LBO Model Walkthrough: Sources & Uses, Debt Schedule, IRR Math

An LBO is a transaction where a financial sponsor (private equity firm) buys a company using a high proportion of debt — typically 60-80% of the purchase price. The sponsor's equity check is the remainder. Over the holding period (usually 5-7 years), the company uses operating cash flow to pay down debt. At exit, the sponsor sells the company. The equity value at exit is enterprise value minus remaining debt — and because debt has been paid down, the equity value is much higher than the initial equity check, even if enterprise value is similar. IRR comes from three drivers: EBITDA growth, multiple expansion, and debt paydown. The mechanics: sources = uses (cash and debt raised = price paid plus fees); debt schedule tracks interest and amortization year by year; free cash flow goes to mandatory debt repayment first, then to optional 'cash sweep' on revolving credit; at exit, apply exit multiple to terminal EBITDA, subtract net debt, and that's the equity proceeds for the sponsor.

The S&U table is where every LBO model starts. Sources is where the money comes from; Uses is where it goes. **Uses:** - Equity purchase price (= enterprise value at entry minus net debt assumed = pure equity check to seller) - Debt refinancing (any existing debt being refinanced or repaid at close) - Transaction fees (advisory, financing, legal — typically 2-4% of EV) - Minimum cash on balance sheet at close (often $20-50M for liquidity buffer) **Sources:** - New debt raised (sum of term loan, revolver draw at close, mezzanine, etc.) - Sponsor equity (the PE firm's check) - Rollover equity (if management or existing holders are rolling some equity) - Cash on balance sheet at close (acquired company's existing cash, if available to fund the transaction) Balance check: total sources = total uses. They MUST balance — if they don't, you have an arithmetic error or missing line item. **Worked example.** Target enterprise value: $500M (6.25x $80M EBITDA). Existing debt: $120M. Cash on B/S: $20M (used to fund the deal), so net debt is $100M. Equity purchase price: $500M − $100M = $400M. Transaction fees: $15M. Minimum cash post-close: $25M. Uses: $400M (equity) + $120M (refinance existing debt) + $15M (fees) + $25M (minimum cash) = $560M. Sources at 60% leverage on EV (i.e., $300M of debt): $300M debt + $20M cash from B/S + sponsor equity (the plug). Sponsor equity = $560M − $300M − $20M = $240M. Leverage ratio: $300M / $80M EBITDA = 3.75x EBITDA. Sponsor equity: 43% of total uses, 48% of EV.

After the S&U, build a multi-year debt schedule for each tranche. **Term Loan B (TLB)** is the most common LBO debt: typically 6-7 year maturity, ~1% mandatory annual amortization, with a cash flow sweep on excess cash. Priced as a spread over SOFR. Senior secured. **Revolver:** undrawn at close (or partially drawn). Used for working capital. Typically 5-year, undrawn fee 50 bps, drawn rate SOFR + 250-400 bps. **Mezzanine / Subordinated:** higher cost, longer maturity, often PIK-toggle (pays interest in cash or new principal). Priced well above senior debt. For each tranche, model year-by-year: - Beginning balance - Mandatory amortization - Cash sweep / voluntary paydown - New issuances (rare except for working capital revolver draws) - Ending balance - Interest expense (typically on average balance) **Cash sweep mechanics:** TLBs typically include a cash sweep — required prepayment from excess cash flow at certain leverage levels. Above 4.5x leverage: 75% sweep. 4.0-4.5x: 50% sweep. 3.5-4.0x: 25% sweep. Below 3.5x: 0% sweep. **Circular reference**: interest expense affects net income, which affects free cash flow, which affects debt paydown, which affects interest expense. Spreadsheets handle this with iterative calculation enabled in their settings (for example, a maximum of 100 iterations).

Project the income statement, balance sheet, and cash flow statement for the holding period (usually 5-7 years). **Revenue:** typically 5-15% growth assumption based on prior performance and management plan. **EBITDA margin:** project margin path. LBO sponsors often model 100-300 bps of margin improvement over the hold period from operational improvements and cost cuts. **EBITDA = Revenue × Margin.** This is the key metric for valuation and debt service. **D&A:** project as percent of revenue or capex (varies by industry). **EBIT = EBITDA − D&A.** **Interest expense** comes from the debt schedule (above). **Taxes:** apply effective tax rate to pre-tax income. NOLs from acquisition can shelter taxes in early years. **Net income = (EBIT − Interest) × (1 − tax rate).** **Free cash flow** = Net Income + D&A − CapEx − Change in WC ± non-recurring items. FCF flows into the cash flow statement, where it's allocated to: 1. Mandatory debt amortization (first claim) 2. Cash sweep on TLB (per leverage formula) 3. Cash on balance sheet (any remainder) No dividends to sponsor during hold period (rare exceptions for dividend recaps).

At exit (year 5-7), apply an exit multiple to terminal EBITDA to get exit enterprise value: Exit EV = Exit EBITDA × Exit Multiple The exit multiple is typically: - Same as entry multiple (constant multiple assumption — most common conservative approach) - Slightly higher (multiple expansion if market has improved or company has scaled) - Slightly lower (multiple contraction if market has deteriorated) Exit Equity = Exit EV − Net Debt at Exit (debt minus cash) Sponsor Equity Proceeds = Exit Equity × (Sponsor's Ownership %). IRR Calculation: IRR is the discount rate that sets PV of cash flows equal to zero. For sponsor: initial investment is the equity check (negative cash flow at year 0). Equity proceeds at exit (year 5-7) is the positive cash flow. With no interim distributions, IRR = (Exit Proceeds / Equity Check)^(1/years) − 1. MOIC (Multiple of Invested Capital): Exit Proceeds / Equity Check. This is the simpler metric — '2.5x' means sponsor doubled and a half their money. Worked example continued. Entry: $80M EBITDA × 6.25x = $500M EV. Sponsor equity: $240M. Year 5 exit: $120M EBITDA (about 8.4% a year EBITDA growth) × 6.25x (constant multiple) = $750M exit EV. Debt at exit: $250M (paid down from $300M). Cash at exit: $40M, so net debt is $210M. Equity at exit: $750M − $210M = $540M. Sponsor proceeds: $540M (assume 100% sponsor ownership for simplicity). MOIC: $540M / $240M = 2.25x. IRR: ($540M / $240M)^(1/5) − 1 = (2.25)^0.2 − 1 = 0.176 = 17.6% IRR. IRR ≥20% is typically the sponsor's target, so this deal falls short of it.

A clean LBO model decomposes IRR into the three sources of value creation: 1. **EBITDA growth (operational improvement):** the company is bigger at exit because of revenue growth, margin expansion, or both. 2. **Multiple expansion (multiple arbitrage):** sold for a higher multiple than purchased. 3. **Debt paydown (financial engineering):** equity grew because debt was paid off, so a constant EV translates into more equity at exit. Formula approach (the three pieces add up exactly, with nothing left over): - EBITDA growth = (exit EBITDA − entry EBITDA) × entry multiple - Multiple expansion = (exit multiple − entry multiple) × exit EBITDA - Debt paydown = entry net debt − exit net debt (debt repaid plus cash built up) - Exit equity value = entry equity value + EBITDA growth + multiple expansion + debt paydown Worked example for our case: - Entry equity value: $500M EV − $275M net debt ($300M debt − $25M cash) = $225M. The sponsor paid $240M: that $225M plus the $15M of fees. - EBITDA growth: ($120M − $80M) × 6.25x = $250M. - Multiple expansion: (6.25x − 6.25x) × $120M = $0 (we held the multiple constant). - Debt paydown: $275M − $210M = $65M ($50M of debt repaid plus $15M of cash built up). - Sum check: $225M + $250M + $0 + $65M = $540M ✓, the exit equity. The sponsor's gain is $540M − $240M = $300M: $315M of value creation less the $15M of fees. In this example, growth is the dominant return driver. Multiple-expansion-driven LBOs are riskier because exit conditions are out of management's control.

**Mistake 1: Sources and Uses don't balance.** Always cross-check the totals. Plug or unbalance hides somewhere — find and fix it before building the rest. **Mistake 2: Forgetting transaction fees in Uses.** Fees are 2-4% of EV — that's $10-20M on a $500M deal, and forgetting them throws off the equity check by the same amount. **Mistake 3: Not enabling iterative calculations.** A spreadsheet needs iterative calculation enabled in its settings to handle the interest/debt circular reference. Without it, you get an error or zero. Typical settings: iterations on, 100 maximum iterations, 0.001 maximum change. **Mistake 4: Using too-high entry multiple with constant exit multiple.** A 12x entry multiple held constant requires massive EBITDA growth or debt paydown to clear a 20% IRR. Sanity-check: at constant multiple, your IRR comes from EBITDA growth and debt paydown only, and that's a tougher mountain than at lower entry multiples. **Mistake 5: Ignoring management options/equity rollover dilution.** Management often gets 5-10% equity in LBOs (option pool or rollover). This dilutes sponsor's exit proceeds. Failing to model this overstates sponsor IRR by 1-3%. **Mistake 6: Constant working capital assumption.** Working capital scales with revenue. As the company grows, working capital investment increases, reducing free cash flow. Project working capital as a percent of revenue, not in absolute dollars. This content is for educational purposes only and does not constitute financial advice. Investing involves significant risk.