LBO Deal Process: Step-by-Step Guide
- Brandon Chicotsky
- Jan 10
- 15 min read
Leveraged buyouts (LBOs) are acquisitions where buyers use borrowed funds - covering 50% to 80% of the purchase price - to acquire companies. The target company's assets and cash flows secure the debt, with the goal of generating returns through debt repayment, operational improvements, and eventually selling the business. This guide explains the LBO process in simple terms, focusing on smaller mid-market companies (less than $25 million in EBITDA) often targeted for their steady cash flows and low capital needs.
Key Steps in the LBO Process:
Planning: Assess if the target can handle 60-80% debt while maintaining financial health.
Target Selection: Look for businesses with steady cash flow, low capital expenditure, and strong market positions.
Valuation: Use EBITDA multiples (3.0x–6.0x) to estimate the company’s value.
Initial Offer: Submit a Letter of Intent (LOI) with key terms and secure exclusivity for due diligence.
Financing: Structure the deal with senior debt, mezzanine financing, and equity.
Due Diligence: Verify financial, legal, and operational details to refine the deal.
Final Agreements: Negotiate purchase terms, debt covenants, and management alignment.
Closing: Transfer ownership, finalize financing, and begin post-close integration.
For smaller deals, business brokerages like God Bless Retirement provide support with valuations, financial modeling, and connecting buyers with experts. Success relies on disciplined execution, focusing on cash flow management, debt reduction, and improving EBITDA over the 3–10 year holding period.
Planning and Feasibility Assessment
Getting the planning right is key to identifying successful LBO opportunities while steering clear of deals weighed down by excessive debt. Before diving in, it’s essential to evaluate whether the target company can handle 60%-80% debt and still deliver the returns investors expect. The big question here is: Can the business operate effectively, meet debt obligations, and maintain financial health with this level of leverage? This initial step lays the foundation for a deeper dive into the company’s financial and operational strengths.
Assessing LBO Suitability
The best LBO candidates share a few common traits: steady cash flow, strong EBITDA margins, and minimal capital expenditure needs. Predictable earnings not only reassure lenders but also attract investors. Companies with a history of consistent performance stand out as safer bets. Low capital expenditure requirements are another plus since it frees up cash for debt repayment instead of tying it up in heavy investments.
Market position is another critical factor. Mature companies in stable, non-cyclical sectors - think healthcare services, industrial distribution, or business services - are generally better equipped to weather economic ups and downs. A solid asset base is also important since it can serve as collateral. Additionally, a strong management team can make or break the deal’s success. Buyers also look for opportunities to improve operations - whether that’s cutting costs, refining processes, or increasing sales - all without the need for significant capital outlays.
For some context, in 2024, the average interest coverage ratio for new LBO deals was 2.34x. This means companies, on average, generated $2.34 in earnings (EBIT) for every $1.00 of interest expense[6]. This metric helps buyers assess whether a target has enough financial cushion to handle debt even if earnings take a hit.
Estimating Debt Capacity and Capital Structure
A three-statement financial model - linking the income statement, balance sheet, and cash flow - is essential for calculating Free Cash Flow (FCF). FCF represents the cash left after covering operating expenses and capital expenditures, which is critical for servicing debt.
Buyers also keep a close eye on credit metrics to ensure compliance with lender requirements. For instance:
Debt/EBITDA ratio: This measures total debt relative to earnings, and lenders often cap it between 4.0x and 6.0x for smaller mid-market deals.
Interest Coverage Ratio: Calculated as EBIT divided by interest expense, this shows whether the company can comfortably handle its interest payments. A minimum coverage ratio of 2.0x is typically expected.
Debt Service Coverage Ratio (DSCR): This more conservative metric, calculated as (EBITDA – CapEx) divided by (Interest + Principal), ensures the company can cover both interest and principal payments.
To prepare for potential challenges, buyers stress-test their assumptions using Base, Upside, and Downside scenarios. For example, even a modest 1% uptick in interest rates can reduce equity returns by 3%-5% over the life of the investment[6].
How Business Brokerages Help with Feasibility
Once the financial groundwork is laid, expert brokerages step in to fine-tune and validate these estimates. Firms like God Bless Retirement specialize in providing valuations based on standard EBITDA multiples. For companies generating less than $25 million in EBITDA, these valuations - typically around 3.0x to 5.0x EBITDA for smaller mid-market deals - help buyers quickly determine if the asking price is in line with market expectations.
Brokerages also play a vital role in creating the Sources and Uses table, which outlines the total capital required for the deal and ensures the funding plan is airtight. On the "Sources" side, you’ll find all the capital components (like senior debt, mezzanine financing, and equity), while the "Uses" side details how the funds will be allocated - covering the purchase price, transaction fees, and any debt refinancing. Both sides must balance perfectly.
In addition, brokerages connect buyers with a network of specialists. These include CPAs for financial due diligence, financial planners for structuring capital, and private equity professionals to confirm debt capacity assumptions. This collaborative approach helps buyers avoid costly mistakes during the planning phase and ensures the proposed capital structure is realistic and competitive.
Deal Sourcing, Valuation, and Initial Offer
After completing a feasibility assessment, the next steps involve identifying a target company, determining its value, and submitting a formal offer. The goal is to secure exclusivity while maintaining an option to exit if due diligence uncovers issues.
Finding and Sourcing Target Companies
There are several ways to source potential acquisition targets. These include reaching out directly to business owners (proprietary outreach), working with intermediaries like investment banks or brokers, and tapping into industry networks.
Proprietary outreach focuses on contacting business owners before their companies are formally listed for sale. This approach can reduce competition and sometimes lead to more favorable pricing. On the other hand, intermediated deals often come with detailed documentation and reliable financial data, making them more straightforward to evaluate. Leveraging industry networks - such as relationships with lenders, consultants, and executives-in-residence - can also provide access to off-market opportunities. For buyers with an existing portfolio, add-on acquisitions can help boost scale while cutting costs. Additionally, corporate divestitures offer chances to acquire stable businesses at appealing price points.
To put it into perspective, private equity firms typically reach out to 40–50 potential targets for every deal they successfully close [7]. For businesses generating less than $25 million in EBITDA, firms like God Bless Retirement rely on confidential networks to identify opportunities while safeguarding sensitive information. Expert brokers also play a key role, assisting with direct outreach and industry connections.
Once a target is identified, the next step is to determine its value using a Leveraged Buyout (LBO) model.
Valuation and Building a Basic LBO Model
Valuing a target company starts with calculating its Enterprise Value (EV). This is usually done by multiplying the company’s last twelve months (LTM) EBITDA by an appropriate multiple. In the lower mid-market, these multiples typically range from 3.0x to 6.0x EBITDA, although certain industries may command higher valuations.
At this stage, buyers refine the "Sources and Uses" table to finalize deal terms. On the "Uses" side, this includes the purchase price, transaction fees (usually 2%–4% of the deal value), and financing costs (about 2%–3% of the total debt). The "Sources" side outlines funding sources such as senior debt, mezzanine financing, and sponsor equity, which serves as the balancing figure [8].
Next, buyers create financial projections for a 5- to 7-year holding period. This involves forecasting the income statement, balance sheet, and cash flow statement to estimate Free Cash Flow (FCF) available for debt repayment. Detailed schedules for amortization, interest, and cash sweeps - where extra cash is used to pay down debt faster - are also developed.
To estimate potential returns, buyers calculate the exit equity value and key metrics like the Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC). For mid-market LBOs, target returns typically fall between a 15%–25% IRR and a 2.0x–4.0x MOIC over a five-year period [8]. Sensitivity analysis is crucial here; for instance, a 1.0x change in the exit multiple can shift the IRR by 400–600 basis points in typical mid-market deals [8].
Drafting the Letter of Intent (LOI)
Once valuation is complete and both parties agree on a price, the buyer submits a Letter of Intent (LOI). This document outlines key deal terms, including price, payment structure, and other conditions. Payment can take various forms, such as cash, stock, seller notes, earnouts, or rollover equity. Buyers often prefer asset purchases because they limit exposure to prior liabilities and provide tax advantages. Sellers, however, may favor stock purchases due to their tax benefits.
The LOI also includes an exclusivity clause, which prevents the seller from negotiating with other bidders during the due diligence period. Exclusivity periods typically range from 30 to 120 days [3]. Additional terms, such as management retention plans, closing conditions, and escrow arrangements, may also be detailed to address potential risks.
While the LOI is generally non-binding for the final purchase, certain clauses - like exclusivity, break-up fees (around 6% for deals exceeding $500 million), and confidentiality - are legally enforceable. Securing exclusivity is critical to avoid wasting resources on consultants and legal counsel while competing bids are still in play. For lower mid-market transactions, firms like God Bless Retirement assist with structuring LOI terms and coordinating with CPAs and financial planners. This ensures all parties have a clear understanding of the proposed deal structure, paving the way for thorough due diligence and final negotiations.
Financing, Due Diligence, and Final Agreements
Once exclusivity is secured under the Letter of Intent (LOI), the buyer’s focus shifts to three critical tasks: securing financing, conducting due diligence, and drafting final legal agreements. These steps require close collaboration with lenders, legal experts, and consultants to ensure everything aligns.
Securing Financing for the LBO
Funding a leveraged buyout (LBO) involves building a capital structure typically made up of senior debt, mezzanine financing, and sponsor equity. Debt often accounts for 60% to 90% of the total deal value, with the buyer's equity acting as a safety net for lenders [5][10]. In the third quarter of 2024, U.S. leveraged loan activity hit $206.1 billion, highlighting strong demand for LBO financing [9].
To secure funding, buyers submit detailed financial models to lenders, who issue firm commitment letters. These legally binding documents guarantee funding at closing, provided specific conditions are met [3][10]. Lenders assess the target company's ability to handle debt by analyzing key metrics like the Interest Coverage Ratio (ICR), which generally needs to be at least 2.0x, and the Debt/EBITDA ratio, typically ranging from 4.0x to 6.0x for large-cap deals [10]. Mezzanine financing, which ranks below senior debt in repayment priority, carries higher risk and commands interest rates between 10% and 15% [10].
"A key feature of an LBO is that borrowing takes place at the company level - not with the equity sponsor." – Investopedia [9]
The debt is placed on the target company’s balance sheet through a NewCo structure, using the company’s assets as collateral [9][10]. To protect their investment, lenders impose covenants - such as maintenance covenants (ongoing financial requirements) and incurrence covenants [10]. For smaller deals, firms like God Bless Retirement often assist buyers by coordinating with CPAs and financial planners to meet lender requirements and structure financing that matches the target’s cash flow.
Once financing is in place, the buyer moves on to the next phase: due diligence.
Conducting Due Diligence
Due diligence begins with an initial review lasting 2–3 weeks, followed by a more detailed investigation that can take 2–6 months [12]. The purpose is to verify the seller’s claims, assess risks, and refine the financial model used to secure financing.
This process includes:
Commercial due diligence: Evaluating market size (TAM/SAM/SOM), customer retention trends, and competitive positioning [11].
Financial due diligence: Analyzing revenue trends, profit margins, and working capital to confirm that historical performance supports future projections [11].
Operational reviews: Examining supply chain resilience, scalability, and digital infrastructure, including cybersecurity and data privacy risks [11].
Legal and tax due diligence: Identifying liabilities, reviewing contracts for change-of-control clauses, and optimizing the tax structure.
"The primary goal of diligence is to provide a comprehensive picture of the target, communicate risks, answer any questions, and - possibly most importantly - present the information that will fuel the buyer's thinking around operational improvements." – Axial [12]
Buyers rely heavily on the Confidential Information Memorandum (CIM) and Virtual Data Room (VDR), which house key documents like supplier contracts, lease agreements, and financial records [12]. Third-party validation is a critical step - site visits, management meetings, and interviews with customers and suppliers help confirm the data. Lenders also conduct their own due diligence, assigning credit ratings and negotiating debt covenants to minimize default risk [3].
For smaller deals (under $25 million in EBITDA), brokerages like God Bless Retirement play a vital role by coordinating third-party consultants and maintaining confidentiality throughout the process.
Once due diligence is complete, attention turns to finalizing the legal agreements.
Negotiating and Drafting Final Agreements
At the heart of the transaction is the purchase and sale agreement. This can take the form of a stock purchase, where the buyer acquires shares and assumes all liabilities, or an asset purchase, where specific assets are bought to avoid liabilities and gain tax advantages [3][13]. Buyers often prefer asset deals for their reduced risk and tax benefits.
Financing documents, including credit agreements, outline the terms for senior and mezzanine debt, as well as the covenants designed to protect lenders [3]. Escrow and holdback provisions are common, with a portion of the purchase price withheld to cover potential claims related to undisclosed seller liabilities [3].
Final agreements also address management alignment, detailing compensation plans, equity rollovers, and employment terms to ensure the leadership team is motivated to execute the post-close strategy [3][4].
Negotiating debt covenants is a delicate balancing act. Buyers must meet lender requirements for restrictive terms while retaining enough operational flexibility to grow the business after the acquisition [3]. For smaller transactions, God Bless Retirement works closely with legal and financial professionals to ensure all parties understand the final terms and that the documentation supports a seamless closing process.
Closing the Deal and Post-Close Priorities
Once financing is secured and due diligence is wrapped up, the final phase of the leveraged buyout (LBO) process kicks off. This stage focuses on meeting closing conditions, signing legal agreements, transferring ownership, and then diving into the integration of the new capital structure alongside the operational plan.
Pre-Closing Steps and Final Preparations
Before the deal officially closes, several key steps need to be completed. The bookrunning bank finalizes debt syndication with the participating lenders [4]. Regulatory approvals, such as antitrust clearance and SEC filings for public companies, must also be secured [5,25]. Additionally, the Board of Directors gives formal approval and finalizes its composition, which typically includes the lead fund partner and relevant industry experts [4].
Legal teams handle the preparation of critical documents, including the definitive Purchase Agreement, escrow arrangements for potential liabilities, and management compensation plans designed to align leadership goals with those of the new owners [3]. Wiring instructions are arranged to ensure smooth fund transfers [5,6]. Meanwhile, buyers finalize their strategic "game plan", which outlines operational improvements and key initiatives for the first day of ownership. Once all these pieces are in place, the focus shifts to executing the deal on closing day.
Closing Day Mechanics
Closing day marks the formal transfer of ownership. Final documents are signed, funds are wired, and equity is transferred [4]. At this point, the new Board of Directors assumes control, and management begins operating under the updated structure. In most modern LBOs, the sponsor’s equity contribution typically makes up at least 40% of the purchase price, while debt levels range from 4× to 7× EBITDA [14]. For larger transactions exceeding $500 million, break-up fees - usually around 6% of the total deal value - may apply if the transaction fails to close [3]. Once the funds and legal documents are exchanged, the focus quickly shifts to integration and ongoing performance monitoring.
Post-Close Integration and Performance Monitoring
After the deal closes, the spotlight turns to driving earnings growth, reducing debt, and achieving multiple expansion [4]. The management phase often spans 3 to 10 years, during which the owners execute the strategic plan crafted during due diligence [6,1].
"History has shown that one of the core advantages of financial sponsors over corporations is often their ability to identify the 'few' activities that add the vast majority of the value, and focus obsessively on those activities." – Axial [4]
A top priority is optimizing Net Working Capital (NWC). Buyers aim to free up cash by reducing current assets, such as actively collecting accounts receivable, while extending current liabilities by negotiating longer payment terms with suppliers - for example, 45 days instead of 30 days [4]. This additional liquidity helps with debt servicing. Many buyers also establish an Integration Management Office (IMO) to oversee the roadmap, resolve cross-departmental issues, and track synergy realization across areas like IT, HR, and finance [15].
Key operating metrics are monitored across downside, base, and upside scenarios [4]. Weekly cash flow reports ensure debt obligations are met, while monthly reviews track progress toward EBITDA targets [16]. To secure long-term commitment, management incentives are aligned through equity rollovers and performance-based compensation. For smaller deals, support networks like God Bless Retirement offer access to professionals - CPAs, financial planners, and private equity experts - who assist with integration and monitor performance against the original financial model.
Conclusion
Leveraged buyouts (LBOs) demand careful planning, precise execution, and unwavering focus throughout every critical stage. The goal is straightforward: find a business with dependable cash flows, utilize debt to enhance returns, and implement a strategy that boosts earnings, reduces debt, and sets the company up for a lucrative exit. Having expert advisors involved can simplify this process and improve the likelihood of success.
The key to a successful LBO lies in identifying high-value opportunities early and maintaining focus on them during the typical 3-to-10-year holding period [4]. Whether it's optimizing working capital, improving EBITDA margins, or securing better supplier agreements, the most effective LBOs channel resources into areas with the highest potential for return. Private equity firms often aim for an internal rate of return (IRR) between 20% and 30% [2] and a cash-on-cash return of at least 2.0× [1], which requires both strategic foresight and disciplined execution.
For smaller mid-market transactions - businesses generating less than $25 million in EBITDA - working with experienced advisors can make all the difference. These professionals assist with everything from identifying the right targets and building accurate financial models to negotiating terms and managing post-close integration [2,5]. They also ensure management teams fully understand the risks and rewards of high-leverage deals, including the pressures of interest payments and cash flow management [1].
God Bless Retirement specializes in helping clients navigate the intricacies of buying and selling businesses in this space. Their services range from certified valuations and buyer sourcing to M&A support and discreet deal management. With a family-led approach, they provide personalized attention to every transaction. Whether you're a financial sponsor seeking your next acquisition or a business owner planning an exit, having the right team in your corner can transform a good deal into an exceptional one.
FAQs
What makes a company a good candidate for a leveraged buyout (LBO)?
A company ripe for a leveraged buyout (LBO) usually shares a few standout traits that make it appealing for debt financing while offering strong returns for equity investors. First, it needs stable and reliable cash flows, often demonstrated by consistent EBITDA. This stability ensures the company can manage debt repayments, even with only modest growth. Second, the business should have low capital expenditure requirements and a solid asset base - like real estate or equipment - that can serve as collateral for loans. Third, limited existing debt is essential to leave room for new leverage without overloading the balance sheet. Finally, there must be clear paths for operational improvements or growth, whether through cutting costs, expanding into new markets, or pursuing acquisitions, all of which can boost the company’s value over the typical 3- to 7-year investment horizon.
These qualities align perfectly with the types of businesses God Bless Retirement focuses on, particularly those generating less than $25 million in EBITDA. Their expertise in navigating the buying and selling process ensures a carefully structured mix of debt and equity, maximizing returns while maintaining discretion and leveraging strong professional networks.
How do financial models and credit metrics impact LBO financing decisions?
Financial models, often crafted in Excel, are essential tools for shaping financing strategies in leveraged buyouts (LBOs). These models project key financial elements like cash flow, EBITDA growth, and capital expenditures throughout the investment period while factoring in the proposed debt structure. By analyzing these projections, sponsors can figure out how much equity is needed to hit their target returns and explore different scenarios, such as varying purchase prices, refinancing strategies, or potential exit plans.
Lenders rely on critical credit metrics - like Debt-to-EBITDA, Interest Coverage Ratio, and Cash Flow Coverage Ratio - to evaluate risk and repayment ability. For instance, higher leverage (e.g., Debt/EBITDA exceeding 6×) might result in tighter loan terms or higher interest rates. On the flip side, strong coverage ratios could lead to better loan conditions. The financing plan is fine-tuned to ensure these metrics meet lender expectations, making the deal both practical and financially viable.
For middle-market business owners, God Bless Retirement provides expert support in breaking down these financial models and metrics. They help you grasp how equity, debt, and covenants come together to shape the structure and outcomes of a deal.
What is the role of business brokerages in smaller mid-market LBO transactions?
Business brokerages play an important role in smaller mid-market leveraged buyout (LBO) transactions, making the process smoother and offering expert advice. They handle critical tasks like valuing the business, finding potential buyers or sellers, and maintaining strict confidentiality throughout the deal. Their knowledge is especially helpful when dealing with businesses earning less than $25 million in EBITDA, where LBOs can get particularly intricate.
On top of that, brokerages often provide access to a network of professionals, such as CPAs, financial planners, and private equity specialists. This network ensures that every financial, legal, and strategic aspect of the deal is managed efficiently, creating a seamless experience for all parties involved.