Leveraged Buyout (LBO) Explained: How It Works

Mohammed Aamir ShaikhFounder, Aamir Capital

Updated 5 October 20269 min read

The short answerA leveraged buyout (LBO) is the purchase of a company using a large amount of borrowed money. The buyer repays the debt from the company's own cash flow. Returns come from earnings growth, paying down debt and, less reliably, a higher exit multiple.

What an LBO is

In a leveraged buyout, a buyer, often a private equity fund, puts in some equity and borrows the rest to buy a company. The company's own cash flow is then used to pay interest and repay debt. After a few years the buyer sells the company, repays what remains of the debt and keeps the rest.

How it works

The buyer agrees a price for the company, the enterprise value.
The purchase is funded from debt and equity. This is called sources and uses.
The company uses its cash flow to pay interest and repay debt.
Earnings grow and debt falls, so the value of the equity rises.
After roughly three to seven years, the company is sold or listed.

Sources and uses

Sources are where the money comes from: new debt, the buyer's equity and sometimes equity rolled over by the sellers. Uses are where it goes: buying the company, repaying existing debt and paying fees. Sources must equal uses. See sources and uses.

Where returns come from

Exhibit 1: Where the equity return comes from in the worked example

Illustrative example. Equity invested of 350 grows to 870 at exit: a money multiple of 2.5x and an IRR of about 20% a year.

Earnings growth. Higher EBITDA at the exit raises the value of the business.
Debt paydown. Every unit of debt repaid becomes equity value.
Multiple change. Selling at a higher multiple than you paid adds value, but it is the least reliable driver.

Good LBO cases work even if the exit multiple is no higher than the entry multiple.

A worked example

Entry: EBITDA of 100 and an entry multiple of 8.0x give an enterprise value of 800.
Funding: debt of 450 (4.5x EBITDA) and equity of 350. Fees are ignored to keep the example simple.
After five years: EBITDA has grown to 140. At an exit multiple of 8.0x the enterprise value is 1,120.
Cash flow has repaid debt, so net debt has fallen from 450 to 250.
Equity value at exit: 1,120 − 250 = 870.

Example. The money multiple (MOIC) is 870 / 350 = 2.5x. The internal rate of return (IRR) is about 20% a year. Of the 520 of value created, 320 came from EBITDA growth ((140 − 100) × 8.0) and 200 from debt paydown.

What makes a good LBO candidate

Stable, predictable cash flow that can service debt.
A strong position in its market.
Modest capital spending needs.
Clear ways to improve earnings.
A reasonable purchase price.
Capable management.
Assets or cash flows that lenders are comfortable with.

Key measures

IRR and MOIC: the return to the buyer's equity.
Leverage ratio: net debt divided by EBITDA.
Interest cover and DSCR: whether cash flow comfortably covers debt payments.

Risks

Too much debt leaves no room for error.
Higher interest rates reduce cash flow after interest.
Cyclical earnings can fall just when debt payments are due.
Breaking a loan covenant can give lenders control.
The exit market may be weak when the buyer wants to sell.
Paying too much at entry.

Building an LBO model

Set the entry assumptions: price, multiple and fees.
Build the sources and uses table.
Forecast the operations: revenue, EBITDA, tax, capital spending and working capital.
Build the debt schedule with scheduled repayments and, if used, a cash sweep.
Calculate exit value, equity proceeds, IRR and MOIC.
Test sensitivities to entry and exit multiples, growth and leverage.

Our financial modeling service builds models like this, and the 3-statement template is a good base to start from.

LBOs in the GCC, India and Europe

How much lenders will lend, how interest is treated for tax, and the rules on using the target's assets to secure acquisition debt differ widely by country. Deals in the Gulf and India often involve family owners, partial stakes and co-investors, not only full buyouts. Local legal and tax advice is essential.

Questions

What is a good IRR for an LBO?

Private equity investors often aim for returns of around 20% a year or more, but the right target depends on risk, the market and the fund. There is no fixed rule.

Why do buyers use debt in an LBO?

Debt is cheaper than equity and lets the buyer put in less of their own money. If the business performs, that can raise the return on the equity. It also raises risk.

What is the difference between an LBO and a management buyout?

In a management buyout the buyers are the existing managers. Many management buyouts use the same debt-funded structure as an LBO.

Related explainers

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For education only. This page is general information. It is not financial, investment, legal or tax advice, and it does not take your situation into account.

Leveraged buyout (LBO) explained: how it works and where returns come from