Walk me through an LBO model

An LBO is the purchase of a company using a large amount of borrowed money, with the acquired company's own cash flows used to repay that debt. Private equity firms do this: buy a business, hold it for roughly three to five years, pay down debt, improve the operations, and sell it for more than they paid.

This question is harder than the DCF walkthrough because there are more moving parts and the logic is less linear. It is a standard question in private equity interviews and a common one in banking. The interviewer is testing whether you understand what actually drives the return, not just the mechanical steps.

Signpost the five steps up front: sources and uses, the operating model, the debt schedule, the exit, and the returns.

Step 1 — Sources and uses. Uses: what you're paying for — the purchase price of the equity, refinancing existing debt, and transaction fees. Sources: how you're funding it — various layers of debt, plus the sponsor's own equity cheque, which is the plug that makes both sides balance.

The key ratio here is leverage, usually expressed as a multiple of EBITDA. How much debt a business can carry depends on how stable its cash flows are.

Step 2 — Build the operating model. Project revenue, EBITDA and free cash flow over the holding period, typically five years. This is where operational assumptions live: growth, margin improvement, capex requirements.

Unlike a DCF, you are not discounting these cash flows. You are working out how much cash is available each year to service and repay debt.

Step 3 — Build the debt schedule. Each year, cash flow after interest and mandatory amortisation is used to pay down debt. Track the closing balance of each debt tranche year by year, and the interest expense that flows back into the model.

Be ready for: the circularity issue — interest depends on the debt balance, and the debt balance depends on how much cash is left after interest. In Excel this is handled with iterative calculation.

Step 4 — Exit. Assume you sell at the end of the holding period, usually at an EBITDA multiple. The common conservative assumption is exiting at the same multiple you paid, so the return doesn't depend on multiple expansion.

Exit enterprise value minus remaining net debt gives the equity proceeds to the sponsor.

Step 5 — Calculate returns. Two metrics: IRR, the annualised return, and MoIC (multiple of invested capital), simply exit equity divided by the initial equity cheque. Sponsors typically target around 20%+ IRR and roughly 2–3x MoIC over five years.

Then say what actually drives the return — this is what separates answers. Three things:

1. Debt paydown — every dollar of debt repaid using the company's cash converts into sponsor equity.
2. EBITDA growth — through revenue growth or margin improvement.
3. Multiple expansion — selling at a higher multiple than you paid. This is the least controllable and the least defensible to assume.

Expect: "What makes a good LBO candidate?" Stable, predictable cash flows; low capex requirements; a defensible market position; identifiable operational improvements; and a realistic exit route.

Do you understand leverage? The central idea is that debt magnifies equity returns. If you cannot explain why, you cannot explain an LBO.

Can you hold a complex structure together? Five interlinked steps, with the debt schedule feeding back into the model. This is harder to recite than a DCF.

Do you think like an investor? Naming the three return drivers, and being appropriately sceptical about multiple expansion, signals commercial judgement rather than mechanical knowledge.

Confusing it with a DCF. In an LBO you do not discount cash flows to a present value. You track them to see how much debt gets repaid.

Not being able to explain why leverage boosts returns. The equity cheque is small relative to the total purchase price, so gains on the full enterprise value accrue to a small equity base.

Skipping the debt schedule. It is the heart of the model, and it's what most candidates gloss over.

Assuming aggressive multiple expansion. Assuming you sell at a much higher multiple than you paid is how you signal you don't understand the risk. Flat is the safe base case.

Forgetting fees and refinancing in uses. Transaction fees and repaying existing debt are real uses of cash and are commonly omitted.

Vague return targets. "A good return" is not an answer. Know the rough IRR and MoIC bands.