Walk me through an LBO in under a minute: what happens, why leverage amplifies returns, and the three drivers of the sponsor's return.
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The answer
- A sponsor buys a company using mostly debt, then uses the company's own cash flows to pay down that debt over roughly five years before selling. Returns come from EBITDA growth, debt paydown, and multiple expansion.
- Leverage amplifies returns because the sponsor only puts up a fraction of the purchase price as equity. As free cash flow repays debt, value shifts from the debt column to the equity column, so even modest enterprise value growth or debt reduction produces a much larger percentage gain on the equity check.
- The three drivers: EBITDA growth raises exit EBITDA and exit enterprise value directly. Debt paydown (deleveraging) uses post-interest, post-tax free cash flow to reduce net debt, and every dollar retired adds a dollar of equity value. Multiple expansion means selling at a higher EBITDA multiple than you paid, and that premium flows entirely to equity.
Combined, these produce an exit equity value; MoIC is exit equity over entry equity, and annualizing it gives IRR. For a quick sanity check: 2x over five years is around a 15% IRR, 2.5x about 20%, and 3x about 25%.
Sources & uses
| Term Loan B | 400 |
| Senior notes | 250 |
| Sponsor equity | 370 |
| Total sources | 1,020 |
| Purchase of equity | 900 |
| Refinance existing debt | 100 |
| Financing & advisory fees | 20 |
| Total uses | 1,020 |
Illustrative figures
Also asked as
- What makes a good LBO candidate? Give at least five characteristics and tie each one to the mechanics of the model.
- Build the sources & uses: $600M equity purchase price, $150M of existing debt refinanced, $25M total fees, financed with 4.5x leverage on $100M of EBITDA. What equity check does the sponsor write?
- An acquirer with a 15x P/E buys a target for an effective 25x P/E in an all-stock deal. Is it accretive or dilutive, why, and what after-tax synergy level would make it breakeven if the target has $200M of net income and the deal value is $5,000M?
- Why do sponsors evaluate deals on both IRR and MoIC? Give a concrete scenario where the two metrics disagree about which of two deals is better.
- Buyer pays $2,400M for equity; target's identifiable net assets have a book value of $1,300M; PP&E is written up by $200M and an identifiable customer-list intangible of $300M is recognized; stock deal, 25% tax rate. Compute goodwill, showing the DTL step.
- Paper LBO, out loud: buy at 9.0x on $60M EBITDA with 4.5x leverage; EBITDA grows 8% per year for 5 years; assume $15M/yr of free cash flow sweeps debt in year 1 growing $3M per year; exit at 9.0x. Give MoIC and approximate IRR.
- A sponsor's deal produces a 2.6x MoIC, but $1.0x of that MoIC came from a year-2 dividend recap funded with new debt. Explain how the recap affects IRR versus MoIC, what it does to the remaining equity's risk, and how an LP should think about the quality of this return.
- Your merger model shows +6% EPS accretion in year 1, but the acquirer's stock falls 8% on announcement. Give three rigorous explanations for the market's reaction and the specific model outputs you'd examine to test each.
- Same company, two buyers: a strategic with 30% cost synergies on the target's $50M EBITDA and a sponsor able to lever 5.5x at 8%. The target trades at 9x. Sketch how each buyer's maximum price is determined, and explain which wins the auction and under what conditions the answer flips.
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The rest of this topic
Building an LBO, start to finish
Why must total sources equal total uses in an LBO, and is this an accounting identity or a real economic constraint? Explain the difference.Describe the mechanical flow of an LBO operating model from revenue down to levered free cash flow, naming each line item in order.Walk me through a debt schedule from free cash flow to ending debt balances. Name each step in order.The Revolver as an LBO Cash Plug, ExplainedManagement Rollover as a Funding Source, ExplainedManagement Equity Rollover, Explained