Financial Modeling & Valuation
Module 6: LBO Modeling Fundamentals
Module Overview
A Leveraged Buyout (LBO) is an acquisition financed primarily with debt. Private equity firms use LBOs to acquire companies, improve them, and sell at a profit. Understanding LBO mechanics gives you insight into how financial sponsors think about value and what they're willing to pay.
This module introduces the fundamentals of LBO analysis. While full LBO modeling is an advanced topic, understanding the basics is essential for any finance professional.
Learning Objectives:
By the end of this module, you will be able to:
- Understand the structure and mechanics of leveraged buyouts
- Identify what makes a good LBO candidate
- Model sources and uses of funds
- Build a simplified LBO model
- Calculate returns (IRR and MOIC)
- Understand how LBO analysis informs valuation
Estimated Time: 4-5 hours
6.1 What Is a Leveraged Buyout?
Definition
A Leveraged Buyout (LBO) is the acquisition of a company using a significant amount of borrowed money (debt) to meet the purchase price.
Typical Capital Structure:
- Debt: 50-70% of purchase price
- Equity: 30-50% of purchase price
The target company's assets and cash flows serve as collateral for the debt.
The LBO Players
Private Equity (PE) Firm:
- Provides equity investment (the "sponsor")
- Controls the company post-acquisition
- Responsible for value creation strategy
- Targets specific investment returns (typically 20%+ IRR)
Lenders:
- Provide debt financing
- Senior lenders (banks) have priority
- Subordinated/mezzanine lenders take more risk for higher returns
- Debt is typically paid down from company cash flows
Target Company Management:
- Often retained post-acquisition
- May receive equity incentives (co-invest, options)
- Responsible for executing value creation plan
How PE Firms Make Money
Value Creation Levers:
1. Entry Multiple → Buy at an attractive price
2. EBITDA Growth → Grow earnings through revenue and margins
3. Debt Paydown → Reduce debt, increase equity value
4. Exit Multiple → Sell at a higher multiple (multiple expansion)
The Math:
Entry: Buy company for $1,000M at 8× EBITDA ($125M EBITDA)
Equity: $400M, Debt: $600M
Hold: Grow EBITDA to $175M over 5 years
Pay down $200M of debt
Exit: Sell at 9× EBITDA = $1,575M
Debt remaining: $400M
Equity value: $1,175M
Return: $1,175M / $400M = 2.9× MOIC
IRR ≈ 24%
6.2 LBO Candidates: What Makes a Good Target?
Characteristics of Ideal LBO Candidates
1. Stable, Predictable Cash Flows Debt must be serviced regardless of market conditions. Stable cash flows reduce default risk.
- Recurring revenue (subscriptions, contracts)
- Non-cyclical industries
- Diverse customer base
2. Strong Market Position Companies with competitive advantages can maintain margins.
- Market leadership
- Brand recognition
- High barriers to entry
- Pricing power
3. Low Capital Intensity Less CapEx means more cash available for debt paydown.
- Asset-light business models
- Maintenance CapEx < D&A
- Limited working capital needs
4. Operational Improvement Opportunities PE firms create value through operational improvements.
- Cost-cutting potential
- Revenue enhancement opportunities
- Professional management gaps
- Underperforming divisions to fix or sell
5. Experienced Management Team Execution depends on management.
- Strong track record
- Willingness to stay post-acquisition
- Aligned incentives
6. Clear Exit Path PE firms need to exit within 3-7 years.
- Strategic buyer interest
- IPO potential
- Secondary buyout market
Industries Favorable for LBOs
- Business services
- Healthcare services
- Software (especially B2B SaaS)
- Consumer products (stable brands)
- Industrial distributors
- Food & beverage
Red Flags for LBOs
- Highly cyclical revenues
- Heavy capital requirements
- Rapid technology change
- Commodity businesses with thin margins
- High customer concentration
- Regulatory uncertainty
6.3 Sources and Uses of Funds
The Transaction Mechanic
An LBO transaction needs to balance:
- Uses: What the money is spent on
- Sources: Where the money comes from
Uses of Funds:
Uses of Funds:
Purchase Price (Equity Value) $800M
Refinance Existing Debt $150M
Transaction Fees & Expenses $50M
─────────────────────────────────────────────
Total Uses $1,000M
Sources of Funds:
Sources of Funds:
Senior Secured Debt (Term Loan) $400M
High Yield Bonds $150M
Mezzanine Debt $50M
Equity (PE Sponsor) $350M
Rollover Equity (Management) $50M
─────────────────────────────────────────────
Total Sources $1,000M
Types of Debt in LBOs
Senior Secured Debt (Bank Debt):
- First priority claim on assets
- Lower interest rates (SOFR + 3-5%)
- Amortizing (paid down over time)
- Typically 3-5× EBITDA
High Yield Bonds (Junk Bonds):
- Unsecured or subordinated
- Higher interest rates (7-12%)
- Bullet maturity (principal at end)
- Provides additional capacity
Mezzanine Debt:
- Between senior debt and equity
- Highest interest rates (12-18%)
- May include equity kickers (warrants)
- Used for additional leverage
Debt Capacity
Lenders evaluate debt capacity using credit metrics:
Leverage Ratios:
- Debt/EBITDA: Total debt relative to cash flow
- Senior Debt/EBITDA: Bank debt portion
Coverage Ratios:
- Interest Coverage: EBITDA/Interest Expense
- Fixed Charge Coverage: (EBITDA - CapEx)/(Interest + Mandatory Amortization)
Typical LBO Debt Limits:
- Total Debt/EBITDA: 5-7×
- Senior Debt/EBITDA: 3-4×
- Interest Coverage: >2.0×
6.4 Building a Simplified LBO Model
Model Structure
A basic LBO model has these components:
1. Transaction Assumptions - Purchase price, capital structure
2. Operating Model - Revenue, EBITDA projections
3. Debt Schedule - Interest, amortization, paydown
4. Cash Flow - Operating cash flow, free cash flow
5. Returns Analysis - Exit value, IRR, MOIC
Step 1: Transaction Assumptions
Transaction Assumptions:
─────────────────────────────────────────────
Entry Year: 2025
Exit Year: 2030 (5-year hold)
Purchase Price:
LTM EBITDA: $100M
Entry Multiple: 8.0×
Enterprise Value: $800M
Less: Existing Debt ($50M)
Plus: Cash Acquired $20M
Equity Value (Purchase): $770M
Sources of Funds:
Term Loan (4.0× EBITDA): $400M
High Yield (2.0× EBITDA): $200M
Total Debt: $600M
Sponsor Equity: $200M
Total Sources: $800M
(Plus: Fees funded by cash)
─────────────────────────────────────────────
Step 2: Operating Projections
Operating Projections ($M) 2025 2026 2027 2028 2029 2030
─────────────────────────────────────────────────────────────────────
Revenue 500 525 551 579 608 638
Growth % 5.0% 5.0% 5.0% 5.0% 5.0%
EBITDA 100 108 117 126 136 147
Margin % 20.0% 20.6% 21.2% 21.8% 22.4% 23.0%
Depreciation 15 16 17 18 19 20
EBIT 85 92 100 108 117 127
CapEx 20 21 22 23 24 25
% of Revenue 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%
Change in NWC 5 3 3 3 3 3
Step 3: Debt Schedule
Debt Schedule ($M) 2025 2026 2027 2028 2029 2030
─────────────────────────────────────────────────────────────────────
Term Loan:
Beginning Balance 400 375 350 315 270 215
Mandatory Amortization (25) (25) (25) (25) (25) (25)
Optional Prepayment 0 0 (10) (20) (30) (50)
Ending Balance 375 350 315 270 215 140
Interest Rate 6.5% 6.5% 6.5% 6.5% 6.5% 6.5%
Interest Expense 25 24 22 19 16 12
High Yield Bonds:
Beginning Balance 200 200 200 200 200 200
Ending Balance 200 200 200 200 200 200
Interest Rate 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Interest Expense 20 20 20 20 20 20
Total Debt 575 550 515 470 415 340
Total Interest 45 44 42 39 36 32
Step 4: Free Cash Flow
Free Cash Flow ($M) 2025 2026 2027 2028 2029 2030
─────────────────────────────────────────────────────────────────────
EBITDA 100 108 117 126 136 147
- Interest Expense (45) (44) (42) (39) (36) (32)
- Taxes (25% rate) (10) (12) (15) (17) (20) (24)
- CapEx (20) (21) (22) (23) (24) (25)
- Change in NWC (5) (3) (3) (3) (3) (3)
─────────────────────────────────────────────────────────────────────
Free Cash Flow 20 28 35 44 53 63
Mandatory Amortization (25) (25) (25) (25) (25) (25)
Cash Available for Prepayment (5) 3 10 19 28 38
Cumulative Cash (5) (2) 8 27 55 93
Step 5: Exit Analysis and Returns
Exit Analysis ($M) Exit Year 2030
─────────────────────────────────────────────────
Exit EBITDA: $147M
Exit Multiple: 8.5×
Enterprise Value at Exit: $1,250M
Less: Debt Outstanding ($340M)
Equity Value at Exit: $910M
Initial Equity Investment: $200M
Returns:
Multiple of Invested Capital (MOIC): $910M / $200M = 4.6×
Internal Rate of Return (IRR): ~35%
─────────────────────────────────────────────────
6.5 Return Metrics: IRR and MOIC
Internal Rate of Return (IRR)
IRR is the discount rate that makes the NPV of cash flows equal to zero:
0 = -Initial Investment + CF₁/(1+IRR)¹ + CF₂/(1+IRR)² + ... + Exit Value/(1+IRR)ⁿ
For LBOs:
- Initial investment is the equity check
- Exit value is the equity value at sale
- Interim cash flows (dividends, recaps) may occur
Typical PE Return Targets:
- Gross IRR: 20-30%+
- Net IRR (after fees): 15-25%+
Multiple of Invested Capital (MOIC)
MOIC is simpler—how many times your money did you get back?
MOIC = Total Proceeds / Total Invested Capital
Example:
Invest: $200M
Exit: $910M
MOIC: 4.6×
MOIC vs. IRR:
- MOIC ignores timing (a 3× over 3 years is better than 3× over 7 years)
- IRR accounts for time value
- Both are used together
Return Drivers Analysis
What drove the 4.6× MOIC and 35% IRR?
Attribution Analysis:
─────────────────────────────────────────────────
Entry Equity: $200M
EBITDA Growth Contribution:
($147M - $100M) × 8.5× = $400M +$400M
Multiple Expansion Contribution:
$100M × (8.5× - 8.0×) = $50M +$50M
Debt Paydown Contribution:
($600M - $340M) = $260M +$260M
─────────────────────────────────────────────────
Exit Equity Value: $910M
Breakdown:
- EBITDA Growth: 44% of value creation
- Debt Paydown: 29% of value creation
- Multiple Expansion: 5% of value creation
- (Entry equity represents 22%)
6.6 Sensitivity Analysis for LBOs
Key Variables
LBO returns are sensitive to:
1. Entry Multiple (Purchase Price) The price you pay is the #1 determinant of returns.
2. Exit Multiple Multiple expansion helps; contraction hurts.
3. EBITDA Growth Operational improvements drive value.
4. Leverage Level More debt amplifies returns (and risk).
5. Hold Period Longer holds reduce IRR (even if MOIC is the same).
Sensitivity Tables
IRR Sensitivity: Entry Multiple vs. Exit Multiple
─────────────────────────────────────────────────────────────────
Exit Multiple (× EBITDA)
7.0× 7.5× 8.0× 8.5× 9.0×
──────────────────────────────────────────────────────
7.0× 25.0% 28.5% 31.8% 35.0% 38.0%
Entry 7.5× 21.5% 24.8% 28.0% 31.0% 33.8%
Multiple 8.0× 18.2% 21.3% 24.3% 27.2% 30.0%
8.5× 15.2% 18.1% 21.0% 23.7% 26.4%
9.0× 12.4% 15.2% 18.0% 20.6% 23.2%
─────────────────────────────────────────────────────────────────
Reading the table: Base case (8.0× entry, 8.5× exit): 27.2% IRR If entry improves to 7.5×: IRR jumps to 31.0% If exit declines to 7.5×: IRR falls to 21.3%
Downside Scenario
What if things go wrong?
Downside Scenario:
EBITDA grows only 2% annually
Exit multiple compresses to 6.5×
Exit EBITDA: $110M
Exit EV: $715M
Exit Debt: $450M (less paydown due to weaker cash flow)
Exit Equity: $265M
MOIC: 1.3×
IRR: 6%
PE firms model downside scenarios to stress-test deals.
6.7 LBO as a Valuation Tool
Implied LBO Purchase Price
LBO analysis can determine the maximum price a financial buyer would pay:
The Question: "At what entry price can a PE firm achieve a 20% IRR?"
The Approach:
- Assume target operating projections
- Assume exit multiple and hold period
- Assume capital structure (leverage levels)
- Solve for entry price that achieves target IRR
Example Analysis
Target IRR: 20%
Hold Period: 5 years
Exit EBITDA: $147M
Exit Multiple: 8.0×
Exit EV: $1,176M
Exit Debt: $340M
Exit Equity: $836M
Required equity growth for 20% IRR over 5 years:
Entry Equity × (1.20)^5 = $836M
Entry Equity = $836M / 2.49 = $336M
Maximum Entry Price:
Equity: $336M
Debt: $600M
Entry EV: $936M
Entry EBITDA: $100M
Implied Entry Multiple: 9.4×
Conclusion: A financial buyer targeting 20% IRR could pay up to 9.4× EBITDA.
LBO in the Valuation Football Field
Valuation Summary ($ per share)
─────────────────────────────────────────────────────────────────
Low Mid High
─────────────────────────────────────────────────────────────────
DCF Analysis $22.50 $26.00 $30.00
Trading Comps $21.00 $24.50 $28.00
Precedent Transactions $26.00 $28.50 $31.00
LBO Analysis (20% IRR floor) $28.00 $31.50 $35.00
─────────────────────────────────────────────────────────────────
Current Price: $23.00
LBO analysis often shows the highest values because:
- Leverage amplifies returns
- Financial buyers can be aggressive with debt
- Represents the price floor for competitive auctions
6.8 Advanced LBO Concepts (Overview)
Management Rollover
Management may "roll over" equity into the new company:
- Aligns incentives
- Shows confidence
- Reduces sponsor equity required
Dividend Recapitalizations
PE firms sometimes refinance to pay themselves dividends:
- Take out debt to pay special dividend
- Returns capital before exit
- Accelerates cash-on-cash returns
Add-On Acquisitions
PE-backed companies often make acquisitions:
- "Buy and build" strategy
- Acquire at lower multiples than platform
- Create value through consolidation
Exit Strategies
Strategic Sale:
- Sell to a corporate buyer
- Often gets highest prices (synergies)
Secondary Buyout:
- Sell to another PE firm
- Common in mature PE market
IPO:
- Take company public
- Less common; requires scale and market conditions
Recapitalization:
- Refinance and pay dividend
- Partial return without full exit
6.9 Practical Exercise: Build an LBO Model
Exercise Instructions
Build a simplified LBO model for TargetCo:
Transaction Assumptions:
Target: TargetCo Inc.
LTM EBITDA: $80M
Entry Multiple: 7.5×
Enterprise Value: $600M
Sources:
Term Loan (4.0×): $320M @ 7.0% interest
High Yield (2.0×): $160M @ 10.5% interest
Sponsor Equity: $120M
Fees: Assume covered by target's cash on hand
Operating Assumptions (5-year hold):
Revenue Growth: 6% annually
EBITDA Margin: Improves from 18% to 22% over 5 years
CapEx: 3% of revenue
D&A: 4% of revenue
Working Capital: Increases 2% of revenue growth
Tax Rate: 25%
Mandatory Amortization: $20M/year on Term Loan
Exit Assumptions:
Exit Year: Year 5
Exit Multiple: 8.0× EBITDA
Your Task:
- Build the Sources & Uses
- Project EBITDA for 5 years
- Build the debt schedule with interest and amortization
- Calculate annual free cash flow
- Determine ending debt and equity value at exit
- Calculate IRR and MOIC
- Build sensitivity table: Entry Multiple vs. Exit Multiple
6.10 Key Takeaways
LBO Mechanics
- Acquisition financed with 50-70% debt
- Target's cash flows service the debt
- PE firm provides equity and manages the company
Value Creation
- Entry multiple (buy cheap)
- EBITDA growth (improve operations)
- Debt paydown (reduce leverage)
- Exit multiple (sell high)
Good LBO Candidates
- Stable, predictable cash flows
- Low capital intensity
- Operational improvement opportunity
- Experienced management
- Clear exit path
Returns
- MOIC: Total proceeds / invested capital
- IRR: Time-weighted return rate
- Target: 20%+ IRR, 2-3× MOIC
LBO as Valuation
- Determines what financial buyers would pay
- Provides floor price in competitive auctions
- Useful for understanding downside protection
Looking Ahead to Module 7
You now have four valuation perspectives:
- DCF: Intrinsic value from cash flows
- Trading Comps: Market value from peers
- Precedent Transactions: M&A value from historical deals
- LBO: Financial buyer value from leveraged returns
In Module 7, you'll put it all together in a Capstone Project—valuing a real company using all four methods and presenting an investment recommendation.
Summary
Congratulations on completing Module 6! You can now:
- Explain LBO structure and mechanics
- Identify characteristics of good LBO candidates
- Model sources and uses of funds
- Build a simplified LBO model
- Calculate returns (IRR and MOIC)
- Use LBO analysis as a valuation tool
Ready for the capstone? Proceed to Module 7: Capstone Project to apply everything you've learned.
"In private equity, you make your money when you buy—not when you sell." — PE Industry Wisdom