Can you answer this IB interview question?

What is the goal of an LBO?

The goal of an LBO is to generate a high IRR (typically 20%+) on the sponsor's equity investment by using leverage to amplify returns through debt paydown, EBITDA growth, and potential multiple expansion.

Intuition

An LBO works because debt amplifies equity returns — just like a leveraged real estate investment, you put down a fraction of the price, use cash flows to pay off the loan, and keep all the upside. The entire structure is designed to maximize the return on the relatively small equity check the sponsor writes by letting the company's own cash flows do the heavy lifting on debt repayment.

Watch

Interviewers often follow up with 'What if EBITDA stays flat and there's no multiple expansion — can you still generate returns?' The answer is yes, purely through debt paydown, though IRRs will be lower. This tests whether you understand the independence of the three return levers.

Deep Dive

Explain the fundamental goal of a leveraged buyout and the mechanics of how that goal is achieved.

The goal of an LBO is to generate a high internal rate of return (IRR) — typically 20%+ — on the equity invested by the financial sponsor, by using debt to amplify returns.

Three levers drive equity returns:

Debt Paydown (Deleveraging)
- The sponsor funds the acquisition with a high proportion of debt (e.g., 60-70% of purchase price).
- The target company's own free cash flow repays that debt over the hold period.
- Every dollar of debt repaid converts into a dollar of equity value, because:

Equity Value = Enterprise Value - Net Debt

The sponsor's equity check stays fixed, but its equity claim grows as debt shrinks.

EBITDA Growth
- Revenue growth, margin expansion, cost cuts, or add-on acquisitions increase EBITDA.
- Higher EBITDA at exit directly increases Enterprise Value:

Exit EV = Exit EBITDA \times Exit Multiple

Multiple Expansion
- If the exit EV/EBITDA multiple exceeds the entry multiple, equity value increases beyond what EBITDA growth alone would imply.
- Conservative models assume no multiple expansion; any expansion is upside.

Return Calculation:

MOIC = \frac{Exit Equity Value}{Initial Equity Invested}

IRR = MOIC^{\frac{1}{n}} - 1 (approximation for a single entry/exit cash flow over n years)

Illustrative Example:

Acquisition EV: $1,000M, funded with $600M debt and $400M equity

After 5 years: EBITDA grows, debt paid down to $300M, exit EV = $1,200M

Exit Equity = $1,200M − $300M = $900M

MOIC = $\frac{900}{400} = 2.25 \times$

IRR ≈ $2.2 5^{1/5} - 1 \approx 17.6%$

Return attribution in this example:

Source	Value Creation
Debt Paydown	$300M ($600M → $300M)
EV Growth	$200M ($1,000M → $1,200M)
Total Equity Gain	$500M

The debt magnifies returns: a 20% EV increase ($200M on $1,000M) translates into a 125% equity gain ($500M on $400M). That leverage effect is the entire point.