Methodology

What an LBO is

A leveraged buyout (LBO) is the purchase of a company paid for largely with borrowed money. The buyer, usually a private equity fund, puts in a smaller amount of its own money as equity. While the fund owns the company, the company’s cash flow pays down the debt, so a growing share of the company’s value belongs to the equity. When the company is sold, the remaining debt is repaid and everything left over goes to the fund.

How the model works

All amounts are in € millions. Year 0 is the day of the purchase; the company is owned for N years, the holding period.

1. 1. Entry

   The price paid for the whole company, its enterprise value (EV), is EBITDA times the entry multiple. Debt is EBITDA times leverage, and fees are a percentage of EV. The equity pays for everything the debt doesn’t cover, including the fees.

   EBITDA(0) = Revenue(0) × EBITDA margin

   EV = EBITDA(0) × entry multiple

   Debt(0) = EBITDA(0) × leverage

   Equity invested = EV + Fees − Debt(0)

2. 2. Operations

   Revenue grows at a constant rate. EBITDA, D&A and capex are fixed percentages of revenue. Net working capital (NWC: inventory and receivables minus payables) ties up a share of each year’s increase in revenue. Interest is charged on the debt at the start of the year, so it doesn’t depend on that year’s repayment and the model has no circular reference. Using the opening balance slightly overstates interest when debt is falling, so returns are slightly conservative. Tax is only paid on a profit; a loss doesn’t create a tax refund.

   Interest(t) = Debt(t−1) × interest rate

   Tax(t) = max(EBIT(t) − Interest(t), 0) × tax rate

   ΔNWC(t) = (Revenue(t) − Revenue(t−1)) × NWC %

   FCF(t) = Net income(t) + D&A(t) − Capex(t) − ΔNWC(t)

3. 3. Debt and cash

   All free cash flow (FCF) goes to repaying debt, a 100% cash sweep. Once the debt is fully repaid, the remaining cash builds up in the company. If FCF is negative, the gap is borrowed, so the debt goes up; the model shows a warning for that year.

   Repayment(t) = min(FCF(t), Debt(t−1))

   Debt(t) = Debt(t−1) − Repayment(t)

   Cash(t) = Cash(t−1) + FCF(t) − Repayment(t)

4. 4. Exit and returns

   The company is sold at the end of Year N at the exit multiple. The equity is then worth the sale price minus the remaining debt plus any cash. MoM (multiple of money) is how many times the equity invested comes back. IRR is the annual return that turns the equity invested into the equity at exit over N years. If the equity at exit is zero or negative, the IRR is shown as n.m. (not meaningful).

   Equity at exit = EBITDA(N) × exit multiple − Debt(N) + Cash(N)

   MoM = Equity at exit ÷ Equity invested

   IRR = MoM^(1/N) − 1

5. 5. Credit statistics

   Leverage is debt as a multiple of EBITDA, the standard measure lenders use to size and limit debt. Interest coverage shows how many times EBITDA covers the interest. The model shows a warning for any year with coverage below 2.0x, a simple rule-of-thumb threshold used in this tool.

   Leverage(t) = Debt(t) ÷ EBITDA(t)

   Interest coverage(t) = EBITDA(t) ÷ Interest(t)

6. 6. Value creation bridge

   The gain from equity invested to equity at exit is split into where it came from: higher EBITDA, a higher exit multiple, debt repaid, cash built up, minus the fees. The parts add up exactly to the total gain. This split is one common convention: if the order were reversed, measuring multiple expansion on Year 0 EBITDA first, the split between EBITDA growth and multiple expansion would change slightly.

   EBITDA growth = (EBITDA(N) − EBITDA(0)) × entry multiple

   Multiple expansion = (exit multiple − entry multiple) × EBITDA(N)

   Debt paydown = Debt(0) − Debt(N)

   Cash build-up = Cash(N)

   Equity at exit − Equity invested = EBITDA growth + Multiple expansion + Debt paydown + Cash build-up − Fees

7. 7. Sensitivity

   Each cell of the grid runs the whole model again with only the entry and exit multiples changed. The fees change with the purchase price.

Simplifying assumptions

• One type of debt, at one interest rate.
• Interest is charged on the debt at the start of each year.
• All free cash flow repays debt until the debt is gone (100% cash sweep).
• No minimum cash balance.
• No fixed repayment schedule: debt is only repaid out of free cash flow.
• The company is sold at the end of the final year.
• No dividends before the sale. The equity only has two cash flows, in at the start and out at the end, so IRR = MoM^(1/N) − 1.
• Transaction fees are paid entirely with equity.
• No management equity: the fund owns all of the equity.
• No tax loss carry-forwards: a loss in one year doesn’t reduce tax in later years.
• Cash shortfalls are funded with extra debt at the same interest rate, like drawing on a revolving credit facility.

Colours

Figures you can change are shown in blue; figures the model calculates are in black (white in dark mode). This follows the convention in banking Excel models, where blue marks an input typed in by hand and black a formula.

Illustrative model for educational purposes. Not investment advice.