Operating Model & Projections

The paper LBO from the previous lesson used a single growth rate and a rough FCF-to-EBITDA ratio. A full LBO model replaces those shortcuts with an operating model: a detailed, year-by-year projection of revenue, costs, EBITDA, capital expenditures, working capital, and ultimately free cash flow. The operating model is the engine room of the LBO. It feeds into the debt schedule (how much cash is available to pay down debt each year) and ultimately determines the equity return.

Building a credible operating model is what separates a back-of-the-envelope exercise from a bankable investment recommendation. Partners, lenders, and investment committees all scrutinize the assumptions embedded in the operating model. This lesson walks through the key building blocks: the revenue build, margin assumptions, capex, and working capital.

Once revenue is projected, the next step is modeling costs to arrive at EBITDA. The critical distinction is between fixed costs and variable costs, because this determines the company's operating leverage.

Variable costs scale directly with revenue. Think raw materials, sales commissions, shipping, and payment processing fees. If revenue grows 10%, variable costs also grow roughly 10%. Variable costs are typically modeled as a percentage of revenue.

Fixed costs stay roughly constant regardless of revenue changes (within a range). Think rent, salaried headcount, insurance, and software licenses. Fixed costs are modeled as absolute dollar amounts that grow with inflation or headcount additions rather than as a percentage of revenue.

Operating leverage is the effect that fixed costs create. When a company with high fixed costs grows revenue, each incremental dollar of revenue drops to EBITDA at a higher rate because the fixed cost base is already covered. Conversely, a revenue decline hits EBITDA disproportionately hard because those fixed costs do not shrink. PE sponsors love businesses with high operating leverage and stable revenue, because small revenue improvements generate outsized EBITDA growth.

A well-built operating model breaks out at least three to five cost line items (COGS, SG&A, R&D, rent, other) and applies the correct fixed-vs-variable treatment to each one.

Below the EBITDA line, the operating model must project two critical items that determine how much of EBITDA converts into actual cash flow.

Capital expenditures (capex) come in two flavors. Maintenance capex is the spending required to keep existing assets functioning: replacing worn-out equipment, maintaining facilities, upgrading IT infrastructure. This is a recurring cash cost that does not grow the business. Growth capex is discretionary spending on new capacity, new locations, new product lines, or major technology builds. In the operating model, maintenance capex is typically modeled as a percentage of revenue (often 1-3% for asset-light businesses, 5-10% for asset-heavy ones), while growth capex is modeled as specific project-level investments tied to the value creation plan.

PE sponsors scrutinize the split between maintenance and growth capex because it directly impacts free cash flow available for debt paydown. A company that reports $50M of total capex but only requires $20M of maintenance capex has $30M of discretionary spending that could theoretically be reduced or redeployed.

Working capital represents the cash tied up in the operating cycle: accounts receivable (money owed by customers), inventory, and accounts payable (money owed to suppliers). As revenue grows, working capital typically grows too, because the company carries more inventory and has more receivables outstanding. This growth consumes cash. Working capital is usually modeled as a percentage of revenue, with each component (receivables, inventory, payables) modeled using days outstanding metrics (DSO, DIO, DPO).

The operating model is only as good as its assumptions, and PE professionals spend significant time pressure-testing each one. The diligence team validates revenue drivers with customer interviews, market studies, and historical trend analysis. Margin assumptions are stress-tested with management and compared against peers. Capex estimates are benchmarked against the company's historical spending and asset condition reports.

Once the operating model is built, it produces the year-by-year unlevered free cash flow that feeds directly into the debt schedule (next lesson). The higher the FCF, the faster the company can repay acquisition debt, and the higher the equity return. This is why PE sponsors are obsessive about FCF conversion: a company that generates $50M of EBITDA but only $20M of FCF (due to heavy capex or working capital growth) is a fundamentally different LBO candidate than one that converts $45M of $50M EBITDA into cash.