The Leveraged Buyout (LBO) model is a valuation method that asks a simple question with a very specific lens:
If a private equity firm buys this company using mostly debt, how much can they afford to pay and still hit their target return?
That target is usually around 20% internal rate of return (IRR)—and sometimes more. So rather than valuing a business based on market multiples or discounted future cash flows, the LBO approach looks at how the deal is structured, how much leverage is used, and how much value can be created over time through debt paydown, margin improvement, and eventual resale.
In this article, you’ll learn what goes into an LBO model, how it’s built, how returns are calculated, and why it tends to produce a "floor valuation"—a lower bound for what financial sponsors are willing to pay in an auction process.
What Is an LBO and Why It Matters in Valuation
A Leveraged Buyout is a transaction where a buyer—usually a private equity firm—acquires a company using a combination of equity and a large portion of borrowed money. The idea is to use the company’s own cash flows to repay that debt over time, and then sell the business later at a profit.
Because private equity firms rarely put in 100% of the purchase price with their own money, they care deeply about how much leverage they can use, how quickly they can pay it down, and what kind of return they’ll earn on the cash they do invest.
That’s where the LBO model comes in. It simulates the life of the investment—from entry to exit—and helps determine the maximum price the buyer can pay while still hitting their desired IRR.
In M&A negotiations, LBO models serve as a valuation floor. Strategic buyers might pay more because they see synergies or competitive advantages. But financial sponsors base their offers on the math—and the math only works if they can exit the investment with a strong return.
How an LBO Model Is Structured and What Goes Into It
At a high level, an LBO model is built around a timeline—usually five to seven years—during which the private equity buyer owns the company. The model tracks how much equity they invest, how much debt they borrow, how the company performs, how the debt is repaid, and what the business is worth at exit. From there, it calculates the internal rate of return (IRR) on the equity invested.
To make this work, several key inputs and assumptions are required:
1. Purchase Price and Capital Structure
The first assumption is the purchase price of the business—usually based on a multiple of EBITDA. From there, the model sets the capital structure: what portion of that price will be paid with debt, and how much will be equity.
For example, if the total price is $500 million, a private equity buyer might use $350 million in debt and $150 million in equity.
Leverage Ratio = Total Debt ÷ EBITDA
Most LBOs use leverage between 4× to 6× EBITDA, though this varies by sector, interest rates, and lender appetite.
2. Financial Projections
Next, the model projects the company’s financial performance over the holding period. This includes:
- Revenue growth
- Margins and EBITDA
- Capital expenditures
- Changes in working capital
- Interest payments and taxes
These projections drive the company’s free cash flow, which is used to pay down debt year by year.
3. Exit Assumptions
At the end of the investment horizon, the model assumes the company is sold to another buyer, usually at an exit multiple similar to—or slightly lower than—the entry multiple. This is where the return is crystallized.
For example:
Exit Enterprise Value = Final Year EBITDA × Exit Multiple
Equity Value at Exit = Exit EV – Remaining Net Debt
The final equity value is compared to the original equity investment to calculate the IRR and money-on-money multiple (MoM).
How Private Equity Firms Use the Model to Define What They Can Pay
The LBO model is a pricing tool. Private equity firms use it to reverse-engineer the maximum price they can afford to pay today while still hitting their required return at exit.
Let’s say a fund wants a 20% IRR on any investment it makes. They’ll input assumptions about growth, margins, debt levels, and exit multiples into the model. If the resulting IRR is too low, they know the price is too high. If the IRR is higher than their hurdle, they may be able to bid more.
This process is called back-solving for the purchase price.
Here’s how it works:
- Start with target IRR – say, 20%
- Set the holding period – typically 5 years
- Project company cash flows and exit value
- Adjust the entry price until IRR equals the target
The higher the projected cash flows and the more leverage that can be safely used, the more the PE firm can afford to pay.
But there’s a limit. If the company is too risky, doesn’t generate enough free cash flow, or can’t be sold at a strong multiple, the price has to come down—or the deal doesn’t happen. That’s why LBO valuations are typically more conservative than strategic buyer valuations, which may factor in synergies or long-term strategic positioning.
In deal processes—especially auctions—it’s common for PE firms to be outbid by strategic buyers. But their offers still serve an important role: they define the financial floor of what the business is worth based strictly on returns.
How the Return Is Calculated and What IRR Really Tells You
At the core of every LBO model is the internal rate of return (IRR). This is the annualized rate at which the private equity investor’s initial equity investment grows over the holding period, based on how much cash they get out at the end.
Think of it this way:
You invest $100 million today. Five years later, after selling the business and paying off the debt, your equity is worth $250 million. What was your yearly return? That’s what IRR tells you.
Here’s the simplified formula used in LBO models (solved through iteration in Excel or Python):
IRR = Annualized return that sets:
Initial Equity Investment = Final Equity Value / (1 + IRR)^Years
In practical terms:
- A 20% IRR means the equity doubles roughly every 3.8 years.
- A 2.5× money-on-money (MoM) multiple over 5 years roughly equates to a 20% to 25% IRR depending on the cash flow timing.
- The MoM multiple is simpler—just:
MoM = Exit Equity Value ÷ Initial Equity Investment
Both IRR and MoM help private equity firms evaluate deals, but IRR is more sensitive to time. A deal that returns 2× in 3 years is more attractive than one that returns 2× in 6 years, even though the MoM is the same.
Why IRR Is So Central in LBO Valuation
Because debt magnifies returns on equity, LBOs are highly sensitive to the capital structure and the timing of cash flows. Even small changes in interest rates, EBITDA growth, or exit multiples can dramatically affect IRR.
That’s why PE firms use IRR as a strict filter—if the model shows they can’t achieve their minimum return, they won’t bid. And if they can barely meet the threshold, they may ask for better terms, seller financing, or a lower price.
The IRR becomes the answer to the ultimate question:
How much can we pay for this company without compromising our return?
Closing Thoughts
The LBO model is a cornerstone of how private equity firms think about valuation. It’s not just about what a company is worth—it’s about what an investor can afford to pay today, given how the company will perform, how much leverage can be used, and what kind of return is expected at exit.
In investment banking, LBO models serve a specific role: they define the valuation floor in competitive sale processes and help test whether strategic buyers are overpaying or if a financial sponsor might step in with a credible bid. They are also essential tools when advising private equity clients, whether they’re buying, refinancing, or planning to exit a portfolio company.
Like all valuation methods, LBOs come with assumptions. The difference is that here, those assumptions are tied directly to investment performance. If the cash flows don’t support the debt, or the exit multiple compresses, the returns disappear fast.
In the next article, we’ll explore how these different valuation methods—DCF, Comps, Precedents, and LBO—are used together. You’ll learn how bankers triangulate value across models and present a coherent valuation range to clients.