Private Equity · Leveraged Buyouts
Buy a company mostly with borrowed money, use its own cash flow to pay the debt down, and sell the deleveraged equity at exit. This guide walks through the mechanics of that one sentence, with models you can adjust and space for your own notes.
An LBO is the acquisition of a company financed primarily with debt, executed by a private equity sponsor who contributes a slice of equity and expects the target's cash flows to service that debt.
The cleanest mental model is a mortgage. You buy a $1,000,000 house with $250,000 down and an $750,000 loan. If the house later sells for $1,200,000 and you've paid the loan down to $600,000, your equity went from $250,000 to $600,000, a 2.4x return, even though the house only appreciated 20%. The debt did the heavy lifting. Swap "house" for "company" and "rent covers the mortgage" for "EBITDA services the debt," and you have an LBO.
Critically, the debt sits on the target's balance sheet, not the fund's. The sponsor's downside is capped at the equity check it wrote; the company, not the firm, is on the hook for the loans. That structural ring-fencing is why leverage is used so aggressively.
Leverage doesn't create value, it concentrates it. A fixed claim (debt) sits below a residual claim (equity), so any value above the debt accrues entirely to the smaller equity base.
Two identical companies, each bought for an enterprise value of $1,000M, each grown and sold for $1,400M five years later. The only difference is how the purchase was funded.
| All-Equity | 60% Levered | |
|---|---|---|
| Entry EV | $1,000M | $1,000M |
| Debt raised | $0M | $600M |
| Equity in | $1,000M | $400M |
| Exit EV | $1,400M | $1,400M |
| Debt at exit (paid down) | $0M | $300M |
| Equity out | $1,400M | $1,100M |
| MOIC | 1.4x | 2.75x |
| ~IRR (5 yr) | 7.0% | 22.4% |
Same business, same operating result, the levered case triples the multiple of money. Two forces stack: the equity base starts smaller, and paying down debt converts lender claims into equity value over the hold. That's the engine.
Leverage is symmetric. If exit EV had fallen to $700M, the all-equity buyer takes a haircut to 0.7x and moves on; the levered buyer, with $500M of debt still outstanding, is left with $200M of equity, a 0.5x, and in a worse scenario, zero. Debt magnifies the upside and hands you the downside first. This is why capital structure discipline is the whole game.
Every deal begins with a balancing exercise: where the money comes from (sources) must equal what it's spent on (uses). This table defines the entry capital structure.
On the uses side you're funding the purchase of the target's equity, refinancing any existing debt you're taking out, and paying transaction fees (financing fees, advisory, legal). On the sources side you raise as much debt as lenders and cash flows will support, and the sponsor plugs the remaining gap with equity. Any management rollover reduces the cash equity the sponsor must write.
Sources always equal Uses by construction, the sponsor equity check is the plug. Simplified: cash-free/debt-free basis, no minimum cash, no existing debt to refinance shown separately.
Debt isn't one thing. It's a layered stack of tranches, ordered by seniority and security, cheapest and safest at the bottom, most expensive and most junior on top, with equity as the residual claim above everything.
Seniority determines who gets repaid first in a default and, therefore, price: the more protected the lender, the lower the interest rate they'll accept. Move up the stack and you trade security for yield.
Hover or tap any layer to read what it is and why it's priced where it is.
Every dollar of equity gain in an LBO can be attributed to exactly three levers. Any returns bridge you build in a case study decomposes into these.
Equity gain = (Debt₀ − Net Debt at exit) + Entry Multiple × (EBITDA growth) + EBITDA at exit × (Exit Multiple − Entry Multiple). The Returns Engine below computes this waterfall live.
This is a simplified but honest paper-LBO: it raises debt, projects EBITDA, runs a cash-flow sweep to pay debt down each year, then exits and computes MOIC and IRR, and shows you exactly which of the three drivers earned the return.
Assumptions: 100% cash-flow sweep to debt (excess builds cash once debt hits zero); D&A assumed equal to capex; no changes in net working capital; no dividends during the hold; no transaction fees at entry; IRR from a single entry outflow to a single exit inflow, so IRR = MOIC^(1/years) − 1. Real models layer in a full three-statement build, multiple tranches with distinct amortization, NWC, fees, and management options, but the intuition is exactly this.
A paper LBO is a compressed model you can complete with a pen in five to ten minutes. Keep the page in six blocks: entry, sources and uses, operating case, debt paydown, exit, and returns. Write the formulas first, then the numbers.
A sponsor buys a company on a cash-free, debt-free basis. Use the assumptions below and calculate sponsor equity, exit equity value, MOIC, and IRR.
Draw six labeled blocks down the page: Entry, Uses, Sources, Operations, Exit, Returns. Keep debt amounts positive and subtract them only when bridging from enterprise value to equity value. This prevents sign errors.
Entry enterprise value is the value of the operating business. Subtract existing net debt to get the purchase price paid to existing shareholders.
| Entry enterprise value = $100m x 10.0x | $1,000m |
| Less existing debt | ($200m) |
| Equity purchase price | $800m |
Say this out loud: “The sponsor is buying $1.0bn of enterprise value, of which $800m goes to the seller's equity and $200m refinances the existing lenders.”
Uses are what the transaction must pay for. On a cash-free, debt-free purchase, equity purchase price plus debt refinancing recreates enterprise value. Add fees and any minimum-cash funding.
| Equity purchase price | $800m |
| Refinance existing debt | $200m |
| Transaction and financing fees | $50m |
| Total uses | $1,050m |
Sources are where the money comes from. Calculate each debt tranche from its leverage multiple, add rollover or seller financing if provided, then use sponsor equity as the plug.
| New debt = $100m x 6.0x | $600m |
| Sponsor equity = total uses - new debt | $450m |
| Total sources | $1,050m |
First check: sources must equal uses. Second check: the sponsor equity check includes the $50m of fees; those fees do not create value at exit.
If the interviewer gives exit EBITDA and cumulative paydown, use them. If not, project EBITDA from revenue and margin, then estimate annual free cash flow available for debt repayment.
| Opening new debt | $600m |
| Less cumulative debt paydown | ($250m) |
| Exit debt | $350m |
If the question gives only EBITDA and a cash-conversion percentage, a fast estimate is EBITDA x conversion x years. Flag that this ignores declining interest and annual timing.
Apply the exit multiple to exit EBITDA. Then subtract net debt at exit. This is the same enterprise-to-equity bridge used in valuation.
| Exit enterprise value = $150m x 9.0x | $1,350m |
| Less exit debt | ($350m) |
| Exit equity value | $1,000m |
Sanity check: the deal created value despite one turn of multiple contraction because EBITDA grew and debt fell.
| MOIC = $1,000m / $450m | 2.22x |
| IRR = 2.22^(1/5) - 1 | 17.3% |
In a live interview, you can estimate 17% from the anchor table and then refine if the interviewer wants precision. MOIC measures how much money; IRR also rewards speed.
Prompt: Entry EBITDA $80m, 10.0x entry, $20m fees, 5.0x new debt, exit EBITDA $120m, $150m debt paydown, 10.0x exit, five-year hold.
Answer: Entry EV $800m. Uses $820m. New debt $400m. Sponsor equity $420m. Exit debt $250m. Exit EV $1,200m. Exit equity $950m. MOIC 2.26x. IRR about 17.7%.
Prompt: Entry EBITDA $150m, 12.0x entry, $45m fees, 5.5x new debt, exit EBITDA $210m, exit net debt $450m, 9.5x exit, five-year hold, and no rollover.
Answer: Entry EV $1,800m. Total uses $1,845m. New debt $825m. Sponsor equity $1,020m. Exit EV $1,995m. Exit equity $1,545m. MOIC 1.51x. IRR about 8.7%. The case fails a normal sponsor hurdle because entry price and multiple contraction overwhelm growth and deleveraging.
Prompt: Total uses $1,545m, new debt $825m, management rollover $50m, sponsor equity $670m. Exit equity value is $1,545m after five years. Calculate sponsor MOIC.
Answer: Sponsor owns $670m / ($670m + $50m) = 93.1%. Sponsor exit proceeds are $1,545m x 93.1% = about $1,438m. Sponsor MOIC is $1,438m / $670m = 2.15x, implying roughly 16.5% five-year IRR.
Forgetting fees in uses; counting an undrawn revolver as a source; confusing enterprise value with equity purchase price; subtracting total debt instead of net debt at exit; ignoring rollover ownership; using ending rather than average debt for interest without noting it; applying the exit multiple to revenue or free cash flow; and calling a high IRR good before checking whether it depends on multiple expansion.
Lenders don't underwrite upside, they underwrite the company's ability to keep paying them. A handful of ratios and contractual promises govern how much debt a deal can carry.
Maintenance covenants are tested every quarter regardless of what the company does, e.g. "leverage must stay below 6.0x." Incurrence covenants are only tested when the company takes an action (raising more debt, paying a dividend). Covenant-lite ("cov-lite") loans strip out the maintenance tests, leaving only incurrence, borrower-friendly, and dominant in the institutional term-loan market. Fewer tripwires for lenders to catch trouble early.
If the debt is repaid by the company's own cash flow, then a good target is, above all, a reliable cash machine. The checklist follows directly from that.
Deeply cyclical, capital-hungry, low-margin businesses with no moat are hard to lever, the moment earnings dip, the fixed debt bill doesn't. That's how a levered equity stake goes to zero. Software and business services get bought so often precisely because they're the opposite: sticky revenue, asset-light, high FCF conversion.
Beyond financial engineering, the modern PE playbook leans on operating improvements. The levers map back onto the three return drivers.
Returns aren't real until the sponsor monetizes. Four standard paths, plus one interim option that returns capital without selling.
The assumed exit shapes the whole thesis. Underwriting a strategic sale lets you argue for a higher exit multiple (synergies); an SBO or IPO usually gets underwritten nearer the entry multiple. The exit multiple you can defend is one of the biggest swing factors in the returns, which is exactly why sponsors underwrite it conservatively and why flat is the default assumption.
Pick an answer for each, it locks in immediately, marks right/wrong, and reveals the reasoning. Your running score sits at the bottom. Aim for 18+ before a PE superday.