Structuring an LBO: Sources and Uses

A private equity firm wants to buy a company for $1 billion. It does not write a check for $1 billion from its own pocket — almost nobody does, in a leveraged buyout. Instead it borrows most of the money, using the target company's own future cash flows as the thing that will eventually pay the debt back. Sources and uses is simply the table that shows where every dollar of that $1 billion comes from, and where every dollar goes. Like a balance sheet, the two sides must be equal by construction — if they don't match, the deal isn't fully funded.

The uses side: what the money pays for

Uses come first conceptually, because they set the target the sources must hit. The largest use is almost always the purchase of equity — buying out the current shareholders at the agreed price per share. Close behind is refinancing existing debt: any debt the target already has on its balance sheet is typically paid off and replaced, because the buyer wants a clean capital structure it controls rather than someone else's old loan covenants. Add transaction fees — investment banking advisory fees, legal fees, financing fees paid to the banks arranging the new debt — which commonly run 2–4% of deal size. Some deals also include a cash-to-balance-sheet line, extra cash left on the target's books for working capital.

The sources side: where the money comes from

Debt does most of the work, layered by seniority and cost. A senior secured term loan, usually held by banks and collateralized by the company's assets, sits at the bottom of the risk stack and carries the lowest interest rate. Senior or subordinated high-yield notes sit above it, unsecured or junior, and demand a higher coupon for that extra risk. Some deals add a revolving credit facility (undrawn at closing, there for working-capital swings) and, in smaller or riskier deals, mezzanine debt — a hybrid with warrants or a payment-in-kind coupon, more expensive still.

Sponsor equity is the private equity firm's own cash contribution, and it is deliberately the smallest, most expensive slice of the stack — expensive because equity investors demand the highest return for standing last in line if things go wrong, but small because leverage is what turns a modest equity check into a large deal and, if the plan works, a large equity return.

A worked example

Take the deal above, all in millions. Uses: equity purchase price 850, refinancing existing debt 110, transaction fees 40 — total uses = 1,000. Sources: a senior term loan of 400 (4.0x the target's $100 EBITDA) and high-yield notes of 260 (2.6x EBITDA) give total debt of 660, or 6.6x EBITDA leverage. Sources must still sum to 1,000, so sponsor equity is the plug: $1{,}000 - 660 = 340$. That's a 34% equity contribution — in the middle of the typical 30–45% range seen in large-cap buyouts.

Two numbers fall straight out. The leverage multiple, debt divided by EBITDA, here $660/100 = 6.6\times$, tells lenders and rating agencies how much cash flow the company needs just to service debt. The equity check, 340, is what the sponsor actually has at risk — and every dollar of debt substituted for equity here is a dollar the sponsor doesn't have to put in, which is exactly why leverage amplifies the sponsor's return if the company grows and the debt gets paid down, and amplifies the loss if it doesn't.

• Fees are real cash, not a footnote. On a $1 billion deal, 2–4% in fees is $20–40 million that has to be raised alongside the purchase price itself.
• Refinancing existing debt is a use, not a source, even though it looks like "debt" — it is money going out to retire an old lender, not money coming in.
• The equity check is a plug, not an input. It is whatever is left after debt capacity is maxed out at a leverage level lenders will accept — model the debt side first.