LBO Modeling Fundamentals: How Private Equity Values Companies

A private equity firm pays $1 billion for a company. Five years later, they sell it for $2 billion.

Did they create $1 billion in value? Not exactly.

They put in $400 million of equity. They borrowed $600 million. The debt got paid down over five years. When they sold, the equity was worth $1.4 billion.

That's a 3.5x return on their $400 million. A 28% IRR.

This is the LBO model in action. It's the foundation of how private equity thinks about investments. Understanding it isn't optional for PE recruiting—it's the price of admission.

This guide covers LBO mechanics from the ground up. How the model works, why leverage creates returns, and how to build one yourself.

What Is an LBO?

The Basic Concept

A leveraged buyout is an acquisition funded primarily with debt.

The typical structure:

60-70% debt financing
30-40% equity from the PE fund
The acquired company's cash flows service the debt
The PE firm improves operations and eventually sells

Why it works:

Debt is cheaper than equity (interest is tax-deductible)
Leverage amplifies returns on equity
Operational improvements increase value
Multiple expansion can boost returns further

The Three Levers of LBO Returns

PE returns come from three sources:

1. Debt paydown The company generates cash flow. That cash pays down debt. The equity value grows as debt shrinks—even if enterprise value stays flat.

2. EBITDA growth Improve operations. Cut costs. Grow revenue. Higher EBITDA means higher enterprise value at exit.

3. Multiple expansion Buy at 8x EBITDA. Sell at 10x. The multiple increase directly boosts returns. (But don't count on it—it's not controllable.)

The best deals have all three. Realistic deals rely primarily on the first two.

A Simple Example

Acquisition:

Purchase price: $500M
Debt: $300M (60%)
Equity: $200M (40%)
Entry EBITDA: $50M (10x multiple)

After 5 years:

EBITDA grows to $70M (40% increase)
Debt paid down to $150M
Exit at 10x EBITDA = $700M enterprise value
Equity value = $700M - $150M = $550M

Returns:

Equity invested: $200M
Equity at exit: $550M
Multiple of money (MoM): 2.75x
IRR: approximately 22%

That's the LBO in miniature.

The LBO Model Structure

The Five Building Blocks

Every LBO model has the same core components:

1. Transaction assumptions

Purchase price and entry multiple
Debt structure (amounts, rates, terms)
Equity contribution
Transaction fees

2. Operating model

Revenue projections
Expense assumptions
EBITDA forecast
Capital expenditures
Working capital changes

3. Debt schedule

Opening balances
Mandatory amortization
Optional prepayments (cash sweep)
Interest expense calculations
Closing balances

4. Cash flow statement

Cash available for debt repayment
Debt service coverage
Ending cash balances

5. Returns analysis

Exit assumptions
Enterprise value at exit
Equity value at exit
IRR and MoM calculations

The Flow of the Model

Here's how the pieces connect:

Transaction Assumptions
        ↓
  Sources & Uses
        ↓
   Operating Model
        ↓
   Free Cash Flow
        ↓
   Debt Schedule
        ↓
   Exit Analysis
        ↓
Returns (IRR / MoM)

Each section feeds the next. Transaction assumptions define the starting point. The operating model projects cash flows. Cash flows determine debt paydown. Debt paydown affects exit equity value. Exit equity value determines returns.

Transaction Assumptions

Purchase Price

How much are you paying?

Approaches:

Entry multiple × LTM EBITDA
Per-share price × shares outstanding (for public targets)
Negotiated price based on comparable transactions

Key inputs:

LTM (Last Twelve Months) EBITDA
Entry EV/EBITDA multiple
Any purchase price adjustments

Sources and Uses

Where does the money come from? Where does it go?

Uses of funds:

Purchase equity
Refinance existing debt
Transaction fees (advisory, financing, legal)
Debt issuance costs

Sources of funds:

Senior debt (Term Loan A, Term Loan B)
Subordinated debt (mezzanine, high-yield bonds)
Sponsor equity
Management rollover equity
Cash on balance sheet

The rule: Sources must equal uses. Always.

Debt Structure

LBOs use multiple layers of debt with different characteristics.

Debt Type	Typical Rate	Amortization	Security
Revolving Credit	SOFR + 200-300 bps	None (drawn as needed)	First lien
Term Loan A	SOFR + 200-350 bps	5-10% annually	First lien
Term Loan B	SOFR + 300-450 bps	1% annually	First lien
High Yield Bonds	6-10% fixed	Bullet (at maturity)	Second lien or unsecured
Mezzanine	10-15% (cash + PIK)	Bullet	Subordinated

Key terms to understand:

SOFR: The reference rate replacing LIBOR
Amortization: Required principal payments during the loan term
Bullet: Principal due entirely at maturity
PIK: Payment-in-kind—interest that accrues rather than being paid in cash
Cash sweep: Mandatory prepayment from excess cash flow

Leverage Ratios

How much debt is appropriate?

Common metrics:

Total Debt / EBITDA: Overall leverage (typically 4-6x for LBOs)
Senior Debt / EBITDA: First-lien leverage (typically 3-4x)
EBITDA / Interest: Interest coverage (minimum 2.0x usually required)

What determines leverage capacity:

Business stability and cash flow predictability
Asset base for collateral
Industry norms
Credit market conditions
Lender appetite

The Operating Model

Revenue Projections

How will the company grow?

Approaches:

Historical growth rates
Management projections
Industry analysis
Specific initiatives (new products, markets, pricing)

Best practice: Build a granular revenue model when possible. Units × price. Customers × revenue per customer. Segment by segment.

EBITDA Bridge

How does revenue become EBITDA?

Revenue
- Cost of Goods Sold
= Gross Profit

- Operating Expenses
  - Sales & Marketing
  - General & Administrative
  - Research & Development
= EBITDA

Margin assumptions matter. A 100 bps improvement in EBITDA margin can significantly impact returns.

The PE Value Creation Angle

PE firms don't just hold companies. They improve them.

Common initiatives:

Cost reduction (procurement, headcount, facilities)
Revenue growth (sales force expansion, pricing, new markets)
Working capital optimization
Add-on acquisitions
Management changes

In the model: Reflect these initiatives explicitly. Show the bridge from current EBITDA to projected EBITDA.

Capital Expenditures

Cash spent on long-term assets.

Types:

Maintenance capex: Required to maintain current operations
Growth capex: Investments to expand capacity or capabilities

The PE preference: Asset-light businesses with low capex requirements generate more free cash flow for debt paydown.

Working Capital

Cash tied up in operations.

The calculation:

Working Capital = Current Assets - Current Liabilities
                = (AR + Inventory) - (AP + Accrued Expenses)

Changes in working capital affect cash flow:

Increase in AR = cash outflow (you're waiting longer to collect)
Increase in inventory = cash outflow (cash tied up in goods)
Increase in AP = cash inflow (you're paying suppliers later)

In LBO models: Project working capital as a percentage of revenue, then calculate the year-over-year change.

Free Cash Flow

The Calculation

Free cash flow available for debt service:

EBITDA
- Capital Expenditures
- Change in Working Capital
- Cash Taxes
- Cash Interest
= Free Cash Flow

Some models also subtract:

Management fees (paid to PE sponsor)
Mandatory debt amortization

Why FCF Matters

Free cash flow is what pays down debt. Higher FCF = faster deleveraging = better returns.

The FCF conversion question: What percentage of EBITDA converts to FCF?

80%+ conversion: Very attractive (low capex, stable working capital)
60-80%: Good (typical for healthy businesses)
<60%: Challenging (high capex or working capital needs)

The Debt Schedule

Structure

The debt schedule tracks each debt tranche year by year:

Beginning Balance
+ New Borrowings
- Mandatory Amortization
- Optional Prepayments
= Ending Balance

Interest Expense = Average Balance × Interest Rate

Mandatory Amortization

Required principal payments spelled out in the credit agreement.

Typical terms:

Term Loan A: 5-10% annually
Term Loan B: 1% annually (99% at maturity)
High Yield: None until maturity

Cash Sweep

Excess cash flow used to prepay debt.

How it works:

Calculate excess cash flow (FCF after required payments)
Apply sweep percentage (typically 50-75%)
Prepay debt in order of priority (usually senior first)

The mechanics:

Excess Cash Flow = FCF - Mandatory Amortization - Minimum Cash
Cash Sweep = Excess Cash Flow × Sweep Percentage

Interest Calculations

Interest expense depends on debt type:

Fixed rate debt: Principal × Rate

Floating rate debt: Principal × (SOFR + Spread)

Requires SOFR assumption for each year
Or assume constant spread over current SOFR

PIK interest: Added to principal balance rather than paid in cash

Circular References

Here's where LBO models get tricky.

The circularity:

Interest expense depends on debt balance
Debt balance depends on cash available for paydown
Cash available depends on interest expense

Solutions:

Enable iterative calculations in Excel
Use a circular reference breaker (toggle cell)
Calculate interest on beginning balance (simplification)

Exit Analysis

Exit Assumptions

How and when does the PE firm sell?

Key inputs:

Hold period (typically 3-7 years, most common is 5)
Exit multiple (EV/EBITDA at sale)
Exit EBITDA (from operating model)

Exit Multiple Assumptions

What multiple will you achieve at exit?

Conservative approach: Assume exit multiple equals entry multiple. No multiple expansion.

Base case: Slight expansion if business has improved (better growth, margins, scale).

Aggressive: Significant expansion. (Dangerous to rely on this.)

Calculating Exit Value

Exit Enterprise Value = Exit EBITDA × Exit Multiple

Exit Equity Value = Exit Enterprise Value - Net Debt at Exit

Net Debt = Total Debt - Cash

The Returns Calculation

Multiple of Money (MoM):

MoM = Exit Equity Value / Initial Equity Investment

A 2.5x MoM means you got $2.50 back for every $1 invested.

Internal Rate of Return (IRR):

The discount rate that makes the NPV of cash flows equal zero.

Year 0: -$200M (equity investment)
Year 5: +$500M (equity proceeds)

IRR = 20.1%

The relationship:

Hold Period	2.0x MoM IRR	2.5x MoM IRR	3.0x MoM IRR
3 years	26%	36%	44%
5 years	15%	20%	25%
7 years	10%	14%	17%

Same MoM, different hold periods = very different IRRs.

Building the Model: Step by Step

Step 1: Set Up Transaction

Input purchase price and entry multiple
Define debt structure (tranches, amounts, rates, terms)
Calculate equity required
Build sources and uses table
Verify sources = uses

Step 2: Build Operating Model

Project revenue (5-7 years)
Project EBITDA and margins
Calculate D&A (often simplified as % of revenue)
Project capex
Project working capital changes
Calculate taxes

Step 3: Calculate Free Cash Flow

Start with EBITDA
Subtract capex
Subtract working capital increase
Subtract cash taxes
Result: Cash available for debt service

Step 4: Build Debt Schedule

Set up each debt tranche
Calculate mandatory amortization
Calculate interest expense
Determine cash available for optional paydown
Apply cash sweep
Calculate ending balances
Handle circular reference

Step 5: Calculate Returns

Define exit year and multiple
Calculate exit enterprise value
Subtract ending net debt
Calculate equity proceeds
Compute IRR and MoM

Step 6: Sensitivity Analysis

Test how returns change with different assumptions:

Entry multiple: +/- 0.5x
Exit multiple: +/- 0.5x
Revenue growth: +/- 2%
EBITDA margin: +/- 1%
Leverage: +/- 0.5x turns

Common Interview Questions

The Quick LBO

"Walk me through a quick LBO."

Answer: "An LBO is an acquisition funded primarily with debt. A PE firm might buy a company for $500M using $200M of equity and $300M of debt. The company's cash flows service and pay down the debt over the hold period. If EBITDA grows from $50M to $70M over five years, and debt is paid down to $150M, an exit at 10x EBITDA would yield $700M enterprise value. Subtract $150M of net debt, and equity is worth $550M—a 2.75x return on the $200M invested."

Why Does Leverage Increase Returns?

Answer: "Leverage amplifies equity returns because you're using other people's money to buy the asset. If you buy a company for $100M with all equity and sell for $150M, you make 50%. But if you buy with $40M equity and $60M debt, pay down $20M of debt, and sell for $150M, your equity is worth $110M ($150M - $40M debt). That's a 175% return on your $40M. Same asset appreciation, but leverage concentrated the returns to equity holders."

What Makes a Good LBO Candidate?

Answer: "Good LBO candidates have: stable, predictable cash flows to service debt; strong market position with defensible margins; low capex requirements so cash converts to debt paydown; opportunities for operational improvement; and a clear exit path. Asset-heavy businesses with volatile cash flows or high reinvestment needs make poor LBO candidates."

How Do You Increase IRR?

Answer: "Three main ways: increase exit value through EBITDA growth or multiple expansion; accelerate debt paydown through higher cash flow or lower interest; or reduce the hold period—same MoM over fewer years means higher IRR. The most controllable levers are operational improvements that boost EBITDA and cash flow."

Paper LBO: The Interview Format

What Is a Paper LBO?

Many PE interviews include a paper LBO—doing the analysis by hand without Excel.

What they're testing:

Understanding of LBO mechanics
Ability to do quick math
Thought process and structure
Performance under pressure

The Approach

Write down the key inputs (purchase price, EBITDA, debt/equity split, growth rate, hold period, exit multiple)
Calculate sources and uses (how much debt, how much equity)
Project EBITDA (apply growth rate for each year)
Estimate debt paydown (FCF × hold period, roughly)
Calculate exit value (Exit EBITDA × Exit Multiple)
Calculate equity value (Exit EV - Remaining Debt)
Calculate returns (Exit Equity / Entry Equity = MoM)

Simplifying Assumptions

For paper LBOs, make reasonable simplifications:

Assume D&A = Capex (no cash impact)
Ignore working capital changes
Assume no cash taxes (or simple rate)
Use rough FCF = EBITDA × 50-60%
Round numbers liberally

Practice Problem

Given:

Purchase price: $1,000M
Entry EBITDA: $100M (10x entry multiple)
Debt: 60% ($600M at 5% interest)
Equity: 40% ($400M)
EBITDA growth: 5% annually
Capex = D&A, ignore working capital
40% tax rate
5-year hold
Exit at 10x EBITDA

Solution:

Year 5 EBITDA: $100M × (1.05)^5 = ~$128M

Free cash flow (rough):

EBITDA: $128M (Year 5)
Interest: $600M × 5% = $30M (simplified, decreasing)
Taxes: (~$100M operating income) × 40% = $40M
FCF: ~$50-60M per year

Total debt paydown over 5 years: ~$250-300M Remaining debt: $600M - $275M = ~$325M

Exit EV: $128M × 10x = $1,280M Exit Equity: $1,280M - $325M = $955M

MoM: $955M / $400M = 2.4x IRR: ~19% (2.4x over 5 years)

Common Mistakes

Modeling Errors

Circular reference crashes. Not handling the interest/debt paydown circularity properly.

Cash going negative. Model allows debt paydown that exceeds available cash.

Wrong tax treatment. Interest is tax-deductible; principal payments are not.

Ignoring transaction fees. Fees increase equity required and reduce returns.

Conceptual Errors

Confusing enterprise value and equity value. EV is total firm value; equity value is what the PE firm receives.

Assuming multiple expansion. Don't rely on selling at a higher multiple than you bought.

Ignoring cyclicality. Entry at peak EBITDA can destroy returns.

Underestimating working capital needs. Growing companies often need cash for working capital.

The Bottom Line

LBO modeling is the language of private equity. It reveals how financial sponsors think about value creation: buy at a reasonable price, use leverage efficiently, improve operations, and generate returns through debt paydown and EBITDA growth.

The core mechanics:

Debt funds 60-70% of the purchase
Cash flows service and pay down debt
Returns come from leverage, growth, and (maybe) multiple expansion
IRR and MoM are the key metrics

For interviews:

Know the structure cold
Be able to do a paper LBO quickly
Understand what drives returns
Articulate what makes a good LBO candidate

The math isn't complicated. What matters is understanding why each piece matters and how they fit together.

Master the LBO, and you speak the language of PE. That's non-negotiable for breaking into the buy side.