Leveraged buyouts
By the end of this lecture you will be able to
- Explain how leverage turns a modest business return into a large equity return, and what it costs in risk
- Solve a paper LBO in three minutes, out loud, with IRR rules of thumb
- Build an LBO model: sources and uses, debt tranches with amortisation and cash sweep, interest, exit, MOIC and IRR
- Split equity value creation into EBITDA growth, multiple expansion and deleveraging, and explain why returns are so sensitive to entry and exit multiples
- Describe the debt stack, covenants, dividend recaps and management incentives, and what makes a good LBO candidate
A leveraged buyout is a house bought with a large mortgage, where the house pays its own mortgage. Private equity funds have built a trillion-dollar industry on this idea. Today you will learn to value one on the back of an envelope in three minutes, as interviewers will ask you to, then build the full model a deal team runs, and see where the returns really come from and how they can go wrong.
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Interview questions on this lecture
Walk me through an LBO.
A sponsor buys a company with debt and equity, set out in sources and uses. You project cash flows over the holding period, using free cash flow to pay interest and repay debt. At exit, apply a multiple to final EBITDA, subtract remaining net debt to get equity value, and compare it with the equity invested to compute MOIC and IRR.
What makes a good LBO candidate?
Stable, predictable cash flows to service the debt, low capex and working capital needs, a strong market position, room to cut costs or improve margins, assets that can support borrowing, little existing debt, a capable management team, and a credible exit through a sale or IPO within about five years.