Capital Structure of an LBO (2023)

In a leveraged buyout (LBO), the target company’s existing debt is usually refinanced (although it can be rolled over) and replaced with new debt to finance the transaction. Multiple tranches of debt are commonly used to finance LBOs, and may including any of the following tranches of capital listed in descending order of seniority:

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Revolving Credit Facility ("Revolver")

A revolver is a form of senior bank debt that acts like a credit card for companies and is generally used to help fund a company’s working capital needs. A company will "draw down" the revolver up to the credit limit when it needs cash, and repays the revolver when excess cash is available (there is no repayment penalty). The revolver offers companies flexibility with respect to their capital needs, allowing companies access to cash without having to seek additional debt or equity financing.

There are two costs associated with revolving lines of credit: the interest rate charged on the revolver’s drawn balance, and an undrawn commitment fee. The interest rate charged on the revolver balance is usually LIBOR plus a premium that depends on the credit characteristics of the borrowing company. The undrawn commitment fee compensates the bank for committing to lend up to the revolver’s limit, and is usually calculated as a fixed rate multiplied by the difference between the revolver’s limit and any drawn amount.

(Video) Leveraged Buy Outs Explained Simply

Bank Debt

Bank debt is a lower cost-of-capital (lower interest rates) security than subordinated debt, but it has more onerous covenants and limitations. Bank debt typically requires full amortization (payback) over a 5- to 8-year period. Covenants generally restrict a company’s flexibility to make further acquisitions, raise additional debt, and make payments (e.g. dividends) to equity holders. Bank debt also has financial maintenance covenants, which are quarterly performance tests, and is generally secured by the assets of the borrower. Existing bank debt of a target must typically be refinanced with new bank debt due to change-of-control covenants.

Bank debt, other than revolving credit facilities, generally takes two forms:

Term Loan A – This layer of debt is typically amortized evenly over 5 to 7 years.

Term Loan B – This layer of debt usually involves nominal amortization (repayment) over 5 to 8 years, with a large bullet payment in the last year. Term Loan B allows borrowers to defer repayment of a large portion of the loan, but is more costly to borrowers than Term Loan A.

The interest rate charged on bank debt is often a floating rate equal to LIBOR plus (or minus) some premium (or discount), depending on the credit characteristics of the borrower. Depending on the credit terms, bank debt may or may not be repaid early without penalty.

High-Yield Debt ("Subordinated Notes", "Junk Bonds")

High-yield debt is typically unsecured. High-yield debt is so named because of its characteristic high interest rate (or large discount to par) that compensates investors for their risk in holding such debt. This layer of debt is often necessary to increase leverage levels beyond that which banks and other senior investors are willing to provide, and will likely be refinanced when the borrower can raise new debt more cheaply. Subordinated debt may be raised in the public bond market or the private institutional market, carries a bullet repayment with no amortization, and usually has a maturity of 8 to 10 years.

(Video) Capital Structure

A company retains greater financial and operating flexibility with high-yield debt through incurrence, as opposed to maintenance, covenants and a bullet (all-at-once) repayment of the debt at maturity. Additionally, early payment options typically exist (usually after about 4 and 5 years for 7- and 10-year high-yield securities, respectively), but require repayment at a premium to face value. Interest rates for these securities are higher than they are for bank debt.

The interest on high-yield debt may be either cash-pay, payment-in-kind ("PIK"), or a combination of both. Cash-pay means that coupon is paid in cash, like the interest on bank debt. PIK means that the issuer can pay interest in the form of additional high-yield debt, so as to increase the face value of the debt that must ultimately be repaid. Sometimes, high-yield debt is structured so that the issuer may choose between cash-pay and PIK (the PIK option is usually more attractive to the issuer). Also, the mezzanine debt may be structured so that the PIK option is available for the first few years of the debt’s life, after which cash-pay becomes mandatory.

Mezzanine Debt

The mezzanine ranks last in the hierarchy of a company’s outstanding debt, and is often financed by private equity investors and hedge funds. Mezzanine debt often takes the form of high-yield debt coupled with warrants (options to purchase stock at a predetermined price), known as an "equity kicker", to boost investor returns to acceptable levels commensurate with risk. For example, regular subordinated debt might have an interest rate of 10%, while a hedge fund investor expects a return (IRR) in the range of 18-25%. To bridge this gap and attract investment by the hedge fund investor, the borrower could attach warrants to the subordinated debt issue. The warrants increase the investor’s returns beyond what it can achieve with interest payments alone through appreciation in the equity value of the borrower.

The debt component has characteristics similar to those of other junior debt instruments, such as bullet payments, PIK, and early repayment options, but is structurally subordinate in priority of payment and claim on collateral to other forms of debt. Like subordinated notes, mezzanine debt may be required to attain leverage levels not possible with senior debt and equity alone.

Seller Notes

A portion of the purchase price in an LBO may be financed by a seller’s note. In this case, the buyer issues a promissory note to the seller that it agrees to repay (amortize) over fixed period of time. The seller’s note is attractive to the financial buyer because it is generally cheaper than other forms of junior debt and easier to negotiate terms with the seller than a bank or other investors. Also, the acceptance of a seller’s note by the seller signals the seller’s faith and confidence in the business being sold. However, seller financing may be unattractive to the seller because the seller retains the risks associated with the business without having any control over it. Moreover, the seller’s receipt of proceeds from the sale is delayed.


Securitization of the cash flows attributable to particular assets, such as receivables or inventory, may provide another source of financing when a secondary market for securitization of such assets exists.

(Video) Basic leveraged buyout (LBO) | Stocks and bonds | Finance & Capital Markets | Khan Academy

Common Equity

Equity capital is contributed through a [private equity] fund that pools capital raised from various sources. These sources might include pensions, endowments, insurance companies, and wealthy individuals.

Exhibit A – Tranches in the LBO Structure

Source of Funds Key Terms Comments
Bank Debt
  • Typically 30-50% of capital structure
  • Based on asset value as well as cash flow
  • LIBOR-based (i.e. floating rate) term loan
  • 5-8 year maturity, with annual amortization often in excess of that which is required (average life 4-5 years)
  • 2.0x – 3.0x LTM EBITDA (varies with industry, ratings, and economic conditions)
  • Secured by all assets and pledge of stock
  • Maintenance and incurrence covenants
  • Bank debt will also include an unfunded revolving credit facility to fund working capital needs
  • Can be split into Term A (shorter term, higher amortization) and Term B (longer term, nominal amortization, bullet payment)
  • Generally, no minimum size requirement
  • Amortizes over the life of the loans
  • Generally, no prepayment penalties
High-Yield and Subordinated Debt
  • Typically 20-30% of capital structure
  • Generally unsecured
  • Fixed coupon
  • May be classified as senior, senior subordinated, or junior subordinated
  • Longer maturity than bank debt (7-10 years, with no amortization and a bullet payment)
  • Incurrence covenants
  • Public and 144A high yield offerings are generally $150mm or larger; for offerings below this size, assume mezzanine debt. In some case, it may be appropriate to include warrants such that the expected IRR is 17-19% to the bondholder
  • Senior and senior subordinated offerings are generally cash-pay; junior subordinated offerings (which would generally be issued in combination with senior subordinated offerings) may be zero coupon and issued at a holding company
  • Bullet payment (non-amortizing)
Mezzanine Debt
  • Can be preferred stock or debt
  • Convertible into equity
  • IRRs in the high teens to low twenties on 3-5 year holding period
  • Occasionally used in place of high-yield debt
  • Generally a combination of cash pay and PIK; can be both, or change over time
  • Often includes warrants to enhance IRR to desired level above coupon rate
Total Debt
  • Typically 3.0x – 6.0x LTM EBITDA
  • Interest coverage at least 2.0x LTM EBITDA/first year interest
  • Total debt varies by sector, market conditions, and other factors
Common Equity
  • Typically 20-35% of capital structure
  • 20-30% IRR on about a 5-year holding period
  • Exit multiple = entry multiple
  • Management options of 5-10%
  • Required IRR may be lower for larger or less risky transactions

Early Repayment Penalties

When a borrower repays its loans early, the lender must reinvest the repayments to earn acceptable returns. However, there is some risk that the lender will be unable to loan money on terms equivalent or better than it obtained from the borrower who is repaying early if, for example, interests rates may have declined since the lender originally made the loan to the borrower. To mitigate this risk, lenders sometimes charge borrows a premium to repay their loans early.

Credit Statistics

When considering an appropriate capital structure for an LBO transaction, is it very important to target realistic credit statistics. Credit statistics that are calculated as a multiple of interest expense are called "financial coverage" ratios.

Exhibit B – Typical Credit Statistics

ParameterTypical Value*
Total Debt / EBITDA 4.5x – 5.5x
Senior Bank Debt / EBITDA 3.0x
EBITDA / Interest Coverage > 2.0x
(EBITDA − CapEx) / Interest Coverage> 1.6x

* These parameters will change with market conditions. Consult the leveraged finance group at an investment bank for current parameters. Also, the financing limit will depend on the circumstances specific to the transaction and the growth potential of the target.

(Video) 2 Hour 3-Statement LBO Case Study - Private Equity - Built from Scratch

Sources & Uses

The pro forma capitalization and transaction structure are set forth in the "sources and uses" of funds. The sum of the sources of funds must always equal the sum of the uses of funds. Any debt or equity is "rolled over" appears as both a source and use of funds. The table below provides examples of sources and uses of funds:

Exhibit C – Common Sources & Uses of Funds

Excess cashPurchase of equity
Debt assumed by the buyerInvestor roll-over
Minority interest assumedFund target’s cash balance
RevolverAssumed (roll over) debt
Term Loan A Refinance short-term debt
Term Loan BRefinance long-term debt
Senior notesAssume (roll over) minority interest
Mezzanine preferred stockPurchase (buy out) minority interest
Subordinated (high-yield) notesTransaction fees and expenses
Mezzanine debtFinancing fees
Seller notes
Preferred stock
Common equity (sponsor’s investment)
Management equity roll-over
Investor roll-over


What is the capital structure of an LBO? ›

Capital structure in a Leveraged Buyout (LBO) refers to the components of financing that are used in purchasing a target company. Although each LBO is structured differently, the capital structure is usually similar in most newly-purchased companies, with the largest percentage of LBO financing being debt.

Does capital structure matter in LBO? ›

For the most part, a company's existing capital structure does NOT matter in leveraged buyout scenarios. That's because in an LBO, the PE firm completely replaces the company's existing Debt and Equity with new Debt and Equity.

How do you determine optimal capital structure? ›

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value.

How do you know if a company is a good LBO? ›

8 The best candidates for LBOs typically have strong, dependable operating cash flows, well-established product lines, strong management teams, and viable exit strategies so that the acquirer can realize gains.

What is the structure of a leveraged debt? ›

Leveraged loans are typically structured with a revolving credit facility and several term loan tranches with successively longer repayment terms. The revolving debt portion may be secured by a traditional borrowing base of working assets, with the term tranches collateralized by available business assets and stock.

Is capital structure the same as leverage? ›

Financial leverage is concerned with financing activities of the firm. It is determined by the capital structure of the firm. It is the firm's ability to use fixed financial charges to magnify the effects of changes in EBIT on its earnings per share.

How does capital structure affect valuation? ›

A company's capital structure — essentially, its blend of equity and debt financing — is a significant factor in valuing the business. The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor would be willing to pay for the company or for an interest in it.

Does capital structure affect Ebitda? ›

EBITDA is an earnings metric that is capital-structure neutral, meaning it doesn't account for the different ways a company may use debt, equity, cash, or other capital sources to finance its operations.

What are the 4 types of capital structure? ›

The types of capital structure are equity share capital, debt, preference share capital, and vendor finance. In addition, it ensures accurate funds utilization for business. The right capital structure level decreases the overall capital cost to the highest level. Also, it increases the public entity's valuation.

What is optimal capital structure and leverage? ›

“Optimal capital structure” involves a trade-off between the benefits of higher leverage, which include the tax-deductibility of interest and the lower cost of debt relative to equity, and the costs of higher leverage, which include higher risk for all capital providers and the potential costs of financial distress.

What are the optimal capital structure assumptions? ›

The capital structure theories use the following assumptions for simplicity: 1) The firm uses only two sources of funds: debt and equity. 2) The effects of taxes are ignored. 3) There is no change in investment decisions or in the firm's total assets. 4) No income is retained.

What makes a successful LBO? ›

What Makes a Good LBO Candidate? LBO Candidates are characterized by strong, predictable free cash flow (FCF) generation, recurring revenue, and high profit margins from favorable unit economics.

What is an LBO most sensitive to? ›

LBO Sensitivity Analysis

The entry multiple and exit multiples are usually the two assumptions with the most impact on returns, followed by the leverage multiple and other operational characteristics (e.g. revenue growth, margins).

What company would be a good LBO candidate? ›

A company with no debt and high free cash flow may be a great candidate given the fact that you can buy the company with senior debt and use the free cash flows of the company to pay the principal and interest due.

What is capital structure with leverage? ›

“Optimal capital structure” involves a trade-off between the benefits of higher leverage, which include the tax-deductibility of interest and the lower cost of debt relative to equity, and the costs of higher leverage, which include higher risk for all capital providers and the potential costs of financial distress.

What is capital structure in valuation? ›

A company's capital structure — essentially, its blend of equity and debt financing — is a significant factor in valuing the business. The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor would be willing to pay for the company or for an interest in it.

What is the structure of a term loan B? ›

Term Loan B – This layer of debt usually involves nominal amortization (repayment) over 5 to 8 years, with a large bullet payment in the last year. Term Loan B allows borrowers to defer repayment of a large portion of the loan, but is more costly to borrowers than Term Loan A.


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