Leveraged buyouts: how debt turns a steady business into a return

01what it is

Equity at entry

equityin = purchase price − debt raisedFees left out, as a paper LBO usually does.

Equity at exit

equityout = exit EBITDA × exit multiple − net debt at exit

Multiple of money

MOIC = equityout / equityin

IRR from the multiple

IRR = MOIC1/n − 1n is the holding period in years; exact when there is one cheque in and one back.

• A small cheque and a large loan¹

  In a leveraged buyout a specialised investment firm acquires a company using a relatively small portion of equity and a relatively large portion of outside debt.

• Debt raises the return on the equity^2,3

  The less equity the fund puts in, the more any gain in the company's value is worth to it, so an LBO model is built around how much debt the business can carry and how fast it can repay it. The paper LBO asks you to show the result in a few minutes with a pen.

• IRR and the multiple of money^2,4

  Returns are measured two ways: the multiple on invested capital - exit equity divided by the equity put in - and the internal rate of return, its annualised version. A 3.27x multiple over five years is an IRR of about 27%. In Mergers & Inquisitions' worked case study the likely outcomes are 20-30% IRRs and 2-3x multiples.

• A paper LBO, worked (illustrative)³

  Buy a company with EBITDA of 100 at 10x: a price of 1,000, paid with 600 of debt (6x) and 400 of equity. Over five years EBITDA grows to 130 and the cash flow repays 300 of the debt. Sell at the same 10x: 1,300, less the 300 of debt left, is 1,000 of equity. MOIC = 1,000 / 400 = 2.5x, and IRR = 2.5^(1/5) − 1 = 20.1%. The numbers are invented for the arithmetic; the method is the one the paper LBO tutorial teaches.

• The same deal without the debt (illustrative)¹

  Pay the full 1,000 in equity and keep the 300 of cash the business throws off instead of repaying debt. Exit equity is 1,300 plus 300 of cash, 1,600: a 1.6x multiple and an IRR of 1.6^(1/5) − 1 = 9.9%. The business is identical; the debt is what turns 9.9% into 20.1%, and it is also what can wipe the equity out if the cash flow falls short.

next: where the return comes from →

02where the return comes from

Value created, split three ways

Δequity = ΔEBITDA × entry multiple + exit EBITDA × (exit multiple − entry multiple) + debt paydown

• Three drivers⁴

  Every LBO return splits into EBITDA growth; multiple expansion, selling on a higher multiple than the one paid; and debt paydown, the fall in net debt as the company's cash flow repays principal.

• Funds do not bank on the multiple⁴

  Entry and exit multiples swing with markets, so private equity investors typically do not plan on multiple expansion. In Wall Street Prep's worked example, debt paydown supplies more of the value created than EBITDA growth and multiple expansion combined.

• The worked deal, attributed (computed)⁴

  In the paper LBO above equity grew from 400 to 1,000, so 600 was created. EBITDA growth: 30 × 10 = 300. Multiple expansion: 130 × (10 − 10) = 0. Debt paydown: 300. The three add back to 600, which is the check that the split is right; had it sold at 11x, multiple expansion would have added 130 and the IRR would have been (1,130 / 400)^(1/5) − 1 = 23.1%.

next: what makes a good candidate →

03what makes a good candidate

• Cash flow first⁵

  Strong free cash flow is the requirement everything else serves: it pays the interest, repays the principal, and decides how much lenders will offer and on what terms.

• Predictable, and light on capital⁵

  Recurring revenue makes cash flow predictable and so raises the debt a company can carry. Low capital expenditure and working-capital needs leave more of that cash for debt service.

• Room to improve, and a fair price⁵

  Funds look for operations they can streamline, non-core assets they can sell, add-on acquisitions that build scale, and a purchase multiple low enough to leave room for a return.

• The fund behind the deal

  How the funds themselves are organised - general and limited partners, the fees, the ten-year life - and how they recruit bankers is on the private equity page.

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