Building LBO Models
When To Use
- Modeling a financial sponsor's acquisition of a target company using significant debt financing
- Evaluating debt capacity, optimal capital structure, and leverage multiples for a buyout
- Calculating sponsor IRR and MOIC under base, upside, and downside scenarios
- Stress-testing exit assumptions (timing, multiple, and method) to assess risk-adjusted returns
- Comparing LBO returns across multiple potential acquisition targets or bid levels
Inputs To Gather
- Target financials: Historical income statement (3–5 years), balance sheet, and cash flow statement; latest available LTM figures
- Transaction assumptions: Purchase price or entry EV/EBITDA multiple, transaction fees (advisory, financing, legal — typically 2–4% of TEV), minimum cash balance
- Debt structure: Tranches (revolver, Term Loan A/B, senior notes, subordinated/mezzanine, seller note), interest rates (fixed vs. floating + spread), amortization schedules, mandatory vs. optional prepayment terms, commitment fees
- Operating projections: Revenue growth rates, EBITDA margin trajectory, capex (maintenance vs. growth), working capital assumptions (days sales outstanding, days payable outstanding, days inventory outstanding)
- Exit assumptions: Holding period (typically 3–7 years), exit EV/EBITDA multiple, potential dividend recaps or partial exits
- Sponsor parameters: Target equity check size, fund return hurdles (e.g., 20%+ IRR, 2.5x+ MOIC), management rollover percentage
Workflow
Build the Sources & Uses table
- Sources: equity contribution, each debt tranche, any rollover equity or seller financing
- Uses: equity purchase price, transaction fees, debt issuance costs, refinanced existing debt
- Verify sources = uses; if they don't balance, recheck assumptions before proceeding
Construct the operating model
- Project revenue, EBITDA, EBIT, and unlevered free cash flow over the hold period
- Model working capital changes using historical days metrics, not flat percentages
- Separate maintenance capex (tied to D&A) from growth capex (tied to revenue expansion)
- Calculate tax using effective rate; flag any NOL carryforwards or tax shield assumptions [VERIFY]
Build the debt schedule
- For each tranche: beginning balance → mandatory amortization → cash sweep (if applicable) → optional prepayment → ending balance
- Calculate interest expense per tranche (apply SOFR + spread for floating-rate debt [VERIFY current benchmark rate])
- Model revolver draws/repayments based on cash flow shortfalls; track commitment fees on undrawn amounts
- Enforce leverage covenant tests (e.g., Total Debt / EBITDA ≤ 6.0x) and flag covenant breaches
Calculate returns at exit
- Apply exit multiple to projected EBITDA at each potential exit year
- Subtract net debt at exit to derive equity value to sponsor
- Compute IRR and MOIC on total invested equity (including any add-on investments)
- Model dividend recaps separately if applicable — show returns with and without recap
Run sensitivity and scenario analysis
- Build two-way data tables: entry multiple vs. exit multiple, EBITDA growth vs. leverage
- Stress-test downside: revenue decline of 10–20%, margin compression of 100–300 bps, one-year exit delay
- Test debt paydown scenarios: aggressive vs. minimum mandatory amortization
- Identify the breakeven entry multiple at which the sponsor achieves its minimum return hurdle
Assess credit metrics and debt capacity
- Track Total Debt / EBITDA, Senior Debt / EBITDA, Interest Coverage (EBITDA / Interest), and Fixed Charge Coverage through each projection year
- Compare against typical market thresholds (e.g., senior leverage ≤ 4.0x, total leverage ≤ 6.0x [VERIFY against current credit market conditions])
- Confirm the business generates sufficient FCF for mandatory debt service in all scenarios
Output
- Sources & Uses summary with clearly labeled equity and debt components
- 5-year operating projection with revenue, EBITDA, unlevered FCF, and key margins
- Debt schedule showing balance, interest, and amortization for each tranche by year
- Returns matrix: IRR and MOIC at various exit multiples and exit years
- Sensitivity tables: Entry price vs. returns, EBITDA growth vs. leverage, exit timing vs. returns
- Credit metrics dashboard: Leverage ratios, coverage ratios, and covenant compliance by year
- Key assumptions page listing every material input with source or [VERIFY] flag
Quality Checks
- Sources & Uses must balance to zero — no rounding gaps
- Ending cash balance never goes negative in any scenario; if it does, the revolver must draw or the model is broken
- Debt balances decline monotonically unless add-on acquisitions are modeled
- IRR and MOIC are internally consistent (a 2.0x MOIC over 5 years ≈ 15% IRR)
- Exit equity value must equal entry equity plus cumulative FCF to equity minus distributions (cash flow identity check)
- Interest expense ties exactly to average debt balances and stated rates — no hardcoded interest figures
- Circular reference handling: if using iterative calculations for cash sweeps, document the approach and confirm convergence
- All market-dependent assumptions (multiples, rates, leverage thresholds) are tagged [VERIFY] with date of last validation