LBO Model: Sources & Uses Video Lecture | Leveraged Buyouts and LBO Models : Startup Valuation - Finanace & Accounting

okay hello and welcome to another
tutorial video this time we're going to
be going over the leveraged buyout model
again and specifically focusing focusing
on these sources and uses schedule and
just to give you an idea of what we're
talking about here I'm going to bring up
examples from a few different lvl models
in our courses where we have the sources
and uses schedule here's an example for
the three billion dollar leveraged
buyout of j.crew and then we have
another example here for a hypothetical
leveraged buyout of Best Buy and we also
have similar looking sources in use of
schedule there and then a third example
is for the dell leverage about silver
lakes 24 billion dollar leveraged buyout
of dell we again have a sources and uses
schedule right here so it's a very
common feature in LB o models and
something that you're going to need to
understand if you want to really
understand the leveraged buyout model in
depth and the reason why it matters so
much is that your sources your funding
for the deal has to equal your uses how
you're spending the net the money it's
sort of like how the asset side of a
balance sheet has to equal the
liabilities equity side or like in math
how two sides of an equation must
balance or in physics how energy and
momentum can be neither created nor
destroyed so if you've studied physics
before of course you know about the
conservation of momentum the
conservation of energy and basically it
says that with any change that you have
in the natural environment between
objects moving together or something
like that energy is going to stay the
same
you cannot create energy and same with
momentum mass times velocity it can't be
created it can't be destroyed so it
always has to remain in balance for
regardless of what goes on outside and
it's sort of the same thing with the
sources and uses schedule money in this
case we're not talking about energy or
momentum or math but money can be
neither created nor destroyed now as I
say here sort of tongue-in-cheek yes
central banks of course have been known
to print money irresponsibly rampantly
to devalue currency so that is one
exception about companies and private
equity firms can neither create nor
destroy money and that's we're dealing
with here so that's why it matters and
to illustrate these
poins going through this what I have up
here is extracts from some of those
models that I just showed you a
simplified sources in use the schedule
for j.crew and then a more complex one
for Best Buy and then an even more
complex one for the leveraged buyout of
Dell and so what we're going to do here
is once we go through a few more points
and what to watch out for on why
sourcing uses matter I'm going to tell
you what goes into the schedule how you
build the sources and you schedule a few
more complex items and then we'll go
through at the end what to do next if
you want additional practice with this
topic so as I say up here the point that
the source and uses schedule the sources
must balance the uses that's all well
and good but the real point of the
sources that use the schedule is that it
determines how much cash the private
equity firm has to contribute toward a
deal and that in turn determines the
internal rate of return on the deal so
if the P firm puts in less cash well
it's easier to get a high return if the
PE firm puts in more cash it's more
difficult to get a high return so they
could sell the company for the same
amount but if they paid less for it up
front they're going to get a higher
return if they paid more for it up front
they're going to get a lower return so
that's why it's so important we're
saying okay here's how much it costs to
buy this company with all the expenses
included here's how much debt we have to
fund it here's how much and other
sources of funding we have and then you
say but taking into account all that we
still need to put in something ourselves
to close the gap to make sure for
example that when we buy a company and
we have to pay three billion dollars for
the equity and we have say 1.6 billion
of debt well we need to plug that gap
somehow and the way you do that is with
investor equity so this is the real
point of a sources in you schedule yes
both sides have to balance but it's
really all about calculating this number
figuring out the private equity firms
own contribution and then one final
point here is that the schedule often
explains why shareholders dislike
buyouts and how and why they can often
get a bad deal from these types of
leveraged buyout transactions and we'll
go through an example of that toward the
end with again the Dell deal using that
as an example so step two here we've
been over why the sourcing use of
schedule matters and why it's so
important for a leveraged buyout model
and the real point of it step two we
want to go into what goes into a sources
and use the schedule and how do you
build one and I think it's easiest here
to start with
user side so in other words what you
have to spend money on when you buy a
company and there are basically three
main categories here number one is the
equity purchase price of the company so
you have to buy all the company's
outstanding shares to acquire a company
or if it's private you just pay a lump
sum for the company and then you also
have to pay fees to a lot of people
bankers lawyers lenders a lot of others
advising you on the deal or providing
financing so there are fees and then a
third major category here is if debt
gets repaid so if the company already
has existing debt that gets repaid this
also counts as a use why does it count
as a use because if you're spending
money to pay off that debt you need to
put in more of your own cash or you need
to raise more debt to pay it off so
those are the three main categories here
now let's go down and take a look at the
use of schedule four j.crew using this
as an example so the equity purchase
price here was around three billion
dollars then we have around twenty five
million of fees and then the third major
category they had about twenty four
million of debt to where somebody gets
repaid so we can add up our uses of
funds down here and really those are the
main categories even in more complex
schedules they're usually just
variations of these and different
categories within these now let's move
to the sources side next note the made
items here as I say are the debt that
you raise to buy the company and then
the investor equity so all types of debt
you can have one tranche of debt or two
or ten or 15 and then the investor
equity what you have to put in
personally to fund the deal there are
all different types of debt here you
have term loans you could have a
revolver you can have senior note
subordinate notes mezzanine I'm not
going to get into the details of these
because it's not what this tutorial is
about but I've arranged these in order
of roughly the least risky to the
riskiest form of debt and then the
important part here is that when you
calculate the investor equity the final
category you have to take your total
uses and then subtract the total sources
so far so everything above the investor
equity line item and you have to follow
this process that I outlined here so you
have to calculate the purchase price of
the company add in the fees and the debt
that's being paid off on the sources
side add the debt that using the fund
the deal and any other sources of
funding and then when you calculate
investor equity you have to set it equal
to total uses minus sources so far and
then add up total sources at the bottom
so let's see an example of this in
action for Jaykar again that we've
already added up our uses funds here we
know it costs about just over
three billion dollars to buy this
company and about twenty four million to
repay their debt now the source is a fun
so we've calculated elsewhere the amount
of debt that we're using about 1 billion
dollars of term loans and then about 600
million of a riskier higher interest
subordinated note now what do we do next
well next up here is for the investor
equity we want to take our total uses
and then subtract our sources so far so
this plugs the gap the investor equity
here is always going to plug the gap and
that's why it's so important and that
tells us that the PE firm has to
contribute about 1.4 to 1.5 billion
dollars of its own cash to do this deal
how is this important why does this
really matter well take a look at a few
things here we could look at this and
say okay what if the purchase price went
up what if went up to 3.5 billion
well now the P firm asked to contribute
1.9 billion what if we funded it with
say a billion dollars of term loan a
instead well now the P firm only has to
contribute 900 million or a billion
dollars of its own money so it directly
impacts how much cash they're putting in
and it's going to very directly impact
the private equity firms returns on this
deal as well and that's why the schedule
is so important so we're done with this
second part of this second step here
what goes into the schedule and how do
you build the sources and use the
schedule and now let's go to the second
half of this which is a few more complex
items that go into the sources and use
the schedule and I'm going to start with
the uses side because that's a little
bit more straightforward but really the
main addition here the other addition
that you could see is a line item called
assumed existing debt and how this works
is that if the company already has debt
on its balance sheet and as an example
let me just show you the model for Best
Buy over here so you can see exactly
what I mean I'm going to go down to
their balance sheet and you can see here
they actually already have an existing
draw and revolver and not only that they
have about 1.9 billion worth of existing
long-term debt right here so they
already have these forms of debt and the
question and any buyout deal like this
is what do you do with it do you have to
repay it can you keep it on the
company's balance sheet now obviously
most of the time it helps the PE firm if
they can keep the debt around because it
means they don't have to pay anything to
repay it so it's usually in their
interest to do it but they cannot always
do that
let's take a look at the uses side for
Best Buy just to see what happens here
so equity value about 8.5 billion for
the steel assume existing debt take a
look at this were streaming it stays on
the balance sheet so it appears under
both uses and other sources and it has
no net impact on the cash that is
required to do this deal and that's the
key takeaway here when you're assuming
existing debt you're not paying off it
appears under both sides of sources and
uses and it has no impact on the cash
required now under this we still have
some of the similar items such as fees
here we have the equity value of the
company so those are all the same we
have refinancing existing debt but this
is the new item I want to show you
quickly let's add up the total uses here
so I can show you what happens in this
case we have about ten point five
billion and then under sources of funds
so we have debt here on top and it's a
little bit different but it's still
basically the same thing just different
types of debt we're using a few more
different types in this case we have
assumed existing debt I just went over
that on them and then we have two new
interesting items here excess cash used
and Founder rollover what does this mean
excess cash used if a company has a
large cash balance that is far above
what it needs to operate it can actually
use some of the cash to fund the deal
itself so instead of the PE firm
actually putting its own cash forward or
raising debt to fund the deal the
company itself can take some of that
cash and say you know what we're going
to use this cash to buy some of our own
shares and help get this deal done and
once we do that the P firm will not have
to buy as many shares which is why it
counts as a source of funds because it
reduces the amount of shares that the
private equity firm has to pay thereby
reducing the purchase price and the cash
they contribute so that's one new item
now this item can be very controversial
many shareholders really just like this
because they look at this and say well
okay you can do that but what about if
you just issue us a dividend and then we
keep holding your shares because then we
can capture upside if your share price
goes up and we get a dividend why are
you favoring the new investors in your
company the new PE firm that's going to
buy you guys out so this can be a
controversial item and then this other
item here found a rollover so in this
case the founder of Best Buy owned 20%
of the company and in this scenario if
you have a founder or management team
that is keeping a certain percent of the
company what's going to happen is that
it counts as a soar
of funds why because if they're keeping
20% the private equity firm only needs
to acquire 80% of the company not a
hundred percent thereby reducing the
investor equity that's required to do
the deal so these are both funding
sources because again it reduces the
amount the private equity firm has to
pay and that's a simple check you can do
for any of these items if it increases
how much they have to pay like repaying
debt that's going to go on the user side
if it decreases the amount then it's
going to go in the sources side and if
has no net impact it's going to appear
on both sides like assume existing debt
right here so I have the explanation in
words over here so sources side assume
debt excess cash use founder management
rollover and we've already been over all
that so what I wanted to now is just
flesh out the schedule and show you
exactly what happens for this best buy
scenario so invest your equity we've
already completed the first few steps
our process we end up our uses of funds
over here invest your equity let's take
our total uses and then subtract our
sources so far and then add up
everything there the bottom so 10.5
billion and these match and we've done
this correctly and then let's go down to
this last schedule here for Dell and I
just want to show you this very quickly
because there is one new item here
that's interesting uses of funds we sell
the equity purchase price
we still have repaying existing debt we
selves assuming existing debt if we want
to do that and this again appears on
both sides of these sources and uses
schedule as it should and then of course
we still have all of our fees here at
the bottom so the user side is pretty
standard not too much there that's
different let's add that up the deal
price here was announced as 24 billion
because the equity purchase price at the
share price that silver like offered was
corresponding to a value in about that
range now under sources of funds we
still have basically all different types
of debt here at the top
the revolver here is not drawn in the
beginning so this is zero so if you're
not drawing on that revolver initially
there's going to be zero the rest these
are drawn initially so these all have
dollar amounts
assuming system get excess cash you've
been over and then founder roll over
equity we went over that for Best Buy
and then one new item here is the cash
contribution for equity so what is this
item mean this item means that Michael
Dell in this case the founder the
company said you know what I own a
certain percent right now I'm going to
keep that stake I'm going to maintain
this and roll it over
but it
to that I actually want to put in some
of my cash and acquire more of this
company for myself so you can actually
change the ownership percentage in a
deal like this and that's another very
important use case for sourcing uses it
is a more advanced item but it does come
up and it's important to go over what's
the net impact of this well if he puts
in seven hundred fifty million more
think about it this way the new
ownership is going to consist of him
these two items and then Silverlake now
these other items up here these do not
factor into the ownership because these
are all other people's money raising
debt doesn't give the lenders any
ownership of the company's equity so
this has no impact all that has an
impact is these last three items here
and so what does it do well let's take a
look at it for ourselves invest your
equity let's take our total uses and
then subtract our sources so far so 1.2
billion for Silverlake let's add up our
total sources down here what is the
overall impact of this well the overall
impact is that Michael Dell will now own
let's just do the math right here about
70% of the company now if we didn't put
in that cash contribution he would only
owned about 65% the company silver like
we'd have to contribute a lot more and
that is the impact of a cash
contribution to up a management team or
founders stake in a business like this
so that's sources and uses and as I say
here this is something that can really
infuriate shareholders and actually I'm
going to bring up the Dell I'll be a
model to show you what happens take a
look at this Michael Dell owned 15%
before but then after the deal takes
place
he owns 78% of the company can you
imagine how mad shareholders would get
at this because he didn't really do a
great job of leading it yes he owned a
percentage of it but the share price had
fallen a lot of company wasn't doing
well and then because of this deal he
opted his ownership percentage
astronomically going from 15% to 78% and
this is why people like Carl I can for
example protested so much when the deal
took place and of course the moral of
the story is that if you understand the
sources and use a schedule and you
understand that the equity here
represents ownership and the company's
new equity and that everything else
above it does not then you understand
how this works and the dynamics of why
these deals can off
be a bad deal for shareholders so that's
it for our tutorial to sum up what we
did here we started off with wise
sources and uses schedule that schedule
matters what goes into it and how you
build one start with the user side
calculate everything there then go to
the source side look at debt investor
equity is the plug just equal to total
uses minus sources so far and then we
looked at a few more complex items like
the assumption of debt excess cash
rollovers and additional cash
contributions what next find a deal
you're interested in find a deal you've
read about and use press releases
company filings to construct your own
sources and use a schedule maybe you
won't be able to do it exactly but you
come up with a rough estimate of it and
then be prepared for these questions and
interviews they're very common in
private equity interviews but sometimes
even in investment bank interviews
you're going to have to know about it
and of course if you get a case study on
this you get a modeling test you're
definitely going to have to know it for
these interviews and then finally if you
read about shareholders or activists
investors getting angry like the car
like an example you'll know exactly why
so that's it for our tutorial on sources
and uses hope you got a lot out of this
one and that you understand the concept
more effectively now
you