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Leveraged Buyout (LBO) Modeling

Structure, Mechanics & Financial Analysis

Leveraged Buyout Overview

Definition:

  • A financial sponsor (PE firm) acquires a company using significant debt financing alongside equity
  • Target company's cash flows service the debt over the holding period
  • Exit after 3-7 years through sale or IPO

Return Drivers:

  • Operational improvements
  • Debt paydown
  • Multiple arbitrage

Key Point:

The "leverage" amplifies equity returns but increases risk

Capital Structure at Entry

Typical Layers:

  • Senior Debt (40-50%) - Revolver, Term Loan A, Term Loan B
  • Subordinated Debt (10-20%) - Mezzanine, Second Lien
  • Equity (30-40%) - Sponsor equity contribution

Key Concept:

Higher leverage = higher potential returns (and risk)
Typical Range: 4.0x - 6.0x Total Debt / EBITDA

Transaction Financing Overview

Sources (How it's funded):

  • Revolver
  • Term Loan A
  • Term Loan B
  • Senior Notes
  • Sponsor Equity
  • Management Rollover

Critical Rule:

Total Sources = Total Uses (must balance)

Transaction Financing Overview

Uses (What it pays for):

  • Purchase Equity Value
  • Refinance Existing Debt
  • Transaction Fees (legal, advisory)
  • Financing Fees (OID, arranger fees)
Total Sources = Total Uses

Transaction Entry Assumptions

Core Valuation Metrics:

  • Purchase Price: Based on negotiated enterprise value
  • Entry Multiple: Purchase Price / LTM or NTM EBITDA (typically 8x-12x)
  • Transaction Enterprise Value: Equity Value + Net Debt
  • Pro Forma Capital Structure: Post-transaction debt and equity layers
Enterprise Value = Equity Value + Total Debt - Cash

Core Modeling Components

Three Main Sections:

  • Transaction Assumptions - Entry valuation, purchase price, financing structure
  • Operating Model - Revenue, EBITDA, CapEx, NWC projections (typically 5 years)
  • Returns Analysis - Exit valuation, debt paydown, IRR and MOIC calculations

Model Flow:

Entry → Operations → Exit

Annual Cash Flow Distribution

Waterfall Structure (Starting from EBITDA):

  • EBITDA (Starting point)
  • Less: CapEx
  • Less: Change in Net Working Capital
  • Less: Cash Taxes
  • Less: Cash Interest Expense
  • Less: Mandatory Debt Amortization

Result:

= Free Cash Flow to Equity

Annual Cash Flow Distribution

Excess Cash Usage:

  • Excess cash pays down revolver/optional prepayments
  • Or builds cash balance
Key Point: The waterfall determines how much debt can be repaid and when

Debt Paydown Over Time

Debt Schedule Components:

  • Beginning Balance for each debt tranche
  • + Draws (revolver only)
  • - Mandatory Amortization (per credit agreement)
  • - Optional Prepayments (from excess cash flow)
  • = Ending Balance

Debt Paydown Over Time

Key Conventions:

  • Excess cash sweeps pay down highest-cost debt first
  • Typically: Term Loan B, then TLA, then revolver
Interest Expense = Average Balance × Interest Rate

Working Capital Requirements

Definition:

  • NWC = Current Assets - Current Liabilities
  • Typically modeled as % of revenue

Cash Flow Impact:

  • Increases in NWC = cash use (outflow)
  • Decreases in NWC = cash source (inflow)

Working Capital Requirements

Example Calculation:

  • If revenue grows from $100M to $110M
  • And NWC = 15% of revenue
  • NWC increase = $1.5M (cash outflow)

Key Point:

Fast-growing companies require more working capital investment

Tax Shield from Interest Expense

Pre-Tax Income Calculation:

  • EBITDA
  • Less: D&A
  • Less: Interest Expense
  • = EBT (Earnings Before Tax)

Tax Shield from Interest Expense

Tax Calculation:

  • EBT × Tax Rate = Tax Expense
  • But: Cash Taxes ≠ Tax Expense
  • Adjust for: NOLs, timing differences, cash vs. accrual

Key Benefit:

Interest is tax-deductible (creates "tax shield")

Determining Exit Enterprise Value

Two Approaches:

  • Exit Multiple Method: Year 5 EBITDA × Exit Multiple = Exit EV
  • Comparable Transactions: Based on recent M&A activity

Common Assumptions:

  • Exit multiple = Entry multiple (conservative)
  • Or: Exit multiple based on market conditions
  • Typical range: 8x - 12x EBITDA

Determining Exit Enterprise Value

Exit Equity Value = Exit EV - Net Debt at Exit + Excess Cash

Critical Point:

The exit equity value is what determines sponsor returns

Internal Rate of Return (IRR)

IRR Components:

  • Initial Investment = Sponsor Equity (Year 0, negative)
  • Annual cash flows (typically $0 in LBOs - no dividends)
  • Exit proceeds = Final equity value (Year 5, positive)
NPV = 0 = Initial Investment + CF₁/(1+IRR)¹ + ... + Exit Value/(1+IRR)ⁿ
Excel Formula: =IRR(cash flows)
Target: PE firms typically target 20%+ IRR

Multiple on Invested Capital (MOIC)

MOIC = Exit Equity Value / Initial Equity Investment

Example:

  • Initial equity investment: $300M
  • Exit equity value: $900M
  • MOIC = 3.0x

Interpretation:

  • 2.0x = doubled money
  • 3.0x = tripled money
  • Combine with holding period for fuller picture

Sources of Value Creation

Three Key Drivers:

  • 1. Operational Improvement (EBITDA Growth)
    • Revenue growth and margin expansion
    • Formula: (Exit EBITDA - Entry EBITDA) × Exit Multiple
  • 2. Debt Paydown
    • Principal reduction from cash flows
    • Formula: Beginning Debt - Ending Debt
  • 3. Multiple Arbitrage
    • Buy low, sell high on valuation multiples
    • Formula: Exit EBITDA × (Exit Multiple - Entry Multiple)

Essential Formulas Summary

Enterprise Value = Equity Value + Net Debt

EBITDA Multiple = Enterprise Value / EBITDA

Levered FCF = EBITDA - CapEx - ΔNWC - Taxes - Interest - Mandatory Amortization

Interest Expense = Avg Debt Balance × Interest Rate

Tax Shield = Interest Expense × Tax Rate

Essential Formulas Summary

Exit Equity Value = Exit EV - Ending Net Debt

IRR: 0 = Σ [CFₜ / (1+IRR)ᵗ]

MOIC = Exit Equity Value / Initial Equity Investment

Key Variables to Test

Create Sensitivity Tables For:

  • Revenue Growth (e.g., -2% to +5%)
  • EBITDA Margins (e.g., -200bps to +200bps)
  • Exit Multiple (e.g., 8.0x to 12.0x)
  • Debt/EBITDA at Entry (e.g., 4.0x to 6.0x)

Key Variables to Test

Two-Way Tables:

  • Show IRR at intersections of two variables
  • Example: Revenue Growth vs. Exit Multiple

Purpose:

Understand which assumptions have greatest impact on returns

Cash Management & Revolver

Cash Requirements:

  • Minimum cash balance: Typically $10-25M required
  • Revolver capacity: Provides liquidity cushion

Cash Sweep Logic:

  • IF: Cash > Minimum Balance
  • THEN: Excess pays down debt
  • ELSE: Draw on revolver if needed
Available Cash = Beginning Cash + Operating CF - Mandatory Debt Payments - Min Balance

Monitoring Leverage & Coverage

Leverage Ratios:

  • Total Debt / EBITDA (should decline over time)
  • Net Debt / EBITDA
  • Senior Debt / EBITDA

Monitoring Leverage & Coverage

Coverage Ratios:

  • EBITDA / Interest (Interest Coverage)
  • (EBITDA - CapEx) / Interest

Critical:

Model must stay within agreed covenant thresholds

LBO Model Best Practices

Key Conventions:

  • Circularity: Interest depends on debt, debt depends on cash, cash depends on interest
    • Solution: Enable iterative calculations or use circular reference solver
  • Mid-year convention: Assume cash flows occur mid-year for discounting
  • Stub period: Handle partial first year if applicable

LBO Model Best Practices

Additional Conventions:

  • Transaction date: Model from deal close, not calendar year
  • Optional prepayments: Apply excess cash flow sweep percentage (typically 50-100%)

Excel Model Structure

Recommended Layout:

  • Assumptions tab: All inputs in one place (color coded)
  • Sources & Uses: Transaction summary
  • Income Statement: EBITDA projections
  • Cash Flow Statement: Operating, investing, financing activities
  • Balance Sheet: Assets, liabilities, equity over time
  • Debt Schedule: Individual tranches with paydown
  • Returns: IRR, MOIC, sensitivity tables
  • Summary: Investment memo output page

What Can Go Wrong

Common Mistakes:

  • Overly optimistic projections: Revenue/margin assumptions too aggressive
  • Underestimating CapEx: Maintenance vs. growth capital needs
  • Ignoring working capital: Cash drag from growth
  • Refinancing risk: Can't service debt if market tightens

What Can Go Wrong

Additional Risks:

  • Covenant violations: Breaching leverage or coverage tests
  • Integration issues: For add-on acquisitions
  • Multiple compression: Exit at lower multiple than entry

Mitigation:

Conservative assumptions, stress testing, covenant cushions

Beyond the Basic Model

Additional Elements:

  • Management equity incentive plans: Dilution to sponsor returns
  • Transaction expenses: Legal, accounting, financing fees
  • Add-on acquisitions: Bolt-on growth strategy
  • Dividend recaps: Extract cash before exit

Beyond the Basic Model

Complex Features:

  • PIK interest: Payment-in-kind toggles on mezzanine debt
  • Earnouts: Contingent consideration to sellers
  • Working capital adjustments: Purchase price true-ups

Practical Application Example

Scenario:

  • Target Company: $500M revenue, $100M EBITDA
  • Entry Multiple: 10.0x ($1,000M EV)
  • Leverage: 5.0x ($500M debt)
  • Equity: $500M sponsor investment
  • 5-year hold
  • EBITDA grows to $150M
  • Exit Multiple: 10.0x

Practical Application Example

Results:

  • Exit EV: $1,500M
  • Debt paid down to $350M
  • Exit Equity: $1,150M
  • MOIC: 2.3x | IRR: 18%

Value Creation Breakdown:

EBITDA growth was the primary driver of returns

LBO Modeling Essentials

Summary:

  • LBOs use significant leverage to amplify equity returns
  • Returns driven by: EBITDA growth, debt paydown, multiple arbitrage
  • Cash flow waterfall determines debt repayment capacity
  • Tax shield from interest creates value

LBO Modeling Essentials

Summary (continued):

  • IRR and MOIC measure investment performance
  • Sensitivity analysis tests downside scenarios
  • Credit metrics ensure sustainable capital structure

Remember:

Conservative assumptions and thorough analysis are critical

Further Learning

Next Steps:

  • Practice building models with realistic assumptions
  • Study actual LBO transactions (public filings)
  • Understand credit agreements and covenants
  • Learn industry-specific considerations
  • Master Excel shortcuts and best practices
  • Review PE firm investment memos