Walk me through an LBO model

An LBO is how private equity firms buy companies. The letters stand for leveraged buyout, and "leverage" is just another word for borrowed money.

The basic idea: a firm buys a company using mostly debt, improves it over about five years, then sells it and hopes to have made several times what it put in.

This is one of the harder interview questions because it combines accounting, debt, and returns maths. But the story underneath is simple, and once you see the shape of it, the steps are easy to remember.

Aim for about two minutes.

First, what is private equity?

A private equity firm raises money from investors — pension funds, universities, wealthy individuals — into a pool called a fund.

The firm uses that money to buy whole companies. It owns them privately, away from the stock market, usually for three to seven years. During that time it tries to make them more valuable. Then it sells them and returns the money to its investors, keeping a share of the profit.

The companies they buy are called portfolio companies. The private equity firm is often called the sponsor.

Why borrow so much money?

This is the part worth understanding properly, because it is the heart of the whole thing.

Think about buying a house.

Say a house costs $500,000. You put in $100,000 of your own money and borrow $400,000 from a bank.

Five years later the house is worth $600,000. You sell it and repay the $400,000 loan. You keep $200,000.

You turned $100,000 into $200,000. You doubled your money — even though the house only went up 20 percent.

That is leverage. Borrowing lets a small amount of your own money control a much bigger asset, so gains on the asset become much larger gains on your money.

Private equity does exactly this with companies. Typically 50 to 70 percent of the purchase price is borrowed, and the rest is the firm's own money — called the equity cheque.

And there is a second trick that houses do not have. The company pays down its own debt. The business generates cash, and that cash is used to repay the loan. So every year the sponsor owns a little more of the value, without putting in another penny.

The risk works both ways, of course. If the company struggles, interest still has to be paid, and the equity can be wiped out entirely.

The steps

Step 1: Set the entry price

Start with what you are paying.

Usually this is expressed as a multiple of EBITDA. If the company makes $100 million of EBITDA and you pay 10 times, the purchase price is $1 billion.

That multiple is called the entry multiple.

Step 2: Sources and uses

This is a simple table that shows where the money comes from and what it is spent on. The two sides must be equal.

Uses — what the money pays for:

• The purchase price
• Repaying the target's existing debt
• Fees for banks, lawyers and advisers

Sources — where the money comes from:

• New debt raised
• The sponsor's own equity
• Any cash already sitting in the company

The equity number is usually the plug. You work out everything else, and whatever is left is what the sponsor has to put in.

That equity number is the single most important figure in the model, because every return is measured against it.

Step 3: Project the business

Now forecast the company for about five years. Revenue, costs, profit, and most importantly cash.

Two things matter more here than in most models.

Interest costs. The company now carries a lot of debt, so interest is a large expense. This is why private equity avoids businesses with unpredictable earnings — you cannot miss an interest payment.

Cash available to repay debt. After paying interest, tax and capital spending, whatever cash is left usually goes toward repaying the loan.

Step 4: Build the debt schedule

This tracks the loan year by year.

Start with the opening debt. Add interest. Subtract repayments made from spare cash. That gives you the closing debt, which becomes next year's opening balance.

Over five years, the debt pile shrinks. That shrinking is one of the main ways the sponsor makes money.

Step 5: Exit and calculate returns

At the end of year five, you sell.

Apply an exit multiple to that year's EBITDA to get the sale price. Then subtract whatever debt is still outstanding. What is left is the sponsor's equity proceeds.

Compare that to the equity cheque they put in at the start. Two measures:

Multiple of money (MoM). Simply what you got out divided by what you put in. Put in $300 million, get out $900 million, that is 3.0x.

Internal rate of return (IRR). The annual percentage return that gets you from what you put in to what you got out over the holding period.

As a rough guide, a 2.0x over five years is roughly a 15 percent IRR. A 3.0x over five years is roughly 25 percent. Most sponsors target IRRs somewhere in the 20 to 25 percent range.

The three ways you make money

This is what interviewers most want to hear, and most candidates only name one.

1. Growing profits. If EBITDA rises from $100 million to $150 million, the business is worth more at the same multiple.

2. Paying down debt. Every dollar of debt repaid is a dollar more of value belonging to the owner. This happens automatically as the business generates cash.

3. Multiple expansion. Selling at a higher multiple than you paid. Buy at 10 times, sell at 12 times, and you gain even with no change to the business.

The third is the least reliable, because it depends on market conditions rather than anything the sponsor does. Strong candidates say so. Assuming multiple expansion in a model is generally considered aggressive.

What makes a good LBO target?

Expect to be asked. The answer follows directly from the mechanics.

• Steady, predictable cash flow. You must be able to pay the interest. Cyclical businesses are dangerous.
• Low capital spending needs. Money spent on machines cannot go toward debt.
• A real way to improve the business. Cost savings, a better management team, add-on acquisitions.
• Strong market position. Something that protects it from competition.
• A clear buyer at the end. You need someone to sell to in five years.

Software companies became popular targets because they tick most of these boxes — recurring revenue, high margins, and little physical equipment to buy.

Saying it out loud

"An LBO is where a sponsor buys a company using mostly debt, improves it over about five years, then sells it.

You start with the entry price, usually a multiple of EBITDA. Then you build sources and uses to work out how much debt you can raise and how much equity the sponsor has to put in.

Then you project the business for five years, focusing on the cash available to service and repay the debt, and you build a debt schedule tracking the balance down each year.

At exit you apply an exit multiple to the final year's EBITDA, subtract the remaining debt, and compare what is left to the original equity cheque. That gives you the multiple of money and the IRR.

There are three ways you make money: growing EBITDA, paying down debt, and selling at a higher multiple than you paid. The third is the least reliable because it depends on the market rather than anything you did."

What the interviewer is really checking

Do you understand why leverage boosts returns?

The house analogy is the clearest test. If you can explain in plain words why a smaller equity cheque produces a larger percentage return, you have understood the whole model.

Can you name all three return drivers?

Most candidates name EBITDA growth and stop. Naming debt paydown and multiple expansion — and flagging that the third is the least reliable — is what a strong answer sounds like.

Do you know what makes a good target?

Predictable cash flow, low capex, room to improve, and an exit route. This follows straight from the mechanics, so getting it wrong suggests you memorised steps rather than understanding them.

Can you do rough returns maths?

Some interviewers ask for a "paper LBO" — quick mental arithmetic to a rough IRR. Knowing that 2x over five years is roughly 15 percent, and 3x is roughly 25 percent, is genuinely useful.

Do you remember the debt at exit?

You have to subtract remaining debt from the sale price before working out what the sponsor gets. Forgetting this is common and produces wildly wrong returns.

Common mistakes

Forgetting to subtract remaining debt at exit.

The sale price is not what the sponsor receives. Lenders get paid first.

Assuming multiple expansion with no reason.

Selling higher than you bought is a market bet, not a plan. If you assume it, say so and explain why.

Only naming one return driver.

Growth, debt paydown, and multiple change. All three.

Ignoring fees and interest.

Transaction fees, financing fees and ongoing interest all reduce returns. Leaving them out flatters the model.

Piling on debt the business cannot service.

More debt increases returns only if the company survives. A business with unpredictable cash flow cannot carry heavy leverage safely.

Confusing an LBO with a merger model.

A merger model asks whether a company buying another raises its EPS. An LBO asks what return a financial buyer earns. Different buyers, different questions, different outputs.

Describing the mechanics with no sense of why.

The steps are memorable. Why a sponsor does any of this is the actual answer.