LBO (Leveraged Buyout)
The acquisition of a company financed with a significant proportion of borrowed money (debt), with the target’s own cash flows used to service and repay that debt. The core private equity buyout structure.
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LBO (Leveraged Buyout) · the mechanism
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Structure a buyout, work out the return, and say which of the three drivers it depends on.
Where it comes up. An investment committee asks which of the three return drivers you are actually underwriting, and what happens to the answer if the exit multiple does not cooperate.
Sources and uses
Uses are the purchase price of the equity, refinancing of existing debt, and fees. Sources are the debt tranches lenders will underwrite plus a sponsor equity cheque that plugs the gap. The equity cheque is an output, not a choice.
The debt schedule
Project the business, subtract cash interest and mandatory amortisation, and sweep whatever free cash flow remains into repaying debt, cheapest and most flexible tranche first. This is the engine of the return and the part a modelling test actually marks.
The exit
Apply an exit multiple to final-year EBITDA for enterprise value, subtract the debt still outstanding, and what is left is the sponsor’s equity. Divide by the cheque that went in for the multiple of money, then annualise for an IRR.
Attribute the return
Split the gain three ways: EBITDA growth, debt paydown, and multiple expansion. This is the sentence that separates candidates, because a return that leans on multiple expansion is a bet on the market rather than on the business, and an investment committee will say so.
Worked through
Entry at 10x $100m EBITDA with 5x leverage. Exit in five years at 10x on $150m EBITDA, having repaid $200m.
- Entry EV / debt / equity
- $1,000m / $500m / $500m
- Exit EV
- 10 × $150m = $1,500m
- Exit debt / equity
- $300m / $1,200m
- MOIC and IRR
- $1,200m ÷ $500m = 2.4x, about 19% over five years
Of the $700m of equity gain, EBITDA growth at the entry multiple contributes $500m and debt paydown contributes $200m. Multiple expansion contributes nothing, because the multiple did not move. That is a clean deal to defend.
Check yourselfTwo deals both return 2.5x. One came mostly from debt paydown, the other mostly from multiple expansion. Which would you rather have underwritten?
Answer once you have one →
Debt paydown, because you controlled it. Paydown follows from cash generation you forecast and a structure you chose. Multiple expansion is the market deciding to pay more for the same business, which you cannot cause and cannot rely on. The same 2.5x carries very different risk depending on which bucket produced it.
Be able to say this back next week
- Built sources and uses with the equity cheque as the output, not the input
- Described the sweep repaying the cheapest tranche first
- Attributed the return between growth, paydown and multiple expansion
Why LBO (Leveraged Buyout) matters in interviews
The LBO is the core mechanic of private equity, and every buyside interview will test whether you understand why leverage creates returns rather than merely that it does. The question behind the question is always: where does the money actually come from?
How it works in practice
A sponsor acquires a company using a mix of equity and a large amount of debt secured against the target's own assets and cash flows. The target then services that debt from its operating cash flow over a three-to-five-year hold, and the sponsor exits by sale or IPO.
Returns come from three sources: EBITDA growth (operational improvement or acquisitions), debt paydown (every pound of debt repaid converts directly into equity value), and multiple expansion (selling at a higher multiple than you paid — the least controllable, and the one interviewers are most sceptical of).
A simple case: buy a business at 10.0x $100m EBITDA for $1.0bn, funded with $400m equity and $600m debt. Over five years EBITDA grows to $140m and $250m of debt is repaid. Exit at the same 10.0x gives enterprise value of $1.4bn, less $350m remaining debt, leaving $1.05bn of equity. That is 2.6x MoIC on $400m, roughly a 21% IRR.
What candidates get wrong
- Saying leverage "creates" value on its own. Leverage amplifies returns on the equity slice in both directions; the value has to come from cash flow.
- Ignoring what makes a good LBO candidate: stable and predictable cash flows, low capital intensity, a defensible market position, and assets that can be pledged as security.
- Assuming multiple expansion in a case study. Interviewers expect you to hold the exit multiple flat, or haircut it, and make the returns work on operations and deleveraging.
LBO (Leveraged Buyout): frequently asked questions
What makes a good LBO candidate?
Predictable, recurring cash flows to service debt; low ongoing capital expenditure requirements; a defensible market position with limited disruption risk; hard assets or contracted revenue that lenders can secure against; and a clear path to exit. Cyclical, capital-hungry or technologically fragile businesses are poor candidates regardless of how cheap they look.
Why does leverage increase returns in an LBO?
Because the sponsor puts in less equity for the same asset, so any increase in enterprise value accrues to a smaller equity base. Debt paydown reinforces this: cash flow used to repay debt transfers value from lenders to equity holders pound for pound. The same mechanism amplifies losses if the business underperforms.
What leverage multiple is typical in an LBO?
It varies with credit conditions and sector, but total debt in the range of 4.0x to 6.0x EBITDA has been a common band for mid-market and large-cap deals, with more available for highly stable businesses and less for cyclical ones. Lenders size it against the target's ability to service interest, not against a fixed rule.
Practise it
A fresh deal every time. Solve MOIC and IRR in your head, check the worked math, and see a returns waterfall break it down.
Open Paper LBO Trainer, free, 8 minWhere LBO (Leveraged Buyout) comes up
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