LBO model, worked through
An LBO model works out what a private equity firm earns from buying a company mostly with borrowed money. It sets the price and the funding, projects the cash that repays the debt, then values the equity at exit to get the IRR and multiple of money.
- Sponsor equity
Equity = price + fees − debt
The uses (price and fees) must equal the sources (debt and equity), so equity fills the gap.
- Free cash flow
FCF = EBITDA − interest − tax − capex − increase in NWC
The cash left for the lenders each year. In an LBO it repays debt.
- Exit equity
Exit equity = exit multiple × final EBITDA − net debt
What the sponsor's stake is worth when it sells.
- Returns
MOIC = exit equity ÷ equity, IRR = MOIC^(1/years) − 1
The IRR shortcut works when there is one cash flow in and one out, as here.
Inputs
Worked example
| Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | |
|---|---|---|---|---|---|
| EBITDA | 54.0 | 58.3 | 63.0 | 68.0 | 73.5 |
| Interest | 20.0 | 18.6 | 16.9 | 14.9 | 12.5 |
| Tax | 5.8 | 7.0 | 8.4 | 9.9 | 11.6 |
| Capex | 10.8 | 11.7 | 12.6 | 13.6 | 14.7 |
| Free cash flow | 17.4 | 21.0 | 25.1 | 29.6 | 34.7 |
| Debt, end | 232.6 | 211.6 | 186.5 | 156.8 | 122.2 |
- Sources and uses
- Purchase price50.0 × 10x
- $500.0m
- Plus fees500.0 × 2%
- $10.0m
- Less debt50.0 × 5x
- ($250.0m)
- Sponsor equity510.0 − 250.0
- $260.0m
- Exit after 5 years
- Exit value73.5 × 10x
- $734.7m
- Less debt left
- ($122.2m)
- Equity at exit
- $612.5m
- Returns
- Multiple of money612.5 ÷ 260.0
- 2.36x
- IRR2.36^(1/5) − 1
- 18.69%
- Where the gain came from
- EBITDA growth(73.5 − 50.0) × 10x
- $234.7m
- Change in multiple(10x − 10x) × 73.5
- $0.0m
- Debt paid down250.0 − 122.2
- $127.8m
- Fees
- ($10.0m)
- Gain to the sponsor612.5 − 260.0
- $352.5m
Every dollar of free cash flow repays debt. Interest is on each year's opening balance, capex equals D&A and working capital is flat.
How to build an LBO model
Six steps, in the order a model runs them, with the worked example's numbers.
1. Set the deal
Price is EBITDA times the entry multiple: $50 million times 10, or $500 million. Add $10 million of fees. Lenders put in 5 times EBITDA, $250 million, so the sponsor's equity is $260 million.
2. Project the business
EBITDA grows 8% a year, from $50 million to $73.5 million in year 5. Capex is 20% of EBITDA and equal to D&A, and working capital stays flat.
3. Get to free cash flow
In year 1, EBITDA of $54 million less $20 million of interest, $5.8 million of tax and $10.8 million of capex leaves $17.4 million.
4. Run the debt schedule
Every dollar of free cash flow repays the loan, so it falls from $250 million to $232.6 million in year 1 and $122.2 million by year 5. Interest is on the opening balance, which avoids a circular reference.
5. Exit
Sell at the same 10 times, on year 5 EBITDA: $734.7 million. Repay the $122.2 million of debt left and the sponsor's equity is worth $612.5 million.
6. Returns and the checks
$612.5 million on $260 million is 2.36 times the money and an 18.7% IRR. The $352.5 million gain splits into $234.7 million from EBITDA growth and $127.8 million of debt repaid, less the $10 million of fees.
IRR sensitivity
The same deal at three exit multiples and three growth rates. Everything else stays as in the example.
| Exit multiple, by growth | 4% | 8% | 12% |
|---|---|---|---|
| 9x | 9.1% | 15.7% | 21.8% |
| 10x | 12.3% | 18.7% | 24.7% |
| 11x | 15.1% | 21.4% | 27.4% |
IRR over five years. The bold figure is the worked example: a 10x exit with 8% growth.
Walk an interviewer through your LBO
Interviewers ask you to walk through an LBO, then where the returns came from and what happens with more debt. Practice the answer with an AI interviewer.
Questions people ask
Why does the debt raise the return?
The sponsor puts in less of its own money and keeps all the gain above the debt. With no debt, the same deal needs $510 million of equity and returns 1.81 times, a 12.6% IRR. With 5 times debt it returns 2.36 times and 18.7%.
What is a cash sweep?
A rule that spare cash goes to repaying debt early. This model sweeps 100% of free cash flow. Real loans often have a required repayment plus a sweep of a share of the rest, which the debt schedule template models.
What is the difference between an LBO model and a paper LBO?
A paper LBO is the same logic done by hand in an interview, with round numbers and no debt repaid before exit. The model runs each year's cash and debt, which a timed modeling test asks you to build in Excel.
Why charge interest on the opening debt balance?
Interest on the average balance depends on how much debt is repaid, and the repayment depends on interest. That loop is a circular reference. The opening balance breaks it and moves the answer very little.
What drives the IRR most?
Price paid, growth, leverage and the exit multiple. In the table above, one turn of exit multiple moves the IRR by about 3 points, and 4 points of yearly growth moves it by about 6.
Why include fees?
They are paid in cash at closing, so the sponsor funds them with equity. Here they cost $10 million of the gain, which is why the bridge has a fees line.