Home · Blog

LBO Model Debt Sizing: How to Structure the Debt Stack

Published 2026-05-07 · SFS Models

Debt sizing in an LBO model is not a single calculation — it's an iterative constraint problem with credit ratios, leverage multiples, and coverage tests all biting at once. Here's how PE professionals actually structure the debt stack.

Most LBO model tutorials start with a fixed debt amount and work backwards to returns. In practice, the debt stack is determined by constraints — and identifying which constraint bites first is the core of the debt sizing exercise.

The four debt sizing constraints

Every leveraged buyout is constrained by at least one of these four limits. Often two or three bind simultaneously:

1. Leverage multiple — Senior lenders quote a maximum Debt / EBITDA (e.g. 4.5x senior, 6.0x total). This gives you the headline quantum.
2. DSCR floor — Lenders require minimum debt service coverage (typically 1.10x–1.25x). In Year 1, stressed EBITDA minus capex must cover P&I payments.
3. Fixed charge coverage — Similar to DSCR but includes finance leases, rent, and sometimes management fees.
4. Equity minimum — Most PE deals require 30–40% equity as a minimum. Regulatory capital (for financial institution targets) can push this higher.

Building the debt schedule in order

The correct build sequence is: senior debt first, then mezzanine/subordinated, then PIK/seller notes. Each layer is sized against what the coverage ratios allow after the prior layer.

Step 1: Senior term loan (TLB)

Senior debt = MIN(
    Entry EBITDA × Senior leverage cap,
    (EBITDA - Capex - Tax) / DSCR floor × (1 / annual P+I %)
)

The second term is often harder to calculate because P+I % depends on the debt quantum (circular). Solve by iteration: start at the leverage cap and step down until DSCR clears.

Step 2: Revolving credit facility (RCF)

The RCF sits pari passu with the TLB but is typically excluded from the leverage calculation at close (drawn = 0). Size it as 0.5–1.0x EBITDA for operational liquidity. The RCF tightens the effective DSCR through its commitment fee, which is a fixed charge regardless of drawdown.

Step 3: Mezzanine / unitranche

After senior is maxed, test whether adding a mezzanine tranche is feasible. Mezzanine lenders look at total leverage (typically cap at 6.0–7.0x in today's market) and interest coverage (EBITDA / total interest ≥ 2.0x). PIK mezzanine is tested on cash coverage only (excluding PIK coupon), which is why sponsors prefer it when coverage is tight.

Step 4: Seller note / PIK toggle

Any remaining valuation gap is filled with seller paper (PIK or deferred cash). Seller notes typically sit outside the restricted group covenants, making them effectively equity-like from the senior lender perspective.

The debt schedule mechanics

The critical modelling rule: calculate interest on the opening balance, not the closing balance. Using closing balance creates a circular reference. The correct formula for each period:

Opening balance  = Prior period closing
Scheduled repayment = Amortisation schedule (% or fixed)
Cash sweep       = Excess free cash flow above mandatory debt service
Interest charge  = Opening balance × (rate / 12)
Closing balance  = Opening + Drawdown - Repayment - Sweep

The cash sweep is where most LBO models get it wrong. The sweep applies to free cash flow after mandatory P&I, before dividends, but after capex and working capital. The sweep rate (50%, 75%, 100%) is negotiated — build it as a INPUTS parameter, not a hardcode.

Covenant headroom testing

Three covenant tests to build into the model alongside the debt schedule:

Flag a breach (FAIL) if any covenant threshold is breached in any period. Build this into your CHECKS tab with RAG formatting so a breach is immediately visible.

What changes the returns more than anything else

Sensitivity analysis almost always shows the same result: entry multiple and exit multiple dwarf everything else in their impact on IRR. But debt sizing affects the equity cheque, which determines how hard the leverage effect works.

The mechanical relationship: for every 1.0x of additional leverage at entry (holding purchase price constant), equity invested decreases proportionally. On a 5-year hold with flat EBITDA, 1.0x extra leverage adds approximately 300–500bps to IRR, before interest cost drag.

Above the DSCR floor, the limit on leverage is almost always the senior lender's leverage cap — not the economics. The economics almost always want more debt than the credit market will provide.

Building this in Excel

The debt schedule should have one row per tranche, one column per period. Build it bottom-up:

1. INPUTS tab: all covenant thresholds, leverage caps, interest rates, amortisation %, cash sweep %
2. Debt schedule tab: tranche-by-tranche roll-forward with interest and repayment
3. Covenant check tab: test each covenant each period, flag any breach
4. Returns tab: equity bridge from entry to exit using debt paydown + EBITDA growth + multiple

Our LBO Model covers all of this — senior TLB, RCF, mezzanine, PIK, covenant testing, cash sweep, and equity returns waterfall. Open formulas, no VBA.

SFS Models builds institutional-grade Excel financial models for banking and finance professionals. Browse the catalogue or get the free sample.