Leveraged Buyout (LBO) Modeling and Deal Structuring

✦ A leveraged buyout (LBO) involves acquiring a company using a significant amount of debt, with the target’s assets and cash flows used to secure and repay that debt.

✦ LBO modeling evaluates returns to equity investors under various capital structures, operating scenarios, and exit strategies.

✦ Deal structuring balances debt tranches, sponsor equity, management incentives, and covenants to maximize return while controlling risk.

✦ A disciplined LBO framework helps private equity firms and strategic buyers assess feasibility, bid strategy, and post-acquisition performance.

We’ll explore the key components of LBO modeling and structuring, from sources and uses of funds to debt repayment mechanics and return metrics.

1. What Is a Leveraged Buyout?

In an LBO, an acquirer—typically a private equity (PE) sponsor—buys a company by funding the majority of the purchase price with debt financing.

✦ The acquired company’s future free cash flows are used to repay the debt over time.

✦ The sponsor contributes equity, generally 20–40 % of the purchase price.

✦ The goal is to exit the investment (usually in 3–7 years) at a higher valuation through operational improvements, deleveraging, and multiple expansion.

2. Sources and Uses of Funds

Sources (where the money comes from):

✦ Bank debt (term loans, revolvers)

✦ Subordinated debt (mezzanine, second lien)

✦ Sponsor equity

✦ Seller financing or rollover equity

Uses (where the money goes):

✦ Purchase equity of target

✦ Refinance existing debt

✦ Pay transaction fees (legal, banking, advisory)

✦ Fund cash needs or working capital

Example:

• Purchase price = $500 million

• Transaction fees = $20 million

• Existing debt = $80 million (to be refinanced)

• Total uses = $600 million

• Debt financing = $400 million

• Sponsor equity = $200 million

• Total sources = $600 million

3. Financial Model Structure

✦ Operating model: Forecasts revenue, EBITDA, capex, working capital, and free cash flow.

✦ Debt schedule: Tracks interest, amortization, optional prepayments, and ending balances by tranche.

✦ Cash sweep logic: Applies excess cash to repay debt.

✦ Returns analysis: 

• Internal rate of return (IRR) 

• Multiple of invested capital (MOIC) 

• Exit valuation scenarios (e.g., 5-year sale at 10× EBITDA)

4. Key Assumptions and Drivers

✦ Entry valuation (EV/EBITDA multiple)

✦ Leverage ratio (e.g., 5× debt/EBITDA)

✦ Debt interest rates and repayment terms

✦ Revenue and margin growth

✦ Exit multiple and year

Example:

• Entry EV = 8× EBITDA

• Entry EBITDA = $60 million → EV = $480 million

• Debt = $300 million → Equity = $180 million

• Exit EV = 9× $80m EBITDA = $720 million

• Debt at exit = $120 million → Equity proceeds = $600 million

• IRR = ~27 %, MOIC = 3.3×

5. Debt Types and Capital Stack

✦ Senior debt: 

• Term Loan A (amortizing) 

• Term Loan B (institutional, bullet repayment) 

• Revolving credit line (for working capital)

✦ Subordinated debt: 

• Second lien loans 

• Mezzanine financing (may include PIK interest or equity warrants)

✦ Equity: 

• Sponsor contribution 

• Management rollover or incentive pool

✦ Each tranche has different pricing, maturity, and control rights.

6. Covenants and Risk Management

✦ Maintenance covenants: Leverage ratio, interest coverage—tested quarterly.

✦ Incurrence covenants: Restrict actions like dividends, M&A, or new debt issuance.

✦ Equity cure rights: Allow sponsor to inject equity to avoid covenant breach.

✦ Model must include downside cases to stress-test compliance and liquidity headroom.

7. Return Metrics and Exit Planning

✦ IRR: Annualized return to equity investors. Target > 20 % for most LBOs.

✦ MOIC: Total equity proceeds ÷ equity invested. Typical range: 2.0–3.0× over 5 years.

✦ Exit options: 

• Sale to strategic or PE buyer 

• IPO (partial exit) 

• Dividend recap (leveraged refinancing to return equity)

✦ Sensitivity to exit multiple and timing is critical—model multiple return paths.

8. Management Incentives and Governance

✦ Management often receives equity options or performance-based equity (e.g., 10–15 % of fully diluted equity).

✦ Aligns interests between PE firm and operating team.

✦ PE sponsor typically gains board control and implements KPIs, budgeting discipline, and cash controls.

9. Common Pitfalls to Avoid

✦ Overestimating cost savings or revenue growth.

✦ Assuming aggressive multiple expansion at exit.

✦ Underestimating working capital or capex needs.

✦ Ignoring covenant compliance or liquidity stress.

✦ Building complex models with unclear logic or broken debt schedules.