A leveraged buyout model, or LBO model, is used to analyse the acquisition of a company financed with a significant proportion of debt alongside equity contributed by investors.

Its purpose is to assess the business’s ability to meet its financial obligations and estimate returns on invested equity under different operating, financing and exit scenarios. Leverage can increase equity returns, but it also amplifies the risk of loss. The outcome depends, among other factors, on the acquisition price, business performance, cash generation and exit valuation.

1. Components of an LBO model

The model represents an acquisition financed through a combination of debt and equity provided by the buyer and, where applicable, other investors or shareholders who reinvest in the transaction. The share of each financing source depends on the characteristics of the business and the terms of the transaction.

Its main components are:

• Sources and Uses: Detail the transaction’s financing and how the funds are allocated. Sources may include different debt instruments and equity contributions. Uses cover payments to selling shareholders, refinancing existing debt, transaction and financing costs, and the liquidity required at closing. Total sources must equal total uses.
• Financial projections: Estimate the company’s operating performance and cash generation. In a comprehensive model, they integrate the income statement, balance sheet and cash flow statement, reflecting the effects of the acquisition and the new financing. Simplified models may use more condensed projections for an initial assessment.
• Debt schedule and debt service: Calculate the balances of each debt instrument, new drawdowns, interest, fees and principal repayments for each period. They also help identify funding needs and verify compliance with contractual terms.
• Exit valuation and returns: Estimate the proceeds investors may recover upon exit and calculate metrics such as the internal rate of return (IRR) and the multiple on invested capital (MOIC).

2. Main uses

An LBO model is used to analyse both the return on an acquisition and the sustainability of its financing. Its main applications are:

• Private equity investment assessment: Estimate acquisition returns and determine the maximum purchase price consistent with a target return, given the operating, financing and exit assumptions.
• Scenario and sensitivity analysis: Assess how changes in growth, margins, capital expenditure, interest rates, leverage and exit valuation affect returns, liquidity and debt-servicing capacity.
• Financing structuring and negotiation: Analyse combinations of debt instruments, repayment schedules and financing terms that are consistent with the business’s cash-generating capacity.

3. General structure of an LBO model

Without providing a step-by-step construction guide, an LBO model typically comprises the following building blocks:

1. Entry valuation and acquisition financing: Determine the purchase price, distinguishing between enterprise value and equity value. Next, calculate the funds required to complete the transaction and establish how these will be financed through debt and equity.
2. Operating projections and debt evolution: Project the business’s earnings and cash flows, taking into account capital expenditure, working capital and liquidity requirements, as well as taxes and interest. The model determines the capacity to meet mandatory principal repayments and use available surplus cash for additional repayments, subject to the financing terms. If cash is insufficient, the model must reflect funding needs and applicable limits.
3. Exit valuation: Estimate the enterprise value at the end of the investment period. A common approach is to apply an exit multiple to a reference EBITDA figure. Both the multiple and the EBITDA used should be consistent with the characteristics of the business and the scenario being considered.
4. Return calculation: Starting from enterprise value, derive the value attributable to shareholders by adjusting for debt, cash and other relevant items, including exit costs. Then determine the amount attributable to the investor under analysis and calculate their IRR and MOIC, considering all contributions and proceeds, including interim distributions and additional capital contributions, where applicable.

IRR accounts for the timing of investment and recovery cash flows. MOIC expresses how many times the contributed capital is recovered, without itself accounting for the time elapsed.

The investment return should be distinguished from the net return earned by a fund’s limited partners, which also depends on applicable fees, expenses and profit-sharing arrangements.

Conclusions

• An LBO model helps assess a leveraged acquisition by analysing both returns on invested equity and the business’s ability to service its debt.
• Its main components are sources and uses of funds, financial projections, the debt schedule and exit analysis.
• Cash generation is essential: it enables the business to meet its operating needs, service financial obligations and reduce debt.
• Returns depend on the entry price, operating performance, financing and exit valuation. They are commonly measured using IRR and MOIC.
• Leverage can increase returns, but it also increases the risk of loss. The analysis should therefore consider downside scenarios and different sensitivities.

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