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Standard LBO Model

Determine acquisition value and returns from a leveraged buyout perspective

60 minadvancedCanonical

Overview

What this model is and what it produces

The Leveraged Buyout (LBO) model calculates the maximum price a financial sponsor can pay for a target company while achieving required equity returns. It models the use of significant debt financing to acquire a business, projecting cash flows to service debt, and determining exit value and returns (IRR, MOIC) to equity investors. This is the core analytical framework for private equity investment decisions.

Purpose

Determine the maximum purchase price for an acquisition that achieves target equity returns, and model debt paydown, credit metrics, and exit scenarios.

Key Outputs

  • Maximum Purchase Price
  • Equity IRR and MOIC
  • Debt Paydown Schedule
  • Credit Statistics (Leverage, Coverage)
  • Exit Value and Returns Sensitivity
  • Sources and Uses of Funds

When to Use

  • Evaluating a potential acquisition from a PE fund perspective
  • Structuring debt financing for a management buyout
  • Advising on sponsor-backed M&A transactions
  • Determining bid price in competitive auction processes
  • Modeling recapitalization or dividend recap scenarios

Why This Model Exists

The problem it solves and where it fits

Problem Solved

Strategic buyers pay for synergies; financial buyers pay for returns. The LBO model solves for the maximum price a PE fund can pay while achieving target returns (typically 20-25% IRR), given leverage constraints and exit assumptions. It bridges the gap between intrinsic value and achievable transaction value.

Why Not Simpler Approaches?

DCF values a business based on cash flows; LBO values it based on what a specific buyer class (financial sponsors) can afford to pay. The debt capacity, cash flow timing, and exit multiples create a fundamentally different value calculation that cannot be replicated with simpler methods.

Preferred When

  • Target has stable, predictable cash flows to service debt
  • Significant debt capacity exists in the capital structure
  • Exit pathway is clear (strategic sale, IPO, secondary)
  • Management team is willing to participate in ownership
  • Evaluating competitiveness of sponsor bids vs strategic buyers

LBO modeling is the core technical skill for private equity professionals and M&A bankers advising on sponsor transactions. Most PE interview processes include live LBO modeling tests.

How the Model Works

Structure and flow

The model begins with transaction assumptions: purchase price, financing structure, and sponsor equity. Operating projections generate EBITDA and free cash flow, which service debt obligations according to a waterfall. Mandatory and optional debt paydown reduce leverage over the hold period. At exit, enterprise value (calculated via exit multiple) is reduced by remaining debt to yield equity proceeds. IRR and MOIC compare equity proceeds to initial investment.

Model Sections

1
Transaction Assumptions

Define purchase price, financing mix, fees, and timing

2
Sources & Uses

Balance sheet of how acquisition is funded and where capital goes

3
Operating Model

Revenue, EBITDA, and cash flow projections

4
Debt Schedule

Model each debt tranche: draws, interest, amortization, paydown

5
Cash Flow Waterfall

Allocate cash to debt service, mandatory paydown, and sweep

6
Credit Statistics

Calculate leverage ratios and coverage metrics over time

7
Exit Analysis

Apply exit multiple, calculate equity proceeds

8
Returns Analysis

Compute IRR, MOIC, and sensitivity tables

  • Purchase price drives initial debt quantum and equity check
  • EBITDA drives debt capacity and cash available for debt service
  • Free cash flow determines debt paydown velocity
  • Exit multiple and debt remaining determine equity proceeds
  • Equity proceeds vs initial check determine IRR/MOIC

Key Drivers & Variables

What matters most for value

Primary Drivers

Equity IRR

very-high

The hurdle rate (typically 20-25%) that constrains maximum bid price. Every transaction must clear this threshold.

View variable details

Multiple of Invested Capital

very-high

Measures total return multiple. A 2.0-3.0x MOIC over 5 years is typical. Complements IRR for return analysis.

View variable details

Entry EV/EBITDA Multiple

very-high

Purchase price as multiple of EBITDA. Directly determines equity check size.

View variable details

Exit EV/EBITDA Multiple

very-high

Assumed selling multiple at exit. Often assumes no multiple expansion (conservative).

View variable details

Key Assumptions Required

  • Hold period (typically 5-7 years)
  • Debt structure (senior, mezz, PIK)
  • Interest rates and floors
  • Cash sweep percentage
  • Management rollover and incentives
  • Transaction and financing fees

Best Practices & Common Pitfalls

How to do it well

Best Practices

Assume no multiple expansion

Base case should assume exit multiple equals entry multiple. Multiple expansion is upside, not base case.

Test multiple return levers

Understand whether returns come from debt paydown, EBITDA growth, or multiple expansion. Over-reliance on one is risky.

Model realistic debt terms

Use market-based interest rates, covenants, and structures. Unrealistic leverage kills deals.

Include all transaction costs

Advisory fees, financing fees, legal costs, and D&O tail insurance add up. Typically 2-4% of TEV.

Build downside scenarios

Model recession case where EBITDA contracts 20-30%. Test if debt can still be serviced.

Common Pitfalls

Aggressive exit multiples

Assuming 2-3 turns of multiple expansion to make returns work. Market conditions may not support this.

Ignoring working capital

Growth requires working capital investment. Ignoring NWC overstates cash available for debt paydown.

Unrealistic debt paydown

Assuming 100% cash sweep when covenants, liquidity, or strategic needs require cash retention.

Forgetting minimum cash

Operating businesses need working cash on hand. Cannot sweep all cash to debt.

Pro Tips

  • Back-solve for maximum price at target IRR rather than calculating IRR at a given price
  • Build the returns waterfall (preference vs. common) for accurate sponsor returns
  • Create a sources/uses that ties perfectly—this is a common interview check
  • Model both cash interest and PIK separately for accurate cash flow
References: Investment Banking (Rosenbaum & Pearl): Chapter on LBO Analysis • Private Equity Operational Due Diligence (Scharfman) • FAST Standard: Section 5.1 - Transaction Models

Example Use Case

Applied thinking

A middle-market PE fund is evaluating a healthcare services company in a competitive auction. The target has $50M EBITDA, and strategic buyers are bidding 8-9x.

Role: Vice President at a $2B PE fund

Application

The VP builds an LBO model testing entry multiples from 7-9x with 5x leverage. The model shows that at 8.5x entry, the fund can achieve 22% IRR assuming 10% EBITDA growth and no multiple expansion over 5 years. A 9x bid would require margin improvement or multiple expansion to hit returns.

Insight Generated

LBO analysis reveals maximum bid of 8.5x to achieve target returns under conservative assumptions. The fund decides to bid 8.25x with clear operational value creation plan, accepting lower probability of winning but higher confidence in returns.

Illustrative Data

Entry EBITDA

$50M

Entry Multiple

8.5x

Enterprise Value

$425M

Debt (5.0x)

$250M

Equity Check

$200M

Exit EBITDA (Y5)

$80M

Exit Multiple

8.5x

Equity IRR

22%

MOIC

2.3x

When NOT to Use This Model

Know the limitations

Companies with volatile or unpredictable cash flows

Debt requires stable cash flow for service. Cyclical or project-based businesses may not support leverage.

High-growth companies requiring reinvestment

LBO value creation requires cash generation for debt paydown. Companies reinvesting all cash cannot delever.

Businesses with limited tangible assets

Lenders often require asset coverage. IP-heavy or service businesses may have limited debt capacity.

Strategic transactions with synergies

Strategic buyers value synergies that sponsors cannot capture. LBO underestimates value in strategic M&A.

Consider These Alternatives

Standard DCF

When valuing from a strategic buyer or all-equity perspective

Merger Model

When analyzing strategic acquisitions with synergies

Growth Equity Model

For minority investments in high-growth companies

Paper LBO

For quick screening before building full model

Critical Assumptions That Must Hold

  • Target can support acquisition leverage
  • Lenders will provide financing on assumed terms
  • Operating improvements are achievable
  • Exit market will exist at assumed valuations
  • Management team will execute value creation plan

Related Models

Explore connected frameworks

Paper LBO

Prerequisite

Quick mental math version for initial screening

Coming Soon

LBO with Add-on Acquisitions

Advanced

Platform plus bolt-on acquisition strategy modeling

Coming Soon

Dividend Recapitalization Model

Variant

Model refinancing to return capital to sponsors mid-hold

Coming Soon

Merger Model (M&A)

Complementary

Strategic buyer analysis for comparison to sponsor bid

Coming Soon

Detailed Debt Schedule

Complementary

Deep-dive on debt structuring, covenants, and waterfall

Coming Soon

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Learning Resources

📄LBO Fundamentals for Beginners(20 min)🎬Building an LBO Model Step-by-Step(60 min)📄Understanding Returns: IRR vs MOIC(10 min)