Leveraged Buyout (LBO) Modeling and Debt Capacity Assessment

✦ A leveraged buyout (LBO) involves acquiring a company using a significant portion of debt, with the goal of generating high equity returns through financial leverage and cash flow discipline.

✦ LBO models project operating performance, debt schedules, and exit value to estimate internal rate of return (IRR) and equity multiple for the acquiring sponsor.

✦ Debt capacity is constrained by the target’s free cash flow, leverage multiples, coverage ratios, and lender risk tolerance.

✦ Effective LBO analysis depends on precise forecasting, detailed debt layering, and sensitivity to operating, credit, and exit assumptions.

We’ll break down the structure of an LBO model, how to evaluate debt capacity, and how sponsors measure returns under various scenarios.

1. What Is a Leveraged Buyout?

A leveraged buyout (LBO) is the acquisition of a company primarily funded with debt, with the expectation that the target’s future cash flows will service the debt and generate attractive equity returns upon exit.

✦ Sponsors (usually private equity firms) contribute a minority of the purchase price as equity.

✦ The rest is funded with layers of senior debt, subordinated debt, and possibly mezzanine or PIK (payment-in-kind) instruments.

✦ The strategy relies on: 

• Acquiring at a reasonable valuation 

• Using debt to amplify returns 

• Improving operations or margins 

• Exiting at a higher multiple or valuation

2. Core Structure of an LBO Model

A standard LBO model consists of:

✦ Sources & Uses of Funds — maps out how the deal is financed and what the capital pays for.

✦ Operating Forecast — builds income statement and free cash flow from revenue, margin, capex, and working capital drivers.

✦ Debt Schedule — includes tranches of debt, interest rates, repayment terms, amortization, and revolver usage.

✦ Cash Flow Waterfall — tracks how excess cash repays debt and how remaining cash flows to equity.

✦ Exit Assumptions — models sale at a future EBITDA multiple to estimate equity proceeds and IRR.

3. Sources and Uses Table

Sources (Funding):

• Debt (term loan A, term loan B, senior notes)

• Equity contribution from sponsor

• Seller rollover or management equity (if any)

Uses (Application of Funds):

• Purchase equity of target

• Refinance existing debt

• Pay transaction fees and advisory costs

• Fund working capital, if required

✦ The total sources must equal total uses.

4. Measuring Debt Capacity

Debt capacity is the maximum debt a business can support without breaching lender thresholds or exhausting cash flow.

✦ Leverage multiple: Total Debt / LTM EBITDA 

• Typical max range: 4.0× to 6.5× depending on industry and interest rate environment.

✦ Interest coverage: EBITDA / Cash interest 

• Minimum acceptable: 2.0×–2.5×

✦ Minimum cash: Maintain buffer liquidity to avoid revolver draws.

✦ Free Cash Flow to Debt Service: Core test of sustainability over the hold period.

Sponsors often model base, downside, and aggressive cases to stress-test debt headroom and covenant compliance.

5. Example — Basic LBO Setup

Target Company

• Enterprise Value: $500 million

• LTM EBITDA: $50 million

• Purchase multiple: 10.0×

• Entry equity: 35 % (→ $175 million)

• Debt financing: 65 % (→ $325 million)

Assumptions

• Revenue growth: 5 % per year

• EBITDA margin: 20 %

• Capex: $10 million annually

• Net working capital: 15 % of revenue

• Exit year: 5

• Exit multiple: 10.0×

✦ Forecast FCF annually and apply to mandatory debt repayments.

✦ At exit, company has $60 million EBITDA × 10.0 = $600 million EV 

• Less net debt: $100 million 

• Equity value: $500 million 

• Entry equity: $175 million → Multiple = 2.86× 

• IRR ≈ 23 % over 5 years

6. Advanced Features in LBO Models

✦ Cash sweep logic — repay debt faster if FCF exceeds thresholds.

✦ PIK interest tracking — non-cash accrual that compounds and increases leverage.

✦ Revolver modeling — draws if cash balance is below target; repays if surplus.

✦ Management equity rollover — supports retention and affects post-money ownership.

✦ Covenant modeling — tests leverage and fixed-charge coverage each period.

7. Sensitivity and Scenario Analysis

✦ Vary exit multiple, revenue growth, margin, and interest rate.

✦ Common outputs: 

• IRR vs. exit multiple 

• IRR vs. leverage level 

• Equity value bridge: Entry → Exit

✦ A well-built LBO model lets the user pivot between best case, base case, and downside.

8. Practical Considerations

✦ Leverage appetite is driven by macroeconomic cycle, credit spreads, and sponsor risk tolerance.

✦ Industry-specific norms affect both leverage limits and exit multiples (e.g., healthcare and software often carry higher valuations and tolerate more debt).

✦ Exit strategy: Sale to strategic buyer, IPO, or recapitalisation must be considered upfront.