Building an LBO Model: A Step-by-Step Walkthrough

Leveraged Buyouts (LBOs) are a cornerstone of private equity, allowing firms to acquire companies primarily using borrowed money.

For finance professionals, understanding how to build an LBO model is a crucial skill. It’s not just about crunching numbers; it’s about dissecting a business, forecasting its future, and assessing the viability of a highly leveraged transaction.

This post will walk you through a detailed, step-by-step process to construct an LBO model.

The Foundation: What is an LBO Model?

An LBO model is a financial projection tool that analyzes the returns to a private equity sponsor from acquiring a company using a significant amount of debt.

The goal is to generate an acceptable internal rate of return (IRR) and multiple of money (MoM or MOIC) for the sponsor upon exiting the investment (typically after 3-7 years).

Prerequisites: What You'll Need

• Historical Financial Statements: At least 3-5 years of Income Statements, Balance Sheets, and Cash Flow Statements for the target company.
• Company Information: Details on the target's industry, business model, competitive landscape, growth drivers, and cost structure.
• Transaction Assumptions: Preliminary ideas on purchase price, financing structure (debt tranches, equity contribution), and exit assumptions.

Step 1: Preparing the 3-Financial Statement Model - Inputting Historical Financials & Setting Up Assumptions

This is where you lay the groundwork for your model. Accuracy and organization are paramount.

1.1. Preparing the 3-Financial Statement Model:

• Create Dedicated Tabs: Have separate tabs for the LBO Model & The 3 Financial Statement Model. The 3 Financial Statement will be prepared based on the past ~3 years of historical data and forecasted for the next ~5 years.

1.2. Set Up Key Assumptions:

This is where you'll define the drivers of your projections.

• Growth Assumptions:
  • Revenue Growth: Project year-over-year revenue growth rates. Consider historical trends, industry growth, market share, and any specific initiatives (e.g., new product launches).
  • Cost of Goods Sold (COGS) & Operating Expenses: Project COGS as a percentage of revenue or as a specific growth rate. For operating expenses (SG&A), consider them as a percentage of revenue, a fixed amount, or a growth rate, depending on their nature.
  • Capital Expenditures (CapEx): Project CapEx as a percentage of revenue, or a fixed amount based on historical trends, maintenance needs, and growth initiatives.
• Working Capital Assumptions:
  • Days Sales Outstanding (DSO): Project accounts receivable (AR) days.
  • Days Inventory Outstanding (DIO): Project inventory days.
  • Days Payables Outstanding (DPO): Project accounts payable (AP) days.
• Depreciation & Amortization (D&A):
  • Project D&A based on existing PPE and new Capex. Depreciation on existing PPE will be spread in a straight-line over an average useful life. New Capex will be calculated using a depreciation waterfall e.g. capex in year / average useful life.
• Transaction Assumptions:
  • Purchase Price: This is often a multiple of EBITDA (Enterprise Value / EBITDA). Equity Value = EV + Cash - Total Debt.
  • Debt Structure:
    • Tranches: Specify different debt tranches (e.g., Revolver, Term Loan A, Term Loan B, Senior Notes, Subordinated Notes, Mezzanine Debt, Preferred Stock).
    • Principal Amounts: The amount borrowed for each tranche.
    • Interest Rates: Floating (e.g., LIBOR/SOFR + spread) or fixed rates for each tranche.
    • Amortization Schedules: How each debt tranche will be repaid (e.g., straight-line, balloon payment, no amortization for revolvers).
    • Fees: Financing fees, arrangement fees, commitment fees, and original issue discount (OID). Typically amortized over the life of the debt
  • Equity Contribution: The amount of equity invested by the private equity sponsor. This is typically the plug to make the sources and uses balance.
• Exit Assumptions:
  • Exit Multiple: The multiple of EBITDA at which the company is projected to be sold. This is a critical driver of returns.
  • Exit Year: The assumed year of exit (e.g., Year 5).
  • Adjusted EBITDA Adjustments:
  • Why Adjust? EBITDA is a common proxy for cash flow. However, it often includes one-time, non-recurring, or non-operational items that distort a company's true core profitability. Private equity firms want to understand the normalized earnings power of a business they are acquiring.
  • Common Adjustments (Add-backs): These are typically added back to reported EBITDA to arrive at Adjusted EBITDA:
    • Non-Recurring Expenses: One-time legal fees, restructuring costs, severance payments from a specific event, unusual consulting fees.
    • Owner's Compensation (Excessive): If a private company's owner is taking a salary significantly above market rate for their role, this excess is often added back.
    • Non-Cash Expenses (Other than D&A): Stock-based compensation, impairment charges, unrealized gains/losses.
    • Discontinued Operations: Profits/losses from segments no longer part of the core business.
    • Pro Forma Adjustments: Adjustments for acquisitions/divestitures that have occurred but are not fully reflected in historical financials, or cost savings that will be realized post-acquisition (e.g., eliminating redundant roles).
  • Negative Adjustments (Deductions): Less common, but sometimes required for items that artificially inflate reported EBITDA. For example, if a company benefited from a one-time, non-recurring revenue event.

1.3. Sources & Uses of Funds:

This schedule is crucial for balancing the LBO transaction.

• Uses of Funds: What the money is being used for:
  • Equity Purchase Price of the Target (Equity Value = EV - Total Debt + Cash)
  • Add: Refinancing of Existing Debt
  • Add: Transaction Fees (Legal, Advisory, Financing Fees & OID)
• Sources of Funds: Where the money is coming from:
  • Total Debt Raised (sum of all tranches)
  • Sponsor Equity Contribution (the plug)
  • Any Rollover Equity (existing management equity that rolls into the new structure)

Ensure that Total Uses = Total Sources.

Step 2: Building the Pro Forma Financial Statements (3-Statement Model)

You'll build out the Income Statement, Balance Sheet, and Cash Flow Statement for the projection period (typically 3-7 years).

2.1. Income Statement Projection:

• Revenue: Link directly to your revenue growth assumptions.
• COGS: Link to COGS as a percentage of revenue or growth rate assumption.
• Gross Profit: Revenue - COGS.
• Operating Expenses (SG&A, R&D, etc.): Link to your operating expense assumptions.
• EBITDA: Gross Profit - Operating Expenses.
• Adjustments to EBITDA: Create a clear section below reported EBITDA where you will add back or subtract the non-recurring or non-operational items identified in your assumptions.
• Depreciation & Amortization (D&A): Link to your D&A assumptions.
• EBIT (Operating Income): EBITDA - D&A.
• Interest Expense: This is where it gets more complex. You'll need to link this to your debt schedule (built later). It will be driven by the average debt outstanding and applicable interest rates for each tranche.
• Pre-Tax Income: EBIT - Interest Expense.
• Taxes: Pre-Tax Income * Tax Rate. Be mindful of Net Operating Losses (NOLs) if applicable, which can reduce taxable income.
• Net Income: Pre-Tax Income - Taxes.

2.3. Balance Sheet Projection:

• Assets:
  • Cash: This will be a plug from the Cash Flow Statement.
  • Accounts Receivable: Calculating using Debtor Days.
  • Inventory: Calculating using Inventory Days.
  • Prepaid Expenses/Other Current Assets: Project as a percentage of revenue or as a growth rate.
  • Property, Plant & Equipment (PP&E): Use a PPE Sch and Depreciation Sch.
  • Goodwill & Intangibles: These arise from the LBO transaction. Goodwill is the excess of purchase price over the fair value of net assets acquired. Intangibles may be created and amortized.
• Liabilities & Equity:
  • Accounts Payable: Calculating using Creditor Days.
  • Accrued Expenses/Other Current Liabilities: Project as a percentage of revenue or as a growth rate.
  • Debt: Link directly to your debt schedule.
  • Deferred Tax Liabilities: Link to your tax schedule if applicable. Ensure DT is calculated for any write up of PPE/Intangibles.
  • Shareholders' Equity:
    • Opening Equity: Equity from prior year.
    • Net Income: Add from Income Statement.
    • Dividends: Subtract any dividends paid (usually not a significant factor in LBOs until later stages or exit).
    • Share Repurchases/Issuances: Adjust as necessary.
    • Sponsor Equity: The initial equity contribution from the Sources & Uses schedule.

Key Balance Sheet Check: Assets must always equal Liabilities + Equity.

2.4. Cash Flow Statement Projection:

• Operating Activities:
  • Net Income: From Income Statement.
  • Add back Non-Cash Expenses: D&A, Amortized Financing Fees, PIK interest.
  • Adjust for Changes in Working Capital
• Investing Activities:
  • Capital Expenditures (CapEx): From your CapEx assumption.
• Financing Activities:
  • Issuance/Repayment of Debt: From your debt schedule. Include mandatory amortization & discretionary debt paydown & revolver draw.
• Dividends Paid
• Net Change in Cash: Sum of Operating, Investing, and Financing Cash Flows.
• Beginning Cash: Prior year's Ending Cash.
• Ending Cash: Beginning Cash + Net Change in Cash. (This ending cash figure then flows to the Balance Sheet).

Step 3: Building the Debt Schedule

This is a critical and often complex part of the LBO model, as it manages the various debt tranches, their interest, and their repayment.

3.1. Structure of the Debt Schedule:

Create a separate section for each debt tranche. For each tranche, you'll need:

• Opening Balance: The debt outstanding at the beginning of the period.
• Drawdowns/Issuances: New debt raised.
• Mandatory Amortization: Scheduled principal repayments based on the terms of the debt.
• Optional Prepayments: Cash flow available for debt paydown (e.g., from excess cash flow).
• Closing Balance: Opening Balance + Drawdowns - Mandatory Amortization - Optional Prepayments.

3.2. Revolving Credit Facility (Revolver):

• This is typically drawn as needed to cover cash flow deficits.
• Opening Balance: Prior year's closing balance.
• Drawdowns/Repayments: This is often a plug. If the company's projected cash flow (before revolver) is negative, the revolver is drawn to cover the deficit. If it's positive, the revolver is repaid.
• Closing Balance: Opening Balance + Drawdowns - Repayments.
• Interest: Calculated on the average drawn balance * revolver interest rate.

3.3. Mezzanine Debt/Subordinated Debt:

• Often has a bullet repayment (paid entirely at maturity) or minimal amortization.
• May have PIK (Payment-in-Kind) interest, where interest accrues and is added to the principal balance instead of being paid in cash.

3.4. Cash Available for Debt Paydown (Cash Sweep):

This is crucial for determining how much cash is available to make optional debt payments.

• Starting Point (FCF): Cash Flow from Operations - CapEx.
• Adjustments:
  • Subtract any mandatory debt amortization.
  • Subtract any required cash minimums.
  • Subtract any dividends.
• The remaining amount is available for optional debt prepayments (cash sweep). You'll typically pay down the most senior debt first (e.g., Term Loan A, then Term Loan B, then Mezzanine) unless specific intercreditor agreements dictate otherwise.

3.5. Interest Expense Calculation:

• For each debt tranche, calculate interest expense based on the average of the opening and closing balances of that tranche for the year, multiplied by its respective interest rate.
• Sum up the interest expense from all tranches.
• Circularity: Interest expense affects Net Income, which affects Cash Flow, which affects Debt Paydown, which affects Debt Balances, which affects Interest Expense. This creates a circular reference. You'll need to enable iterative calculations in Excel (File > Options > Formulas > Enable Iterative Calculation).

Step 4: Building the Returns Analysis (IRR & MoM)

This is the ultimate output of your LBO model, showcasing the profitability for the private equity sponsor.

4.1. Sponsor Cash Flow Schedule:

Create a timeline of cash inflows and outflows for the private equity sponsor.

• Year 0 (Initial Investment):
  • Equity Contribution: This is a cash outflow for the sponsor (negative value). Sponsor Equity from Sources.
• Exit Year (e.g., Year 5):
  • Exit Proceeds: Calculate the Enterprise Value (EV) at exit (Exit EBITDA * Exit Multiple).
  • Less: Debt at Exit: Subtract the remaining principal balance of all debt tranches at the exit date.
  • Add: Cash at Exit
• Net Proceeds to Equity: The remaining cash distributed to the equity holders. This is a cash inflow for the sponsor.

4.2. Calculate Internal Rate of Return (IRR):

• Use the IRR function in Excel on the Sponsor Cash Flow schedule. The IRR represents the discount rate at which the Net Present Value (NPV) of all cash flows (initial investment and exit proceeds) equals zero.

4.3. Calculate Multiple of Money (MoM):

• Total Cash Inflows / Total Cash Outflows (Absolute Values)
• MoM = (Net Proceeds to Equity) / (Initial Equity Contribution)
• A MoM of 2.0x means the sponsor doubled their money.

4.4. Sensitivity Analysis:

Build a sensitivity table to show how IRR and MoM change under different scenarios.

• Key Sensitivities:
  • Entry Multiple: How a higher/lower purchase price multiple impacts returns.
  • Exit Multiple: The most impactful sensitivity. How a higher/lower sale multiple impacts returns.
  • Revenue Growth: Impact of faster/slower top-line growth.
  • EBITDA Margin: Impact of changes in profitability.
  • Debt Interest Rates: Impact of higher/lower financing costs.
  • Leverage Levels: How increasing/decreasing the amount of debt impacts returns.

Use Excel's Data Table functionality for this.

Step 5: Building the Transaction Multiple Bridge

This critical analysis demonstrates how the private equity sponsor generates their return, breaking it down into key value drivers. This is often presented as a waterfall chart or a clear table.

5.1. Understanding the Drivers:

The total return to the sponsor can be attributed to a combination of:

• De-leveraging (Debt Paydown): As the company uses its cash flow to pay down debt, the amount of debt outstanding at exit decreases. Since Enterprise Value (EV) is largely fixed by the exit multiple, a reduction in debt directly translates to an increase in equity value. This is typically the largest driver of LBO returns.
  • Calculation: (Initial Debt - Exit Debt) / Initial Sponsor Equity
• EBITDA Growth: The increase in the company's operating profitability (EBITDA) from the entry date to the exit date. This can come from organic revenue growth, market share gains, operational efficiencies, or strategic add-on acquisitions. Higher EBITDA at exit (at a constant multiple) means a higher Enterprise Value and thus higher equity value.
  • Calculation: (Exit EBITDA - Entry EBITDA) * Exit Multiple / Initial Sponsor Equity
• Multiple Expansion (or Contraction): The difference between the entry multiple (EV/Entry EBITDA) and the exit multiple (EV/Exit EBITDA). If the exit multiple is higher than the entry multiple, it contributes positively to returns (multiple expansion). If it's lower, it detracts from returns (multiple contraction).
  • Calculation: (Exit Multiple - Entry Multiple) * Entry EBITDA / Initial Sponsor Equity

5.2. Constructing the Bridge:

1. Start with Initial Sponsor Equity: This is your base.
2. Add Value from De-leveraging: The increase in equity value due to debt reduction.
3. Add Value from EBITDA Growth: The increase in equity value due to higher operating profits.
4. Add Value from Multiple Expansion/Contraction: The impact of the change in valuation multiple.
5. Resulting Exit Equity Value: The sum of these components should reconcile to your calculated Net Proceeds to Equity at exit.

Example Structure for a Table:

This bridge provides a powerful narrative, helping to understand the investment thesis and the key drivers behind the projected returns.

Step 6: Sanity Checks & Refinements

Before presenting your model, rigorously check for errors and refine its presentation.

6.1. Sanity Checks:

• Financial Statement Balances: Do Assets = Liabilities + Equity on the Balance Sheet in all periods?
• Cash Flow Statement Reconciliation: Does the Ending Cash on the Cash Flow Statement match the Cash balance on the Balance Sheet?
• Debt Schedule Balances: Does the interest expense match the average debt balances? Are mandatory repayments being met?
• Reasonableness of Projections:
  • Are growth rates, margins, and working capital assumptions realistic given the industry and company?
  • Are the debt levels sustainable? Calculate Debt/EBITDA, Interest Coverage Ratio (EBITDA/Interest Expense), and observe their trends. Look for signs of distress (e.g., negative cash flow before revolver draws, rapidly increasing debt).
  • Is the LBO deleveraging over time (debt/EBITDA decreasing)?
• Circular Reference Handling: Ensure your iterative calculations are working correctly, or your circularity break is robust.

6.2. Formatting & Presentation:

• Clear Labeling: Label all inputs, calculations, and outputs clearly.
• Consistent Formatting: Use consistent number formatting, colors, and cell styles.
• Input/Output Separation: Clearly separate input cells from calculated cells.
• Error Checks: Include visible error checks (e.g., Balance Sheet Check row that should always be zero).
• Executive Summary: Create a summary tab that highlights key assumptions, the sources and uses, and the ultimate IRR and MoM with sensitivity tables.
• Professionalism: A clean, well-organized model is easier to understand, audit, and trust.

Conclusion

Building an LBO model is a comprehensive exercise that ties together all aspects of financial modeling: forecasting, debt mechanics, and valuation.

It requires attention to detail, a strong grasp of accounting principles, and the ability to think critically about business drivers.

By following this detailed, step-by-step guide you'll be able to construct robust and insightful LBO models.