How to Build a Leveraged Buyout (LBO) Model

A Leveraged Buyout (LBO) model evaluates the acquisition of a company, a process heavily reliant on debt financing. It assesses potential returns for private equity firms or sponsors undertaking the buyout and determines an appropriate valuation for the target company. The goal is to project the target company’s financial performance under new ownership, demonstrating its capacity to service significant debt and generate attractive returns for equity investors upon exit.

Foundational Data and Assumptions

Building a robust Leveraged Buyout model begins with gathering foundational data and assumptions. This involves collecting historical financial statements for the target company, including its Income Statement, Balance Sheet, and Cash Flow Statement. These provide a baseline for future projections, extracting items like revenue, cost of goods sold, operating expenses, assets, liabilities, and cash flows.

Operating assumptions form the core of the target company’s future performance outlook. These include projecting annual revenue growth rates and establishing gross margin and operating expense (SG&A) percentages to forecast profitability. Capital expenditures (CapEx) are estimated to account for future investments in property, plant, and equipment.

Depreciation and amortization (D&A) projections are derived from existing assets and new capital expenditures, impacting taxable income as non-cash expenses. Intangible assets acquired in the transaction, such as goodwill, are amortized for tax purposes over 15 years under IRC Section 197. Changes in working capital components like accounts receivable, inventory, and accounts payable are also forecasted.

Transaction assumptions define the LBO’s financial structure. The assumed purchase price is a primary input, derived by applying an entry multiple to the target’s historical EBITDA. The financing mix details the proportion of equity contributed by the private equity sponsor versus the debt raised; LBOs typically involve debt comprising 50% to 90% of the total purchase price.

Transaction fees, like advisory and legal costs, are typically 2.0% to 2.5% of the total transaction value and expensed immediately. Financing costs, also typically 2.0% to 2.5% of the debt amount, are capitalized on the balance sheet and amortized over the loan’s life, often 5 to 7 years.

Finally, exit assumptions are established to project the investment’s eventual divestiture. The most common approach involves applying an exit multiple to the target company’s projected EBITDA in the assumed exit year. For conservatism, this exit multiple is often assumed to be the same as or lower than the entry multiple. The assumed exit timing, typically around five years post-acquisition, completes the framework for evaluating the investment.

Core Financial Projections

Once foundational data and assumptions are established, the next stage involves constructing the core financial projections. This process begins with building the projected Income Statement, which forecasts the company’s profitability. Revenue is projected based on assumed growth rates, while the cost of goods sold and operating expenses are calculated using historical percentages or established margin targets.

Depreciation and amortization, derived from a schedule accounting for existing assets and new capital expenditures, are included as non-cash expenses. Interest expense is calculated based on projected debt balances from the debt schedule. Applying a projected tax rate to earnings before tax yields the net income.

The projected Balance Sheet is then constructed, detailing assets, liabilities, and equity. Assets like cash, accounts receivable, and inventory link to the cash flow statement and working capital assumptions. Property, plant, and equipment update based on capital expenditures and depreciation.

On the liabilities side, accounts payable and accrued expenses are projected using working capital assumptions, and debt tranches link directly from the debt schedule. Shareholder’s equity is calculated by rolling forward the initial equity investment and adding retained earnings from net income. The Balance Sheet must always balance; total assets must equal the sum of total liabilities and equity, serving as a check within the model.

The Cash Flow Statement integrates information from the Income Statement and Balance Sheet. Cash flow from operating activities starts with net income, then adds back non-cash expenses like depreciation, amortization, and amortization of financing fees. Changes in working capital accounts are also factored in.

Cash flow from investing activities reflects capital expenditures. Cash flow from financing activities details debt drawdowns, principal repayments, and equity contributions or distributions. The ending cash balance from the Cash Flow Statement feeds into the cash line item on the Balance Sheet, ensuring consistency.

These three financial statements are interconnected, creating a circular relationship within the LBO model. For example, interest expense on the Income Statement depends on the outstanding debt balance on the Balance Sheet. Cash flow available to repay debt, calculated on the Cash Flow Statement, affects the debt balance, which influences interest expense. This iterative relationship means changes in one part of the model ripple through all three statements, necessitating an iterative calculation process, often handled automatically by spreadsheet software.

Debt Financing Structure

The debt financing structure is a defining characteristic of an LBO model, detailing how borrowed funds are managed. Multiple tranches of debt are employed, each with distinct seniority, interest rates, and repayment terms. A Revolving Credit Facility (“Revolver”) acts like a corporate credit card, providing short-term liquidity for working capital needs, carrying the lowest interest rates and an undrawn commitment fee.

Senior debt, comprising 50% to 80% of the capital structure, includes Term Loan A and Term Loan B. Term Loan A amortizes evenly over 5 to 7 years, while Term Loan B involves nominal amortization with a larger “bullet” repayment at maturity, 5 to 8 years out. These loans are secured by the target company’s assets and have floating interest rates, such as LIBOR plus a premium.

Mezzanine debt sits below senior debt, a hybrid of debt and equity, carrying higher interest rates in the 10% to 15% range, and includes equity-like features like warrants or options. High-yield bonds are unsecured, bear a fixed interest rate, and feature longer maturities, 7 to 10 years, with a bullet payment at the end.

Building a comprehensive debt schedule involves modeling the initial drawdowns for each tranche based on the Sources and Uses of Funds. Interest calculations are performed periodically, monthly, quarterly, or annually, based on the outstanding principal balance and the applicable interest rate for each debt type. Mandatory repayments, like scheduled amortization for Term Loan A or nominal amortization for Term Loan B, are explicitly modeled.

A primary feature in LBO debt structures is the “cash flow sweep,” which dictates optional debt repayment using excess cash flow. This mechanism uses cash remaining after all operational expenses, capital expenditures, working capital changes, taxes, and mandatory debt payments are covered. The excess cash is then applied to reduce the principal balance of the debt, senior debt first, reducing future interest expense and accelerating deleveraging. While often allowing for a 100% sweep, some agreements limit this to a certain percentage, such as 50%, to manage reinvestment risk for lenders.

Debt covenants are monitored within the model, agreements between the borrower and lenders to maintain financial metrics or restrict actions. These include maintenance covenants, which require the company to meet financial ratios like leverage (Debt/EBITDA) and interest coverage (EBITDA/Interest). Incurrence covenants prevent the company from undertaking certain actions, like paying large dividends or making acquisitions. Modeling these covenants helps assess compliance throughout the projection period.

Exit Valuation and Returns Analysis

The culmination of an LBO model involves determining the investment’s value at exit and analyzing the returns generated for equity investors. Exit valuation relies on the EBITDA multiple approach, where the projected EBITDA of the target company in the exit year is multiplied by an assumed exit multiple. This multiple is derived from comparable company transactions or prevailing market conditions. The resulting enterprise value represents the company’s total value at sale.

A “Sources and Uses of Funds at Exit” analysis details how sale proceeds are distributed. First, any remaining outstanding debt, including the Revolver and Term Loans, is repaid according to seniority. Transaction costs are also accounted for. The residual value, after all debt and expenses are settled, represents the proceeds distributed to the equity holders.

The Internal Rate of Return (IRR) is a primary metric to assess the annualized return on equity investment. This calculation considers the initial equity invested as a cash outflow and subsequent cash inflows, like dividends paid during the holding period and final exit proceeds. The IRR represents the discount rate that makes the net present value of these cash flows zero, providing a time-weighted measure of return.

Another important return metric is the Multiple on Invested Capital (MOIC). MOIC represents the total cash proceeds received from the investment divided by the initial equity invested. Unlike IRR, MOIC does not account for the time value of money, but provides a straightforward measure of how many times the initial investment was multiplied. For example, an MOIC of 2.5x indicates the initial equity investment yielded 2.5 times its original value.

Finally, sensitivity analysis is performed to understand how changes in assumptions impact projected returns. This involves varying inputs like the entry multiple, exit multiple, and revenue growth rates to observe their effect on the calculated IRR and MOIC. Presenting these sensitivities allows investors to gauge the robustness of returns under different scenarios, providing insights into the deal’s risk profile and potential range of outcomes.