Can you answer this IB interview question?

Walk me through an LBO conceptually.

A PE firm acquires a company using mostly debt, uses the company's free cash flow to pay down that debt over ~5 years, then exits — generating equity returns through EBITDA growth, debt paydown, and multiple expansion.

Intuition

An LBO is fundamentally about using leverage to amplify equity returns — the same way a homebuyer uses a mortgage. By funding most of the purchase with debt that the company itself pays off, the sponsor effectively converts the company's cash flows into equity value. The less equity you put in and the more debt the business pays down, the higher your return on the initial equity check.

Watch

A common follow-up is: 'What makes a good LBO candidate?' The trap is listing generic traits. The real answer centers on one thing: predictable free cash flow. Without it, the company can't service debt, and the entire structure collapses. Everything else (low capex, defensible margins, non-cyclical) is just a proxy for FCF stability.

Deep Dive

Explain the mechanics of a leveraged buyout from entry to exit, showing how debt amplifies equity returns.

Phase 1: Sources & Uses at Entry

Determine the purchase price (Enterprise Value = Entry Multiple × EBITDA)

Add transaction fees and financing fees → total Uses

Fund the Uses with a mix of Debt (typically 60-70% of EV) and Sponsor Equity (the remainder) → total Sources = total Uses

Sponsor Equity = Total Uses - Total Debt Raised

Phase 2: Operating Period (typically 5 years)

The company generates EBITDA → subtract cash interest, cash taxes, capex, and working capital changes → Free Cash Flow (FCF)

Mandatory debt repayment (amortization) comes out of FCF; any excess cash can optionally pay down revolver or other tranches

Each dollar of debt paid down increases the equity value dollar-for-dollar, because:

Equity Value = Enterprise Value - Net Debt

So even if EV stays flat, shrinking debt grows equity.

Phase 3: Exit

Apply an exit multiple (often assumed equal to entry multiple) to the exit-year EBITDA:

Exit EV = Exit Multiple \times Exit EBITDA

Subtract remaining net debt at exit → Exit Equity Value

Exit Equity = Exit EV - Net Debt at Exit

Phase 4: Returns Calculation

Money-on-Money (MoM):

MoM = \frac{Exit Equity}{Sponsor Equity at Entry}

IRR is the annualized rate that solves:

Sponsor Equity at Entry \times (1 + IRR)^{n} = Exit Equity

Typical PE targets: $\geq 2.0 \times$ MoM, $\geq 20%$ IRR over ~5 years.

Three levers that drive returns:

Lever	Mechanism
EBITDA Growth	Revenue growth and/or margin expansion increase exit EV
Debt Paydown	FCF retires debt, converting enterprise value into equity value
Multiple Expansion	Exiting at a higher multiple than entry inflates exit EV beyond operational improvement

The entire point of the leverage: the sponsor only writes a check for 30-40% of the purchase price but captures 100% of the equity upside. Debt magnifies returns on the way up (and losses on the way down).

Shortcut: Returns come from only three places — grow EBITDA, pay down debt, or expand the multiple. Every LBO question maps back to which of these three levers is moving.