Why must total sources equal total uses in an LBO, and is this an accounting identity or a real economic constraint? Explain the difference.
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The answer
Total sources equal total uses because the deal literally cannot close unless every dollar the buyer needs to spend has been raised, and you cannot raise more than you need without that extra cash just sitting on the balance sheet as a source-side plug. This is a real economic constraint, not an accounting identity.
An accounting identity, like assets equalling liabilities plus equity, holds by definition regardless of what happens; the sources and uses schedule balances because the sponsor and its financing sources deliberately size the debt tranches and the equity check so that total funding exactly covers total cash required.
If they tried to raise less, the transaction would be short cash; if they raised more, the excess would just end up as idle cash sitting on the balance sheet, money raised with nothing to fund. The discipline of forcing this balance is what reveals the true sponsor equity check size and the resulting leverage multiple, which are two of the most important numbers in the deal and flow directly from this schedule.
Sources & uses
| Term Loan B | 400 |
| Senior notes | 250 |
| Sponsor equity | 370 |
| Total sources | 1,020 |
| Purchase of equity | 900 |
| Refinance existing debt | 100 |
| Financing & advisory fees | 20 |
| Total uses | 1,020 |
Also asked as
- List every standard line item on the uses side and the sources side of an LBO sources & uses schedule, in the order you would present them.
- What does 'cash-free, debt-free' mean, and why do most LBOs use this convention when structuring the purchase price?
- Why does management rollover equity reduce the sponsor's required cash equity check, and why do sponsors generally want management to roll over a stake?
- Purchase price is $350mm enterprise value with existing net debt of $40mm (cash-free, debt-free). New debt is a $150mm term loan and $70mm of high yield notes. Financing fees are 2% of new debt, other fees are $9mm. Compute the required sponsor equity check.
- Explain the difference between the face value of a debt tranche and the actual net cash proceeds it generates when issued at an original issue discount (OID), and why this distinction matters for building an accurate sources & uses schedule.
- Why is the revolver typically shown in the sources & uses schedule as available but undrawn at close, and what would it mean, from a risk perspective, if a deal required a fully drawn revolver on day one?
- Enterprise value is $900mm with existing net debt of $70mm. New debt: a $70mm revolver (undrawn), a $320mm term loan B issued at 97 OID, and $220mm of senior notes at par. Financing fees are 2.25% of new debt face value (excluding the undrawn revolver), legal/advisory fees are $22mm, and management rolls $50mm. Compute the required sponsor equity check, being explicit about how you treat OID and the undrawn revolver.
- Using the deal in the prior question, the lead arranger later tells you the term loan B market will only clear $280mm face value at the same 97 OID. Recompute the sponsor's equity check assuming the sponsor absorbs the entire cash shortfall itself, and state the percentage increase in the sponsor's required equity.
- A target has $45mm of cash, of which $18mm sits in a foreign subsidiary and cannot be repatriated without a 25% tax cost. Enterprise value is $600mm and existing debt is $90mm. Compute the equity purchase price two ways: (a) naively crediting the buyer for all $45mm of cash, and (b) correctly crediting only the freely available cash plus the after-tax value of the trapped cash. Quantify the difference in the required equity check.
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Keep going
- Explain why debt paydown is a real source of equity value creation even when it requires no operational improvement to the business at all.
- What is the difference between Term Loan A and Term Loan B in terms of buyer base, amortization, and covenant package?
- Describe the mechanical flow of an LBO operating model from revenue down to levered free cash flow, naming each line item in order.
- Walk me through a debt schedule from free cash flow to ending debt balances. Name each step in order.
- Guide: Leveraged finance terms study guide
The rest of this topic
Building an LBO, start to finish