Resource
LBO model guide
A transaction-focused guide to LBO mechanics — sources and uses, debt capacity, the cash sweep, covenant headroom and returns attribution — written for teams who will be asked to defend the model.
01
What an LBO model is actually testing
An LBO model tests whether a business can support an acquisition financed largely with debt, and what equity return that structure produces over a defined holding period. It is a financing feasibility test first and a valuation exercise second.
Three questions drive the output: how much debt the cash flows can service, how quickly that debt is repaid, and how much of the eventual return comes from operating improvement rather than leverage or multiple movement. A model that cannot separate those three effects is difficult to defend in an investment committee.
02
Entry structure, sources and uses
The entry structure fixes purchase price, funding mix and the opening balance sheet. Sources and uses must balance before any operating forecast is built, and the equity cheque should be a residual of the structure rather than an input chosen to reach a target return.
Purchase price
Enterprise value at the entry multiple, bridged to equity value through net debt and debt-like items.
Debt quantum
Senior term debt, unitranche or mezzanine and any revolving facility drawn at close, stated as a multiple of adjusted EBITDA.
Fees and costs
Financing fees, advisory costs and transaction expenses, split between capitalised and expensed treatment.
Rollover and equity
Management rollover, institutional equity and any preferred instrument, with its accrual mechanics stated.
03
Debt capacity and the financing schedule
Debt capacity is set by cash flow available for debt service, not by a headline leverage multiple. The financing schedule should model each tranche separately with its own margin, amortisation profile, maturity and cash or PIK interest treatment.
Interest is calculated on average or opening balances consistently, and the revolver absorbs shortfalls so the model never shows negative cash. Where a circular interest calculation is used, keep an iteration switch and a non-circular fallback so the model can be audited by a reviewer who did not build it.
04
Free cash flow and the cash sweep
The cash flow build should run from adjusted EBITDA to cash available for debt service, then apply the waterfall in contractual order. The sweep percentage and any leverage-based step-downs come from the credit agreement, not from convention.
Cash from operations
EBITDA less cash taxes, working capital movement and non-recurring cash items.
Committed outflows
Maintenance and growth capital expenditure, lease payments and mandatory amortisation.
Debt service
Cash interest by tranche, then scheduled repayments, then the excess cash flow sweep.
Residual cash
Minimum operating cash retained, with the balance building on the balance sheet or repaying the revolver.
05
Covenant testing and headroom
Covenant testing turns the model into a risk tool. Leverage, interest cover and fixed-charge cover are calculated on the definitions in the facility agreement, including any EBITDA add-back caps, and tested at each scheduled test date rather than only at year end.
Headroom should be reported as a percentage EBITDA decline to breach, per test date. That single measure is more useful to a credit committee than a table of ratios, because it states directly how much operating underperformance the structure absorbs before a default or a waiver conversation.
06
Exit assumptions and returns attribution
Exit is normally modelled on an EBITDA multiple applied to the exit-year run rate, less net debt at exit, with sensitivity around both entry-to-exit multiple movement and holding period. Returns are reported as IRR and money multiple for each equity instrument, after the waterfall between preferred, institutional equity and management incentive.
EBITDA growth
Return created by revenue growth and margin improvement during the hold.
Debt paydown
Return created by converting operating cash flow into equity value.
Multiple movement
Return created or destroyed by the difference between entry and exit multiples.
Downside case
Returns and covenant position under a recession or delayed-growth case, not only the management case.
07
Reviewing an LBO model
A reviewer should be able to change one assumption and see the consequence flow through the structure without breaking. Before a model is relied on, test the mechanics rather than the narrative.
Balance check
Does the balance sheet balance in every period, including at close and at exit?
Waterfall order
Are mandatory amortisation, sweep and revolver repayment applied in contractual sequence?
Definition consistency
Do EBITDA, net debt and working capital definitions match the credit agreement and the diligence work?
Case switching
Do management, base and downside cases run from a single switch without hardcoded overrides?
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