How a leveraged buyout works
“Walk me through an LBO.”
It's the core private equity question and a favorite in banking interviews too. They want the lifecycle (buy, own, sell) and the reason leverage helps.
A sponsor buys a company mostly with borrowed money, uses the company's own cash flow to pay that debt down, then sells. The gain lands on a small equity check, so returns are magnified.
The mortgage analogy
Buy a rental property for $500,000 with $100,000 down and a $400,000 mortgage. Tenants' rent pays the mortgage down. Sell five years later for $600,000 with $300,000 still owed, and you walk away with $300,000: 3x your money, although the property only rose 20%. An LBO is that, with a company instead of a building.
The lifecycle
Buy: the sponsor agrees a price, usually a multiple of EBITDA, and funds it with a mix of debt (often 50–70%) and equity from its fund. Own: for three to seven years, the company's cash pays interest and principal while the sponsor works to grow EBITDA. Sell: to a strategic buyer, another sponsor, or the public markets via an IPO.
$100 of EBITDA, 40% of each year's EBITDA goes to paying down debt.
Try dragging leverage and watch the IRR.
Why leverage boosts returns
Debt shrinks the equity the sponsor must put in, so every dollar of value created is a larger percentage of that smaller check. Interest is also tax-deductible. The flip side: if the business stumbles, the same leverage magnifies losses, and too much debt can sink the company.
- 1No debt: $600 in, $900 out → 1.5x, about 8% a year.
- 2With $360 of debt (60%): the equity check is only $240. The company's cash flow pays the debt down to $160 by exit.
- 3Exit equity = 900 − 160 = $740 → 740 ÷ 240 ≈ 3.1x, about 25% a year.
Sponsors judge deals on two numbers: IRR (annualized return, often 20%+ targeted) and MOIC (total money back ÷ money in, often 2–3x).
Say it like this
In an LBO, a private equity firm buys a company using a small amount of its own equity and a large amount of debt. It makes assumptions about the purchase price, the debt, and the company's operations, and over a holding period of around three to seven years the company's cash flow pays interest and pays down the debt. Then the firm exits, usually by selling the company, and measures its IRR and multiple of money on the equity it invested. The debt magnifies returns because the gain is earned on a smaller equity investment.
Traps to avoid
- ✕Describing it as the PE firm borrowing. The debt sits on the target company's balance sheet.
- ✕Saying leverage boosts returns because “debt is free”. It works because equity is smaller, and interest is deductible.
- ✕Forgetting the exit. Without a sale or IPO, there's no realized return.
What they'll ask next
›What makes a good LBO candidate?
Stable, predictable cash flow, low capex needs, a defensible market position, room to improve operations, and a clear exit path.
›How can a sponsor boost returns?
Grow EBITDA, pay down debt faster, buy at a lower multiple or sell at a higher one, use more leverage (carefully), or return cash early with a dividend recap.
›Why do strategic buyers often outbid sponsors?
They can count synergies and don't need a 20%+ return on a leveraged equity check.
Check yourself
What is a leveraged buyout?
Put it all together
Sources and uses, five years of debt paydown, exit, IRR, and the most a sponsor could pay.