such as real
estate works the way it does because
leverage will amplify your returns and
if you make money it'll make you'll make
more money with leverage if you don't
make money you'll make even less money
if you use leverage now to show you
another real-world example this I'm
going to go to this model for a j.crew
so this is a leveraged buyout clean by
TPG around a 3 billion dollar deal of
this retailer Jaykar group in the US and
what I want to show you is here at the
bottom how this math works where we
calculate the IRR so let me just set up
a frame quickly so you can see here
invest your equity what we put in the
beginning and then what we get back at
the end so the 1.4 1.5 billion here this
is really just like the down payment
here for the house the 150 so this
serves the same role we get back to the
2.6 2.7 billion after repaying debt as
you can see here which really serves the
same role as the 244 right here we have
zeroes in between and you can see we get
a return of around 12 or 13 percent so
very very low probably not something
most Peter be interested in unless the
assumptions are significantly different
but now let's look at what happens if we
change the percent debt use so in this
case we're using 61 percent debt but
what would happen if we change that to
zero well let's go down and take a look
at this in the model the return drops to
8.3 percent so without leverage the
return Falls by around 30 percent
probably a little bit more than 30
percent going from around 12 or 13
percent down to about 8 percent so makes
a really
a big impact on the model even though in
this case the returns are pretty
missable to begin with likewise if we
change this let's say we use 90% debt
what would happen here well in this case
the return goes up to 19% so you can see
just how big a difference leverage makes
simply by reducing that upfront purchase
price you can increase your IRR by quite
a bit going from 60% to 90% increases
the IRR from 13% to 19% all because of
that upfront purchase price reduction
goes from 1.4 billion down to 700
million now so that is how and why
leverage works in the context of a
leveraged buyout so just to recap what
we went through that analogy that's
often used to explain an LBO which is
buying a house with a down payment on a
mortgage paying off the mortgage over
time selling it at the end not exactly
the best way to understand it it's
better to think of it as a house that
you buy to rent out to other people
because in both cases buying a company
and buying a house you get rental income
or cash flows that you can accumulate
yourself or that you can use to repay
debt with and an LBO works
mathematically because by using leverage
in the beginning you reduce that upfront
cost you use the cash flows to repay
debt principal and interest and at the
end yes you do have to repay debt but on
balance reducing that upfront cost by a
lot outweighs by far the impact of
repaying debt principal interest and
also having a lower net proceeds amount
at the end