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# Walk Me Through an LBO Model

Step-by-Step Guide to Understanding the Basics of an LBO Model | Private Equity Modeling Tutorial

Last Updated March 12, 2024

## Basics of an LBO Model | Private Equity Modeling Tutorial

An LBO model estimates the implied returns from the buyout of a target company by a financial sponsor, or private equity firm, in which a significant portion of the purchase price is funded with debt capital.

Following the leveraged buyout (LBO), the financial sponsor 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.

From the perspective of a private equity (PE) firm, the following pieces of information must be derived from an LBO model to analyze a potential investment opportunity.

1. Entry Valuation → Pre-LBO Entry Equity Value and Enterprise Value
2. Default Risk → Credit Ratios (e.g. Leverage Ratio, Interest Coverage Ratio, Solvency Ratio)
3. Free Cash Flows (FCFs) → Cumulative Debt Paid Down (and Net Debt in Exit Years)
4. Exit Valuation → Post-LBO Exit Equity Value and Enterprise Value of the Target Company
5. LBO Return Metrics → Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC)

## Step 1. LBO Entry Valuation

Suppose you’re currently recruiting for a position to join a private equity firm (PE), and the interviewer sitting across from you asked the following question:

Q. “Walk me through an LBO model?”

So, the first step to building an LBO model is to calculate 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.

Entry Valuation = Purchase EBITDA × Entry Multiple

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

## Step 2. Sources and Uses of Funds Table (S&U)

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 because of 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 Fees)
• 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 and Uses to be equal is the equity contribution by the financial sponsor (i.e. the equity investment to “plug” the remaining funds required).

In the sources and uses of funds table, the total sources must equate to the total uses (Total Uses = Total Sources), akin to the fundamental balance sheet equation.

Where:

• Total Uses → Purchase Enterprise Value (TEV), Transaction Fees, Financing Fees
• Total Sources → Debt Capital (Senior Debt, Subordinated Debt), Mezzanine Financing, Preferred Stock, Sponsor Equity Contribution

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## Step 3. Financial Forecast and Debt Schedule Build

In the subsequent step, the company’s financial performance is projected for a minimum five-year time horizon, which is the standard holding period assumed on the job.

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 following components:

• Revolver Drawdown / (Paydown)
• Principal Amortization (i.e. Mandatory Repayment)
• Cash Sweep (i.e. Optional Prepayment)
• Interest Expense Schedule

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

## Step 4. LBO Exit Returns Schedule (IRR and MOIC)

Next, assumptions regarding the exit – i.e. the realization of the investment by the financial sponsor – are necessary, most notably the exit EV/EBITDA multiple.

EV/EBITDA = Enterprise Value ÷ EBITDA

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

The exit enterprise value is determined by multiplying the exit multiple assumption by the exit year EBITDA.

Exit Enterprise Value (TEV) = Exit Multiple × Exit Year EBITDA

In the next step, 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.

Exit Equity Value = Exit Enterprise Value (TEV) Net Debt

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

The internal rate of return (IRR) is the annualized yield on an investment, with the effects of compounding factored.

Internal Rate of Return (IRR) = (Ending Value ÷ Current Value)^(1 ÷ Number of Periods) – 1
The multiple on invested capital (MOIC) is the ratio between the proceeds retrieved from an investment and the original investment.
Multiple on Invested Capital (MOIC) = Total Cash Inflows ÷ Total Cash Outflows

## Step 5. LBO Sensitivity Analysis Table

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.

• Base Case → The outcome with the highest probability (%) of occurrence.
• Upside Case → The most optimistic outcome, where performance exceeds expectations.
• Downside Case → The most pessimistic outcome, in which the performance of the acquisition target fails to meet expectations.

The downside case is of particular importance in private equity (LBO) investing, because of the debt load placed on the capital structure of the target post-LBO.

In conclusion, the entry multiple and exit multiples are usually the two assumptions with the most impact on returns, followed by the leverage multiple and other operational characteristics, such as revenue growth and profit margins.