The LBO and the paper LBO

A leveraged buyout is exactly what it sounds like: a private equity firm buys a company using mostly borrowed money, then uses the company's own cash flow to pay that debt down. The sponsor puts in a thin slice of equity, the company carries the rest as debt, and over a five-year hold the debt shrinks while (hopefully) the business grows. Sell at the end, and the equity that's left is the prize.

Reason from the sponsor's seat. They don't care about EPS or accounting niceties — they care about one thing: how much cash do I get back versus how much I put in, and how fast? Everything in an LBO serves that return.

Sources and uses

Every LBO starts here. Uses is what you have to pay for (the purchase price plus fees); sources is where the money comes from (debt plus the sponsor's equity). They must equal — the equity check is just the plug.

$\text{Equity} = \text{Purchase Price} + \text{Fees} - \text{Debt Raised}$

Buy a company for $1,000**, fund **$600 with debt, and the sponsor writes a $400 equity check. That's the entire setup: more debt means a smaller check today — and a bigger return multiple if it works.

Why leverage juices returns

Debt is cheaper than equity, and crucially, the lenders don't share in the upside. They get their fixed interest and principal back; everything above that flows to the equity. So the more of the purchase funded with debt, the more concentrated the gains on the sponsor's small slice.

The two return metrics

• MOIC (multiple on invested capital) — exit equity divided by initial equity. Put in $400, get back$1,000, that's a 2.5x MOIC. Simple, ignores time.
• IRR (internal rate of return) — the annualized return, which does account for the holding period. Sponsors typically target an IRR in the ~15–25% range, with 20% the classic benchmark.

A handy mental bridge: over a 5-year hold, a 2.0x MOIC is roughly a 15% IRR, and a 2.5x is roughly 20%. Knowing those landmarks lets you sanity-check a deal without a calculator.

The paper LBO

The "paper LBO" is the interview's favorite LBO test: build the whole thing on a sheet of paper (or out loud) with round numbers. Here's the canonical run:

1. Entry. Buy a company with $100** of EBITDA at a **10x** multiple → **$1,000 purchase price. Fund $600** with debt, **$400 equity.
2. Grow. Hold 5 years; grow EBITDA from $100** to **$150 (say, 8–10% a year, kept clean).
3. Pay down debt. Free cash flow over the hold sweeps the debt from $600** down to **$300.
4. Exit. Sell at the same 10x multiple → $150 × 10 = **$1,500** enterprise value. Subtract the remaining $300** of debt → **$1,200 of exit equity.
5. Returns. $1,200 /$400 = 3.0x MOIC over 5 years — well north of a 20% IRR.

Notice the three levers that created value: EBITDA growth, debt paydown, and (here, neutral) multiple expansion. Those are the only three ways an LBO makes money.