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Walk Me Through an LBO Model

Learn the Step-by-Step Process of Building an LBO Model

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Walk Me Through an LBO Model

In This Article
  • What is a leveraged buyout (LBO)?
  • What are the steps to building an LBO model?
  • How do private equity firms profit from an LBO?
  • What sorts of insights are obtained from an LBO model?

LBO Model Overview

LBO models estimate the implied returns from the buyout of a company by a financial sponsor (i.e. private equity firm), in which a significant portion of the purchase price is funded with debt capital.

Following the buyout, the firm operates the post-LBO company for around five to seven years – with the free cash flows (FCFs) of the company used to pay down more debt each year.

The following information should be determined from an LBO model:

LBO Model 5-Step Framework

LBO Model Framework

Entry Valuation – Step 1

The first step to building an LBO model is calculating the implied entry valuation based on an entry multiple assumption.

To calculate the enterprise value at entry, the entry multiple is multiplied by either the last twelve months (LTM) EBITDA of the target company or the next twelve months (NTM) EBITDA.

If we assume a “cash-free, debt-free” transaction, then the calculated enterprise value is the purchase price of the LBO target.

Sources & Uses Schedule – Step 2

All else being equal, the lower the required upfront equity contribution from the financial sponsor, the higher the returns.

The next step is to create the sources & uses schedule, which approximates:

  • “Uses” Side – The total amount of capital required to complete the acquisition
  • “Sources” Side – The specific details on how the firm plans to come up with the required funding

The majority of the “uses” side will be attributable to the buyout of the target’s existing equity. But in addition, other transaction assumptions are made such as:

  • Transaction Expenses (e.g. M&A Advisory, Legal)
  • Financing Fees

From here, numerous financing assumptions are made regarding the sources of funds such as the:

  • Total Debt Financing (i.e. Leverage Multiple, Senior Leverage Multiple)
  • Lending Terms for Each Debt Tranche (e.g. Interest Rate Pricing, Required Amortization, Cash Sweep)
  • Management Rollover Assumptions
  • Cash to B/S (i.e. Excess Cash)

The remaining amount for the sources & uses side to be equal is the equity contributed by the financial sponsor (i.e. the “plug”).

Financial Forecast and Debt Schedule – Step 3

In the subsequent step, the financial performance of the company is projected for a minimum five-year time horizon, which is the standard holding period assumed for modeling purposes.

A complete 3-statement model is required for the LBO assumptions to properly impact the income statement and cash flow statement (i.e. the free cash flow build).

The debt schedule is used to closely track the:

  • Revolver Drawdown / (Paydown)
  • Mandatory Amortization
  • Cash Sweeps (i.e. Optional Prepayment)
  • Calculating Interest Expense

For the LBO model to calculate the returns accurately, the debt schedule must adjust each debt tranche accordingly to determine the amount of debt paid down in each period (and the ending balances).

Exit Valuation and LBO Returns – Step 4

Next, the assumptions regarding the exit must be made – most notably, the exit EV/EBITDA multiple.

In practice, the conservative assumption is to set the exit multiple equal to the purchase multiple.

Upon calculating the exit enterprise value using the exit multiple assumption and exit year EBITDA, the remaining net debt on the balance sheet as of the presumed date of exit can be deducted to arrive at the exit equity value.

After calculating the exit equity value attributable to the sponsor, the key LBO return metrics – i.e. the internal rate of return (IRR) and multiple of money (MoM) – can be estimated.

Sensitivity Analysis – Step 5

In the final step, different operating cases must be considered – e.g. a “Base Case”, “Upside Case”, and a “Downside Case” – along with sensitivity analyses to assess how adjusting certain assumptions impacts the implied returns from the LBO model.

Typically, the entry multiple and exit multiples are the two assumptions with the most significant impact on returns, followed by the leverage multiple and other operational characteristics (e.g. revenue growth, margins).

Master LBO Modeling Our Advanced LBO Modeling course will teach you how to build a comprehensive LBO model and give you the confidence to ace the finance interview.
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