Leveraged Buyout (LBO)

A PE firm identifies a target, structures the financing (typically 50–70% debt, 30–50% equity) laid out in the sources & uses table, acquires the company, improves operations over a 3–7 year hold period, and exits via sale or IPO. The debt is secured by the target's assets and must satisfy debt covenants. Because the PE firm only invests 30–50% of the purchase price in equity, even modest enterprise value growth can generate outsized equity returns. This 'leverage effect' is the fundamental principle behind LBOs.

1. EBITDA Growth: Operational improvements, revenue growth, and margin expansion increase the base for valuation. 2) Multiple Expansion: Selling at a higher EV/EBITDA multiple than the entry multiple. 3) Debt Paydown: Using FCF to repay debt increases equity value dollar-for-dollar. 4) Timing: Returning capital faster boosts IRR. The best LBO returns come from all four working together. In a base case, assume the exit multiple equals the entry multiple (no multiple expansion) to be conservative.

The best LBO targets have: stable, predictable cash flows (to service debt), strong market position with high barriers to entry, low CapEx requirements (maximizing FCF), opportunities for operational improvement (cost cutting, pricing power), a fragmented industry allowing for add-on acquisitions, and asset-heavy balance sheets that can secure debt. Industries like healthcare services, business services, industrials, and food & beverage are classic LBO sectors. High-growth tech companies are generally poor LBO candidates (volatile cash flows, high reinvestment needs).

PE firms typically target 20–25% gross IRR and 2.0–3.0x MOIC on individual deals. Fund-level returns are lower after fees (management fees + carry). A simplified LBO return: entry at 8x EBITDA, $100M EBITDA, 60% leverage ($480M debt, $320M equity). Over 5 years, EBITDA grows to $130M, $200M debt repaid, exit at 8x = $1.04B EV. Equity = $1.04B - $280M remaining debt = $760M. MOIC = $760M / $320M = 2.4x. IRR ≈ 19%.