What is an LBO?
A leveraged buyout is the purchase of a company paid for largely with debt. Here is how it works and where its returns come from.
Try it in the LBO CalculatorHow does an LBO work?
A private equity fund buys a company with some of its own money, the equity, and a large amount of borrowed money, the debt. The debt sits on the company and is repaid from its cash flow. After a few years the fund sells the company, pays off what is left of the debt and keeps the rest.
LBO formula
Entry price = EBITDA × Entry multiple
Equity invested = Entry price + Fees − Debt
Exit equity = Exit EBITDA × Exit multiple − Net debt at exit
MOIC = Exit equity / Equity invested
IRR = MOIC^(1 / years) − 1
The IRR formula is exact when nothing is paid out before the exit.
LBO example
A fund buys a company with an EBITDA of 10 at a 10,0x multiple, so it pays 100, with 50 of equity and 50 of debt. Five years later EBITDA is 14 and the debt is down to 30. The fund sells at the same 10,0x for 140 and keeps 110, which is a MOIC of 2,20x and an IRR of 17,1 %. Fees and dividends are left out to keep the sums simple.
Where do LBO returns come from?
There are three sources: growing EBITDA, selling at a higher multiple and repaying debt. In the example the fund makes 60. EBITDA growth adds 40 (4 × 10,0x), debt repayment adds 20 and the multiple adds nothing, because the company is sold at the price it was bought.
What makes a good LBO candidate?
The debt has to be paid in good years and bad ones, so funds look for stable cash flows, low capital needs and a solid market position. It also helps if there is a clear way to improve the business and an entry price that leaves room for a return.
How much debt should an LBO have?
More debt means less equity, which lifts returns when things go well and deepens the losses when they do not. The limit is set by what the company can repay: lenders look at net debt to EBITDA and at interest cover, which you can test in the Debt Capacity tool.