Basic, lesson 1 of 3
What an LBO is and why leverage helps
A leveraged buyout is buying a company mostly with borrowed money and using the company's own cash flow to pay that money back. The equity check is small, so every dollar of value created lands on fewer dollars.
7 min, 2 checks
1The idea in one paragraph
A private equity firm, called the sponsor, finds a company with steady cash flow. It buys the company using a mix of its own fund's money (equity) and borrowed money (debt). The debt sits on the company's balance sheet, not the sponsor's. Over three to seven years the company's cash pays interest and pays down the debt. Then the sponsor sells, repays whatever debt is left, and keeps the rest.
Think of it like buying a rental property with a mortgage. The tenant's rent pays the mortgage. When you sell, you keep the equity that has built up, and you only put down a fraction of the price at the start.
2Why borrowing raises the return
The value of the business does not care how it was financed. What changes is how big the equity check is. Less equity in, same value out, higher multiple on the equity.
Worked example
Same company, two ways to pay
- 1A company is bought for $100m and sold five years later for $150m. Ignore fees and assume no cash builds up.
- 2All equity: put in $100m, get back $150m. That is 1.5x your money, about 8.4% a year.
- 3With $60m of debt that is never repaid: put in $40m. At exit, repay $60m of debt and keep $150m minus $60m, which is $90m. That is 2.25x, about 17.6% a year.
- 4Now let the company's cash pay the debt down to $30m by exit: keep $150m minus $30m, which is $120m. That is 3.0x, about 24.6% a year.
The business earned the same $50m of value in every case. Leverage and paydown turned 1.5x into 3.0x on the sponsor's money.
Check 1
A company is bought for $200m with $120m of debt. It sells for $260m and the debt has been paid down to $80m. What multiple of its money (MOIC) does the sponsor make?
3The catch
Leverage cuts both ways. If the company is sold for less than it was bought for, the debt still has to be repaid in full, and the loss lands entirely on the small equity slice. Interest also has to be paid every year whether or not the business had a good year. Miss it and the lenders can take the company.
That is why sponsors want businesses with predictable cash flow, and why lenders cap how much they will lend as a multiple of EBITDA.
Check 2
In the example above, the company is sold for $90m instead of $150m, with $60m of debt still outstanding. What happens to the sponsor's $40m?
4Who does what
| Party | Role | What they want |
|---|---|---|
| Sponsor (PE fund) | Puts in the equity and controls the company | A high return on a small check |
| Lenders | Provide the debt, secured or unsecured | Interest paid on time and principal back |
| Management | Runs the business, usually rolls some equity | Upside through equity and options |
| Bankers | Advise the seller, or arrange the debt for the buyer | Fees on the sale and the financing |
As a banker you meet LBOs from two sides. On a sell-side deal you run a process where sponsors bid, and you need to know what a sponsor can afford to pay. In leveraged finance you arrange the debt. Either way, the LBO model tells you the price a sponsor can pay and still hit its return target.
Terms in this lesson: Leveraged buyout, Sponsor, Balance sheet, Multiple of invested capital, EBITDA.
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