Leveraged buyout model

Question

What can a financial sponsor pay for a business today and still earn the required return on equity at exit?

Inputs

Input	Source
Purchase price assumption	Entry multiple times current-year earnings, plus fees
Sources and uses	Equity check, debt tranches (senior, subordinated, mezzanine), rollover equity, fees
Debt terms	Interest rate per tranche, amortization schedule, covenants
Operating projections	Revenue growth, margin expansion, capital expenditure, working capital — five-year minimum
Exit assumption	Exit multiple times exit-year earnings, exit year (typically year five or six)
Required return	Target internal rate of return and multiple on invested capital

The structure is the answer in an LBO. Sources must equal uses to the cent.

Procedure

1. Set the entry. Apply the entry multiple to the latest earnings before interest, taxes, depreciation, and amortization. Add transaction fees. That is the funded purchase price.
2. Build the capital stack. Equity at the top of the stack. Debt below — typically senior secured first, then second lien, then mezzanine. Document the cost of each tranche. Sum to the purchase price.
3. Project operations. Revenue, margins, capital expenditure, working capital across the hold period. The plan must explain how the business gets from where it is to where the exit multiple makes sense.
4. Build the debt schedule. For each year, beginning balance, mandatory amortization, optional sweep, ending balance. Apply interest to the average balance. Most sponsors model a cash sweep — excess cash repays the highest-cost tranche first.
5. Compute free cash flow available for debt service. Operating cash flow minus capital expenditure minus tax. What is left repays debt and accrues to equity.
6. Project the exit. Apply the exit multiple to the exit-year earnings. Subtract remaining debt. The result is the exit equity value.
7. Compute returns. Internal rate of return on the equity cash flows (negative at entry, positive at exit, with any interim distributions). Multiple on invested capital is the exit equity value divided by the equity check.
8. Sensitize. Internal rate of return against entry multiple. Internal rate of return against exit multiple. Internal rate of return against the operating growth case. The grids show the deal's tolerance for downside.

Gates

• Sources do not equal uses — the model is wrong on its face
• Debt covenants break in any projection year (the deal will not close)
• Interest coverage ratio falls below the typical bank threshold (deal is over-levered)
• Exit multiple is above the entry multiple without a defensible reason (the model is paying for itself with multiple expansion)
• Operating plan assumes margin expansion with no specific operational lever
• Hold period is shorter than the time required to deliver the plan
• An input has no source comment

Output

A model with three returns scenarios (downside, base, upside), each showing internal rate of return, multiple on invested capital, and the debt paydown schedule. The output stages for the investment committee, not for direct decision.

Common Mistakes

• Paying for the deal with multiple expansion (entry low, exit high, no operational reason)
• Modeling a cash sweep but forgetting to apply mandatory amortization first
• Forgetting transaction fees in sources and uses
• Discounting equity cash flows at the weighted average cost of capital instead of the cost of equity
• Treating mandatory and optional amortization the same way

Adjacent Methods

• Discounted cash flow — the cash basis underneath the multiples
• Comparable company analysis — the entry and exit multiple anchor
• Investment committee memo — the wrapper for any approved LBO

Questions

Do sources equal uses to the cent?

• Does the downside scenario still deliver the required return?
• Is exit multiple above entry multiple, and if so, what is the operational reason?