In plain English
A leveraged buyout is buying a company mostly with borrowed money, using the company's own cash flow to pay the loan down, then selling it a few years later. If the business is worth roughly the same on exit but the debt is smaller, the equity is worth much more.
The advanced view
An LBO is a levered equity claim on a cash-generating asset with a fixed maturity. Returns decompose into deleveraging, EBITDA growth (volume, price, margin) and multiple expansion. Only the first two are within the sponsor's control, so a credible investment case leans on operations and treats multiple expansion as an upside case, not a base case.
Build in a fixed order. Sources & uses first: uses are the purchase enterprise value, refinanced debt, and fees; sources are the debt tranches plus the sponsor equity that plugs the gap. Then the operating case: revenue, margin, capex and working capital. Then the debt schedule with each tranche's rate, amortisation and cash sweep. Then the exit and the returns. Any model that computes returns before it has a debt schedule is guessing.
The LBO skeleton
Entry EV = Entry EBITDA × Entry multiple Uses = Entry EV + Refinanced debt + Fees; Sources = Debt tranches + Sponsor equity Sponsor equity = Uses − Debt raised Cash available for debt service = EBITDA − Cash interest − Cash taxes − Capex − ΔWorking capital Cash sweep = (Cash available − Mandatory amortisation) × Sweep % Exit EV = Exit EBITDA × Exit multiple; Exit equity = Exit EV − Net debt at exit MoM = Exit equity / Sponsor equity; IRR = MoM^(1/n) − 1 Leverage = Net debt / EBITDA; Interest coverage = EBITDA / Cash interest
The capital stack, senior to junior
Revolver (RCF)
Undrawn working-capital line, commitment fee on the unused part. Drawn only when the sweep leaves a shortfall.
Term Loan A / B
Senior secured. TLA amortises and is bank-held; TLB is largely bullet, institutionally held, floating over a reference rate.
Second lien / mezzanine
Junior secured or subordinated, higher coupon, often part PIK. Fills the gap when senior capacity runs out.
High-yield notes
Bullet, fixed-rate, incurrence covenants only, callable with a premium. Buys flexibility at a higher coupon.
Sponsor equity
The residual. Usually 30-50% of uses in the current market; management rolls in alongside.
Covenants
Maintenance tests (leverage, coverage) checked quarterly versus incurrence tests triggered only by an action such as new debt or a dividend.
Worked example: a five-year LBO
Step 1 of 13
- 1Entry EBITDA 200, entry multiple 9.0x → EV =
Sensitivity is where the interview happens. IRR is most sensitive to the exit multiple, then entry leverage, then margin improvement, then growth. A one-turn move in the exit multiple on 255 of exit EBITDA is 255 of equity value — in the example above roughly 3-4 points of IRR. Build the two-way table (entry multiple against exit multiple, and leverage against margin) and know which cell is your base case. Sponsors typically underwrite to a 20-25% IRR and a 2.0-2.5x MoM over five years.
Must know cold
- ✓Sponsor equity is the plug: uses minus debt raised.
- ✓MoM ≈ 2.0x over 5 years is roughly a 15% IRR; 2.5x is ~20%; 3.0x is ~25%.
- ✓Doubling money in 3 years ≈ 26% IRR, in 4 years ≈ 19%, in 5 years ≈ 15%.
- ✓Higher leverage raises IRR and raises the probability of breaching a covenant — say both.
- ✓Cash flow, not accounting profit, services debt: capex and working capital sit above the sweep.
- ✓The best LBO targets have stable cash flow, low capex, a defensible niche and an identifiable exit route.
Common pitfalls
- ×Assuming exit multiple above entry multiple in the base case.
- ×Sweeping cash the business needs for working-capital seasonality, then breaching the revolver.
- ×Forgetting that interest falls as debt is repaid, which understates the cash available in later years.
- ×Ignoring fees, the management option pool and the sponsor's monitoring fee in the equity bridge.
- ×Quoting IRR without MoM: a 40% IRR over one year on a small cheque is not a fund-returning deal.
Essential vocabulary
- Sources & uses
- Table showing what the deal costs and where every krona of funding comes from.
- Cash sweep
- Contractual requirement to use surplus cash to repay debt early.
- PIK
- Payment-in-kind interest, accrued into the principal instead of paid in cash; preserves cash, compounds the balance.
- MoM / MOIC
- Multiple of money: exit equity divided by invested equity.
- Dividend recap
- Re-levering the company to pay the sponsor a dividend, crystallising return before exit.
- Rollover equity
- Management reinvesting their proceeds into the new structure, aligning them with the sponsor.
Strategy connection
Leverage is a discipline device as well as a financing choice. Mandatory debt service removes the option to fund weak projects out of surplus cash, which is exactly the agency problem free cash flow creates. It also removes the option to absorb a bad quarter, so leverage suits businesses whose demand is predictable and destroys businesses whose demand is not.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
Entry at 8.0x on EBITDA of 150 with 4.5x leverage. After five years EBITDA is 195, net debt is 400 and the exit is at 8.5x. Compute sponsor equity, exit equity, MoM and IRR, then attribute the value created.
Exercise 2
Same deal, but the exit multiple compresses to 7.0x. What happens to IRR, and what margin improvement would offset it?
Exercise 3
Structuring exercise: a sponsor asks whether a subscription software business or a regional bus operator is the better LBO candidate. Structure the comparison.