LBO basics

A leveraged buyout, or LBO, is the purchase of a company funded largely with debt, usually by a private equity fund, called the financial sponsor. LBO questions come up in leveraged finance, private equity-facing coverage teams and many M&A superdays. You should be able to explain why sponsors use debt, sketch a simple model, and estimate returns without a spreadsheet.

Why use so much debt

Think of buying a house with a mortgage. If you pay £100,000 of your own money and borrow £300,000 for a £400,000 house, and the house rises in value to £500,000, your £100,000 has become £200,000: you doubled your money while the house rose only 25%. Debt magnifies the return on equity, in both directions.

A sponsor does the same with a company. It puts in a relatively small equity cheque, borrows the rest against the company's cash flows, uses those cash flows to repay debt over the holding period, then sells. Lenders receive a fixed return, so every extra pound of value goes to the equity.

Sources and uses

Every LBO starts with a sources and uses table. Uses are what the money pays for; sources are where it comes from. The two must match.

Total leverage here is 5.0x EBITDA, and the sponsor funds just over half the total. In the UK and Europe, mid-market buyouts are often financed with a unitranche loan from a direct lending fund rather than several layers of bank debt and bonds. The logic is the same.

What makes a good LBO candidate

• Stable, predictable cash flows that can cover interest and repay debt
• Low capital expenditure needs, leaving more cash for repayment
• A strong market position and resilient margins
• Room to improve operations or buy smaller competitors
• Assets that lenders can lend against, and a realistic route to exit

Where returns come from

• EBITDA growth: through revenue growth and margin improvement
• Multiple expansion: selling at a higher EV/EBITDA multiple than you paid, which sponsors do not like to rely on
• Debt paydown: every pound of debt repaid from cash flow becomes a pound of equity value

Money multiple and IRR

Sponsors track two return measures. The money multiple, or MoM, is equity received divided by equity invested. The internal rate of return, or IRR, is the annual compound return, which accounts for how long the money was tied up. With a single investment and a single exit:

In an interview you will usually be asked to estimate IRR in your head, so learn a few anchors.

So the 2.04x over five years in the example is about 15%. Many sponsors target around 20% or more, which in this deal would need faster growth, more debt paydown, a lower entry price or a higher exit multiple. Adding leverage raises IRR if things go well, but also raises the risk of a covenant breach or default if they do not.

Exits and the lenders' view

Sponsors usually plan to exit within three to seven years. The main routes are a sale to a strategic buyer, a sale to another private equity fund (a secondary buyout) or a stock market listing. Some also pay themselves a dividend funded by new debt part way through, called a dividend recapitalisation, which returns cash early and lifts IRR even though it adds risk.

Lenders look at the same deal from the other side. They focus on leverage, measured as debt ÷ EBITDA, and interest cover, measured as EBITDA ÷ interest. Loan agreements may include covenants, such as a maximum leverage ratio, which give lenders early warning and a seat at the table if performance slips.

The paper LBO

Some superdays include a paper LBO: a short case solved with pen and paper in 10 to 30 minutes. Keep numbers round, write out the sources and uses, project EBITDA and cash available to repay debt, calculate exit equity, then the money multiple, and estimate IRR from your anchors. Show your working clearly, because interviewers mark the approach as much as the final number.