What is a leveraged buyout and how does the LBO model work?

Q: What is the typical debt structure in an LBO?

LBO debt stacks in tranches by seniority: revolvers and Term Loan A (first lien, SOFR + 200-350bps, amortizing), Term Loan B (first lien, SOFR + 300-500bps, 1% annual amortization with bullet maturity), high-yield bonds (unsecured, 7-12% fixed, bullet), and mezzanine (subordinated, 12-18% cash plus PIK, bullet). Senior debt has lowest cost but most covenants.

Q: What IRR and MOIC targets do private equity firms aim for?

PE firms typically target 20-25% IRR and 2.0-3.0x MOIC. Key benchmarks: 2x in 5 years equals roughly 15% IRR, 3x in 5 years equals roughly 25% IRR. IRR penalizes long holds, so a 3.0x MOIC over 10 years yields only 12% IRR, below most fund hurdles. This drives PE firms toward faster exits and dividend recaps.

Q: Why is sponsor equity the plug in an LBO sources and uses table?

In the Sources & Uses table, debt capacity is constrained by lender limits (typically 4-6x Debt/EBITDA and interest coverage ratios). Transaction uses are fixed (purchase price, fees, refinancing). Whatever debt cannot cover, the sponsor's equity fills as the residual. More debt means less equity required and potentially higher returns, but increases execution risk.

Q: What is a cash sweep provision in LBO debt?

A cash sweep requires excess free cash flow above a defined threshold to go toward mandatory debt repayment. This accelerates deleveraging by reducing the debt balance and interest expense faster than scheduled amortization. While it benefits the overall LBO return through faster debt paydown, it limits the sponsor's ability to take distributions during the hold period.

Master LBO mechanics: debt financing, equity returns, and value creation drivers. Essential technical interview prep for PE and IB roles.

OfferGoblin·7 min read··

"Other people's money." — Louis Brandeis, Other People's Money and How the Bankers Use It (1914)

Concept

A leveraged buyout is an acquisition where the buyer finances the purchase primarily with debt—typically 50-70% of the purchase price. The acquired company's own cash flows and assets secure and repay that debt. The buyer (usually a private equity firm) contributes a smaller equity check, aiming to generate outsized returns by paying down debt over a 3-7 year hold period before selling.

Intuition

The logic is simple: leverage magnifies returns. If you buy a company for $1B with $300M equity and $700M debt, and sell it for $1.3B (debt paid down to $500M), your equity goes from $300M to $800M—a 2.7x return. Without leverage, that same $300M gain on $1B invested is only 1.3x.

But leverage is symmetric—it magnifies losses too. If EBITDA declines and you can't service debt, equity gets wiped out first. This is why LBO targets need stable, predictable cash flows. You're not betting on growth; you're betting on not missing debt payments.

The real estate analogy: An LBO mirrors buying rental property with a massive mortgage. Minimal equity down, tenant rent services the debt, sell the asset for profit.

Components

Sources & Uses

What It Is: The Sources & Uses table reconciles where the money comes from (sources) and where it goes (uses). It's the balance sheet of the transaction at Day 1.

How to Calculate It:

Uses:

Purchase Enterprise Value
Refinancing existing debt
Transaction fees (advisory, legal, financing)
Cash to balance sheet (if any)

Sources:

Senior Secured Debt (Term Loan A, Term Loan B)
Subordinated Debt / Mezzanine
High-Yield Bonds
Rollover equity (management or seller)
Sponsor equity (the plug)

Sources must equal Uses. Sponsor equity is always the plug—whatever debt doesn't cover, equity fills.

Key Consideration: Debt capacity constrains the deal. Lenders look at Debt/EBITDA (typically 4-6x) and interest coverage. More debt means higher equity returns but also higher execution risk.

Debt Structure

What It Is: LBO debt stacks in tranches with different seniority, rates, and repayment terms. Senior debt sits at the top (lowest risk, lowest cost); subordinated debt sits below (higher risk, higher cost).

Tranche	Seniority	Typical Rate	Amortization
Revolver	1st Lien	SOFR + 200-300 bps	None (drawn as needed)
Term Loan A	1st Lien	SOFR + 200-350 bps	5-10% annual
Term Loan B	1st Lien	SOFR + 300-500 bps	1% annual, bullet at maturity
High-Yield Bonds	Unsecured/2nd Lien	7-12% fixed	Bullet
Mezzanine	Subordinated	12-18% (cash + PIK)	Bullet

Key Consideration: Cash sweep provisions accelerate paydown. Excess free cash flow above a threshold goes to mandatory debt repayment—this reduces interest expense faster but limits sponsor distributions.

Value Creation Levers

What It Is: Private equity returns come from three sources: deleveraging, EBITDA growth, and multiple expansion. Understanding the mix tells you how much was skill versus market tailwind.

Lever	Mechanism
EBITDA Growth	Grow earnings to increase exit value
Multiple Expansion	Sell at a higher multiple than purchase (buy 8x, sell 10x)
Debt Paydown	Cash flow repays debt; every dollar repaid transfers to equity

Key Consideration: Multiple expansion is unreliable. Sophisticated LPs discount returns driven by multiple expansion because it reflects market timing, not value creation. Deleveraging and EBITDA growth are more defensible.

Return Metrics

What It Is: LBO returns are measured by IRR (time-weighted return) and MOIC (cash-on-cash return). Both matter—they tell different stories.

MOIC = \frac{Total Cash Returned}{Total Cash Invested}

A 5-year hold returning 2.5x MOIC means $100M invested became $250M.
That same 2.5x over 5 years is roughly 20% IRR.
The same 2.5x over 3 years is roughly 36% IRR.

IRR penalizes long holds. A 3.0x MOIC over 10 years is only 12% IRR—below most fund hurdles.

Key Consideration: PE firms target 20-25% IRR and 2.0-3.0x MOIC. IRR hurdles drive behavior: firms may push for faster exits (dividend recaps, quick flips) to juice IRR even if MOIC is lower.

Paper LBO Framework

Step 1: Entry Equity

Entry Equity = Purchase Price - Debt

Step 2: Exit Equity

Exit Equity = Exit EV - Remaining Debt + Excess Cash

Step 3: Returns Calculation

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

Convert MoM to IRR using the lookup table.

IRR Lookup Table

Memorize this.

MoM	3 Years	5 Years
1.5x	~14%	~8%
2.0x	~26%	~15%
2.5x	~36%	~20%
3.0x	~44%	~25%

Rule of thumb: 2x in 5 years ≈ 15% IRR. 3x in 5 years ≈ 25% IRR.

The Rule of 72 / 115 / 144:

Double (2x): 72 / Years ≈ IRR (e.g., 72 / 5 ≈ 14.4%)
Triple (3x): 115 / Years ≈ IRR (e.g., 115 / 5 ≈ 23%)
Quadruple (4x): 144 / Years ≈ IRR

Use these to gut-check any LBO model output immediately.

Worked Example

Prompt: Buy a company for $100M at 5x EBITDA. 60% Debt, 40% Equity. 10% interest rate. EBITDA flat at $20M with 100% FCF conversion. Exit after 5 years at same multiple. Calculate IRR.

Step 1: Entry Equity

Purchase Price: $100M
Debt: $60M (60%)
Entry Equity: $40M

Step 2: Exit Equity

Annual FCF: $20M EBITDA − $6M Interest = $14M
Total Cash Generated: $14M × 5 = $70M
Debt Repaid: $60M (fully paid off)
Excess Cash: $70M − $60M = $10M
Exit EV: $100M (5x × $20M EBITDA)
Exit Equity: $100M + $10M = $110M

Step 3: Returns

MoM: $110M ÷ $40M = 2.75x
IRR: 2.75x over 5 years falls between 2.5x (~20%) and 3.0x (~25%) → ~22%

Standard Interview Response

"Walk me through an LBO."

"An LBO is an acquisition funded primarily with debt, where the target's cash flows service that debt over a 3-5 year holding period.

Step 1: Make assumptions—Purchase Price, Debt/Equity split, Interest Rate.

Step 2: Build Sources & Uses. Sources: Debt + Equity. Uses: Purchase Price + Fees.

Step 3: Adjust the Balance Sheet for the new capital structure. Add Goodwill if purchase price exceeds book value.

Step 4: Project financials to calculate Free Cash Flow available for debt repayment.

Step 5: Calculate Exit Value using an EBITDA multiple, subtract remaining Net Debt, determine Ending Equity Value. Returns measured as MoM and IRR.

The three drivers of returns are EBITDA growth, multiple expansion, and debt paydown."

Interview Script

A leveraged buyout is an acquisition where a private equity firm finances the purchase primarily with debt—typically 50-70% of the purchase price—using the target company's own cash flows and assets to secure and repay that debt. The logic is that leverage magnifies returns: if you buy a company with 30% equity and the value increases, your equity return is much higher than if you'd paid all cash. This is why LBO targets need stable, predictable cash flows—you're essentially betting on the company's ability to service debt, not on growth.

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Frequently Asked Questions

What is the typical debt structure in an LBO?

What IRR and MOIC targets do private equity firms aim for?

Why is sponsor equity the plug in an LBO sources and uses table?

What is a cash sweep provision in LBO debt?