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Step 1. LBO Entry Valuation

Suppose you’re currently recruiting for a position to join a private equity firm (PE), and the interviewer sitting across from you asked the following question:

Q. “Walk me through an LBO model?”

3-Statement Modeling Sign Convention

In the PP&E roll-forward schedule, be sure to maintain consistency throughout the model and pay close attention to the formulas.

• Capital Expenditures (Capex) → Increase in Ending PP&E Balance
• Depreciation → Decrease in Ending PP&E Balance

For example, Capex should be subtracted from the PP&E balance if using the negative sign convention for expenses and expenditures – i.e. the double-negative makes a positive (+).

So, the first step to building an LBO model is to calculate the implied entry valuation based on an entry multiple assumption.

To calculate the enterprise value at entry, the entry multiple is multiplied by either the last twelve months (LTM) EBITDA of the target company or the next twelve months (NTM) EBITDA.

Entry Valuation = Purchase EBITDA × Entry Multiple

If we assume a “cash-free, debt-free (CFDF)” transaction, the enterprise value is the purchase price of the LBO target.

Step 2. Sources and Uses of Funds Table

All else being equal, the lower the required upfront equity contribution from the financial sponsor, the higher the returns.

The next step is to create the sources & uses schedule, which approximates:

• Uses Side ➝ The total amount of capital required to complete the acquisition
• Sources Side ➝ The specific details on how the firm plans to come up with the required funding

The majority of the “Uses” side will be because of the buyout of the target’s existing equity. But in addition, other transaction assumptions are made, such as:

• Transaction Costs ➝ M&A Advisory Fees, Legal Fees, and Consulting Fees
• Financing Fees ➝ Debt Issuance Costs (Underwriting Fees)

From here, numerous financing assumptions are made regarding the “Sources” of funds, such as the:

• Total Debt Financing (i.e. Leverage Multiple, Senior Leverage Multiple)
• Lending Terms for Each Debt Tranche (e.g. Interest Rate Pricing, Required Amortization, Cash Sweep)
• Management Rollover Assumptions
• Cash to B/S (i.e. “Excess Cash”)

The remaining amount for the Sources and Uses to be equal is the equity contribution by the financial sponsor (i.e. the equity investment to “plug” the remaining funds required).

In the sources and uses of funds table, the total sources must equate to the total uses (Total Uses = Total Sources), akin to the fundamental balance sheet equation.

Where:

• Total Uses ➝ Purchase Enterprise Value (TEV), Transaction Fees, Financing Fees
• Total Sources ➝ Debt Capital (Senior Debt, Subordinated Debt), Mezzanine Financing, Preferred Stock, Sponsor Equity Contribution