Introduction
This post organizes some of our existing content into a self-study course for private equity finance. We wrote the content and the outline below primarily for two groups of people:
- Investment banking analysts preparing for private equity (both for interviews and actual associate roles)
- Ambitious students looking to prepare for their first finance jobs
In retrospect, our investment banking years prepared (most of) us well for private equity, but we felt varying degrees of anxiety: Have I learned what I need to? Anything I should review? It was hard to get answers, and it’s still difficult now, although perhaps the requirements of the role are a bit more transparent. Regardless, we hope the materials below will help you review and fill any gaps in your education. We believe strongly that educational content should be free and available online.
If you master the concepts below, you will be ready for any private equity associate role.
1) LBO Modeling
LBO modeling is the most fundamental skill for private equity associates. It encompasses several different branches of knowledge:
- Excel fluency
- Finance & accounting
- Capital structure
1.1) LBO Basics
Start with our easy LBO model. Master this template and the contained concepts before advancing.
1.2) Capital Structure Fundamentals
Now that you’ve mastered some LBO basics, let’s explore capital structure from a first principles perspective.
One of the most important takeaways from this article is that sponsor returns are the product of two components:
- unlevered asset returns (ROA) and
- capital structure.
While you will build skill in structuring transactions and arranging financing, the surest path to success is acquiring the best assets at the cheapest prices (high ROA). If the unlevered return is high, you don’t need a genius capital structure to achieve great equity returns.
1.3) Intermediate LBO
This is the LBO template we used to prepare for private equity interviews. It is more sophisticated than any modeling test you’ll encounter. Furthermore, it’s a good template for any first-pass LBO (e.g., digest this CIM and tell me what you think).
If you can complete this LBO in under two hours (without looking at the instructions), you’ll be ready for any private equity modeling test.
2) LBO Returns
Great, you’ve mastered LBO modeling fundamentals. But what is your LBO really telling you? What’s driving that juicy 25% IRR?
This section will focus on interpreting and thinking critically about LBO models.
2.1) LBO Value Creation
Here, we introduce the dreaded value creation bridge. Whenever you make an LBO, you should understand what is driving your returns. For example, how much (what %) is the debt financing contributing to your returns?
Many value creation bridges are much more complicated than this one. Over the course of a deal, as the sponsor gathers information and refines the operating model, the private equity associate may create a detailed value creation bridge showing the impact of each operational lever. For example, the revenue growth and margin improvement for each division might be included as separate line items. This level of granularity enables you to answer questions, like: How much is division A’s revenue growth contributing to our overall returns? What happens to our returns if division A stagnates?
Some may call this false precision, but doing this exercise forces you to confront all the implicit assumptions in your investment case. Wow, I didn’t expect leverage to contribute so heavily to returns. Or: That add-on acquisition is responsible for 30% of total value creation. That seems iffy.
This is a really important concept, so take your time working through this template. It may seem deceptively simple.
2.2) Understanding Multiple Expansion
Multiple expansion is a fundamental finance concept and impacts LBO returns.
Go back through our intermediate LBO template and see how much multiple expansion affects projected returns.
2.3) Ability-to-Pay
Ability-to-pay analysis is basically a reverse LBO. Rather than starting with the purchase price and calculating implied returns, you start with the required returns and calculate the maximum implied purchase price.
This is primarily a sellside tool, but can be useful in framing bid strategy and in general, for understanding LBO drivers.
3) Advanced LBO Functionality
At this point, you’ve learned LBO modeling and how to analyze LBO returns. This section will introduce advanced LBO modeling concepts.
3.1) Dividend Recaps
Dividend recaps are a way to return capital to shareholders while retaining control of the underlying company. Modeling dividend recaps as part of an LBO can be tricky. The attached Excel template shows you one method for layering additional transactions on top of your base LBO model.
3.2) Equity Waterfall
When creating a simple LBO, you generally group all shareholders into a single line item (“Sponsor Equity”) and calculate aggregate equity returns. But as you progress further along in a deal, you generally outgrow this approach.
The invested equity can be structured into numerous tranches, and when combined with management’s equity-based compensation, the resulting equity structure can be quite complex.
While each equity waterfall is unique, it’s important to understand this concept, because it surprises many ex-bankers. You’re used to thinking about equity as one or two uniform tranches. But the equity split between the sponsor and the management team can be nuanced and is an important negotiation point.
3.3) Casing & Sensitivity Analysis
Adding flexibility and proper casing to your model is key. This guide shows you how to turn our intermediate LBO template into a sophisticated, flexible model.
Appendix A - Other Modeling Topics
This is an assortment of other financial modeling topics that are applicable to private equity.
A-1) Accretion / Dilution
Accretion / (dilution), while primarily relevant to strategics, can be useful in evaluating add-on acquisitions. Furthermore, many sponsor exits are sales to strategics. Understanding how they evaluate transactions is key.
A-2) Adding Cases to Your Model
Over the course of a deal, you’ll be asked to evaluate many different scenarios and potential outcomes. This article lays out a simple example of adding cases to your model.
A-3) Self-Referencing If Statements
Self-referencing if statements are an extremely powerful Excel feature and can be used to make data tables that don’t slow down your model. This is the right way to create data tables.