LBO and Paper LBO

What an LBO is

In a leveraged buyout a financial sponsor (a private equity firm) buys a company using a large amount of debt — often 50–70% of the purchase price — and a smaller equity cheque. The company's own cash flow services and repays the debt, and the sponsor sells after 3–7 years. The target return is typically a 20–25% IRR and a 2.0–3.0x MOIC.

Walk through a basic LBO model

1. Transaction assumptions — purchase multiple (e.g. 10.0x EBITDA), debt tranches and leverage (e.g. 6.0x EBITDA), interest rates, fees.
2. Sources and uses — uses are the equity purchase price, refinanced debt and fees; sources are the debt tranches, any rollover and the sponsor equity plug.
3. Adjust the balance sheet — new debt, new equity, write-ups and goodwill; eliminate the target's old equity.
4. Project the income statement and cash flow — EBITDA, interest on the new debt, taxes, capex and working capital to reach free cash flow.
5. Debt schedule — mandatory amortization, then optional repayment with excess cash; the revolver covers shortfalls.
6. Exit — EBITDA in the exit year × exit multiple = exit EV; subtract net debt for exit equity.
7. Returns — MOIC and IRR on the sponsor's equity, with sensitivities to entry and exit multiples and leverage.

Why leverage boosts returns

• Less equity is needed for the same purchase price, so any value gain is spread over a smaller base.
• Debt paydown from operating cash flow accrues to the equity holders.
• Interest is tax-deductible, creating a tax shield.

Leverage cuts both ways: if the business underperforms, fixed interest and covenants can wipe out the equity.

Can more leverage lower IRR?

Yes. Beyond a point, extra debt costs more (higher coupons, PIK, tighter covenants), interest absorbs the free cash flow that would otherwise repay debt, and the risk of breaching covenants or needing an equity cure rises. If the after-tax cost of the marginal debt exceeds the return the business earns on its capital, more leverage dilutes returns.

What makes a good LBO candidate

• Stable, predictable cash flow to support debt.
• Low capex and working capital needs.
• Strong market position and pricing power.
• Opportunities to improve margins or grow (organically or via add-ons).
• A realistic exit route — strategic sale, secondary buyout or IPO.
• Assets that can serve as collateral, and a capable management team.

Variables that matter most

Purchase and exit multiples and EBITDA growth usually move returns the most; leverage and interest rates come next. Always ask how the deal performs if the exit multiple is 1–2 turns lower than entry.

Interview answer template

"A sponsor buys a company with mostly debt, uses the company's cash flow to pay interest and reduce debt over five years or so, then sells it. In the model we set assumptions, build sources and uses, project cash flow and a debt schedule, calculate exit equity, and measure IRR and MOIC."

The paper LBO format

A paper LBO is a mental-maths LBO you do with a pen in five to ten minutes. The interviewer wants a structured process and sensible rounding, not decimals.

Step by step with numbers

Assumptions: EBITDA 100, purchase at 10.0x, leverage 6.0x, 5-year hold, exit at 10.0x, ignore fees and minimum cash.

1. Entry: EV = 100 × 10.0x = 1,000. Debt = 6.0 × 100 = 600. Sponsor equity = 1,000 − 600 = 400.
2. Operations: EBITDA grows to 150 by year 5. Free cash flow after interest and taxes totals 300 over the hold and is used to repay debt, so debt falls to 300.
3. Exit: EV = 150 × 10.0x = 1,500. Exit equity = 1,500 − 300 = 1,200.
4. Returns: MOIC = 1,200 ÷ 400 = 3.0x. IRR ≈ 25% (3.0x over five years is about 24.6%).

IRR shortcuts to memorise

Doubling in five years is roughly 15%; tripling is roughly 25%.

Attribute the gain

The equity grew by 800 (from 400 to 1,200). Split it:

• EBITDA growth: 50 of new EBITDA × 10.0x entry multiple = 500
• Multiple expansion: exit multiple equals entry, so 0
• Deleveraging: debt repaid 600 − 300 = 300

500 + 0 + 300 = 800. Interviewers love this split because it shows where value came from.

Sensitivity: exit one turn lower

At a 9.0x exit, EV = 1,350 and exit equity = 1,050. MOIC = 2.6x and IRR falls to about 21%. Multiple contraction of one turn cost 150 of equity, which is why sponsors underwrite a flat or lower exit multiple.

Back-solving the price for a target IRR

"What can we pay for a 20% IRR?" 20% for five years ≈ 2.5x. Exit equity 1,200 ÷ 2.5 ≈ 480 of equity today. Holding debt at 600, the maximum EV is about 1,080, or roughly 10.8x EBITDA.

Common mistakes

1. Forgetting to subtract remaining debt at exit.
2. Using EV instead of equity for MOIC.
3. Applying free cash flow before interest — cash available to repay debt is after interest and taxes.
4. Ignoring fees in a real deal; they add to uses and increase the equity cheque.

Use the sources and uses quiz and the returns diagrams in this module to rehearse each step.