What are the key assumptions to keep in mind when building an LBO model?

1 Purchase price

The purchase price is the amount that the PE firm pays to buy the target company, usually expressed as a multiple of its earnings before interest, taxes, depreciation, and amortization (EBITDA). The purchase price depends on several factors, such as the industry, the growth potential, the competitive landscape, and the negotiation process. You need to make a reasonable assumption about the purchase price, based on comparable transactions and market conditions, and test how it affects the deal economics and the internal rate of return (IRR).

2 Financing structure

The financing structure is the composition of debt and equity that the PE firm uses to fund the LBO deal. The debt can be divided into different tranches, such as senior debt, subordinated debt, mezzanine debt, and preferred equity, each with different interest rates, repayment terms, and covenants. The equity can be either from the PE firm itself, or from co-investors or management. You need to make assumptions about the financing structure, based on the availability and cost of capital, the leverage ratio, and the target capital structure, and test how it affects the debt service, the cash flow, and the exit value.

3 Operating performance

The operating performance is the projection of the target company's income statement and cash flow statement, based on its historical performance and expected growth drivers. The operating performance includes assumptions about the revenue growth, the operating margin, the working capital, the capital expenditures, and the taxes. You need to make assumptions about the operating performance, based on the industry trends, the competitive advantages, the synergies, and the operational improvements, and test how they affect the free cash flow generation and the debt repayment capacity.

4 Exit value

The exit value is the amount that the PE firm expects to sell the target company for, usually after a holding period of 3 to 7 years. The exit value can be calculated using different methods, such as applying a multiple to the EBITDA or the free cash flow of the last year, or using a discounted cash flow (DCF) model. You need to make assumptions about the exit value, based on the expected growth rate, the exit multiple, and the exit date, and test how they affect the return on equity and the IRR.

5 Sensitivity analysis

The sensitivity analysis is the process of changing one or more assumptions in the LBO model, and observing how they affect the output variables, such as the IRR, the return on equity, the exit value, and the debt repayment. The sensitivity analysis helps you identify the key drivers and risks of the LBO deal, and evaluate different scenarios and outcomes. You need to perform a sensitivity analysis, using tables or charts, to show how the LBO model responds to changes in the purchase price, the financing structure, the operating performance, and the exit value.

6 Quality checks

The quality checks are the steps that you take to ensure that your LBO model is accurate, consistent, and logical. The quality checks include verifying the formulas, the references, the formats, and the calculations in the LBO model, and making sure that they match the assumptions and the data sources. You also need to check the balance sheet, the cash flow statement, and the debt schedule, and make sure that they balance and reconcile. You need to perform quality checks, using tools such as error checks, circular references, data validation, and scenario manager, to avoid errors and mistakes in your LBO model.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?