How an LBO (Leveraged Buyout) Works
An LBO buys a company mostly with debt, uses the company's own cash flow to pay that debt down, and sells it years later for a return on a comparatively small equity check. Here is the full mechanic, from sources and uses to MOIC and IRR.
What an LBO is
A leveraged buyout is the purchase of a company funded mostly with borrowed money rather than the buyer's own cash. A private equity sponsor puts in a relatively small slice of equity, raises the rest as debt secured against the target's own assets and cash flow, and the target company itself is on the hook for repaying that debt out of its future operating cash flow, not the sponsor personally.
Good LBO candidates tend to share a few traits: stable, predictable cash flow (so debt payments are reliable), modest ongoing capital needs, a strong market position, and room to pay down debt without starving the business. Interviewers ask about LBO mechanics because the math, sources and uses, a debt schedule, and a returns calculation, is standard across the industry and testable with clean numbers, even though it's a private equity, not public markets, valuation exercise.
Sources and uses: how the deal gets funded
Every LBO starts with a sources-and-uses table. Uses are everything the deal has to pay for: the purchase price (enterprise value paid for the target) plus transaction fees. Sources are where that money comes from: new debt (often several tranches at different rates and seniority) plus the sponsor's equity check, filling whatever uses the debt doesn't cover.
Worked example: total uses (purchase price plus fees) of $500mm, funded with $300mm of debt. The sponsor's equity check is $500mm − $300mm = $200mm.
Paying down debt with the company's own cash flow
Over the hold period, typically three to seven years, the target company generates free cash flow that is used largely to repay the acquisition debt rather than being paid out to the sponsor. Each dollar of debt repaid shifts value from debt holders to the sponsor's equity, since enterprise value minus a shrinking debt balance leaves a growing equity stake, even if the business itself doesn't grow at all. This effect, sometimes called the “deleveraging return,” is one of the three classic levers of LBO returns, alongside EBITDA growth and any expansion in the exit valuation multiple versus the entry multiple.
Exit value and calculating returns: MOIC and IRR
At exit, the sponsor sells the business (or takes it public), typically valuing it again as an EBITDA multiple, the same mechanic as the exit multiple in a DCF's terminal value. Equity value at exit is that exit enterprise value minus whatever debt remains at that point.
Exit Equity Value = Exit Enterprise Value − Remaining Net Debt at Exit
Two figures describe the sponsor's return:
- MOIC (multiple of money): total equity value received at exit divided by the equity originally invested, with no regard for how long that took.MOIC = Exit Equity Value ÷ Entry Equity Invested
- IRR (internal rate of return): the annualized return that accounts for the holding period, solving MOIC = (1 + IRR)years for IRR.IRR ≈ MOIC(1 ÷ years) − 1
Worked example: a sponsor invests $200mm of equity to buy a company for an enterprise value of $500mm (funded with $300mm of debt). Over five years, the company pays debt down to $100mm and grows enough that it sells for an exit enterprise value of $700mm.
MOIC = $600mm ÷ $200mm = 3.0x
IRR ≈ 3.0(1/5) − 1 ≈ 24.6%
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Common interview questions
What makes a company a good LBO candidate?
Stable and predictable free cash flow, since that cash flow has to service a heavy debt load; modest ongoing capital expenditure needs; a defensible market position; and a capital structure with room to add debt, meaning the company isn't already highly leveraged.
How is the size of the sponsor's equity check determined?
From the sources-and-uses table: total uses (the purchase price plus transaction fees) minus however much debt is raised to fund the deal. Whatever isn't covered by debt has to come from the sponsor's own equity.
What are the three main levers of returns in an LBO?
EBITDA growth (the business becoming more profitable over the hold period), debt paydown (using the company's own cash flow to retire debt, which shifts value to equity even in a flat business), and multiple expansion (selling at a higher EBITDA multiple than was paid at entry, though sponsors typically don't underwrite to this as their base case).
Why does simply paying down debt increase equity value, even if the business doesn't grow?
Equity value equals enterprise value minus net debt. If enterprise value holds flat but the debt balance shrinks because the company used its own cash flow to repay it, equity value rises by exactly that amount, since the same enterprise value is now supporting a smaller debt claim and a correspondingly larger equity claim.
What's the difference between MOIC and IRR, and why can they tell different stories?
MOIC is simply total cash returned divided by cash invested, with no regard for time. IRR annualizes that return over the actual holding period. A 3.0x MOIC earned in three years is a much stronger IRR than the same 3.0x earned in seven years, which is why sponsors track both: MOIC for the total dollars made, IRR for how efficiently they were made.
What is a dividend recapitalization?
A transaction where the portfolio company raises new debt mid-hold-period specifically to pay a cash dividend out to the sponsor, returning some capital before the eventual exit. It increases the company's debt load again but lets the sponsor realize part of its return earlier, which can meaningfully improve IRR even without a full exit.