LBO (basic) Flashcards
(18 cards)
- Walk me through a basic LBO model.
An LBO (Leveraged Buyout) model shows how a private equity firm acquires a company using a large amount of debt and a smaller amount of equity, aiming to generate a strong return (IRR) upon exit.
Step-by-step structure:
1. Make transaction assumptions
* Purchase price (usually based on an EBITDA multiple)
* Debt and equity mix — e.g., 60% debt / 40% equity
* Interest rate on debt, fees, and repayment schedule
2. Create a financial forecast (typically 5–7 years)
* Project Revenue, EBITDA, and Free Cash Flow
* Estimate debt repayment and interest expense each year
* Assume minimal or no dividend payments
3. Build a debt schedule
* Track how much debt is outstanding each year
* Include:
o Interest expense
o Mandatory repayments
o Optional prepayments using excess cash flow
4. Calculate exit assumptions
* Assume an exit year (e.g., Year 5)
* Apply an exit multiple (e.g., 8× EBITDA) to calculate exit Enterprise Value
* Subtract remaining debt and add cash to get Equity Value at exit
5. Calculate IRR and MoIC
* Use the initial equity investment and the exit equity value to calculate:
o IRR (Internal Rate of Return)
o MoIC (Multiple of Invested Capital)
- Why would you use leverage when buying a company?
Leverage (i.e. using debt) is used in an LBO to boost returns for the private equity firm (the financial sponsor).
Why leverage helps:
1. Lower upfront equity investment
* The PE firm puts in less of its own money
* Debt covers most of the purchase price (often 60–80%)
2. Higher return on equity
* If the company performs well and is sold at a higher value, the firm earns a greater return on a smaller initial equity outlay
3. Debt is cheaper than equity
* Interest on debt is tax-deductible, lowering the company’s effective cost of capital
* Equity investors demand higher returns than lenders
Simple analogy:
Buying a house:
If you pay £100K in cash and it increases to £150K → 50% return
But if you borrow £80K and invest only £20K of your own money → sell for £150K, repay £80K
→ You now have £70K → 3.5× return on your £20K
- What variables impact an LBO model the most?
Purchase Price (Entry Multiple)
* The higher the price paid, the lower the return, all else equal
* A lower entry multiple means the PE firm pays less for each $1 of EBITDA → better upside
2. Exit Multiple
* The assumed exit EBITDA multiple at the end of the investment period
* If the firm sells at a higher multiple than it paid → large boost to IRR
* If the multiple contracts → returns drop sharply
3. Leverage (Debt Amount and Structure)
* More debt = less equity invested → potentially higher IRR
* But too much debt increases financial risk and limits flexibility
4. EBITDA growth / Operational performance
* Higher EBITDA leads to:
o A higher exit value (since EV = EBITDA × multiple)
o More free cash flow to repay debt
o Stronger return profile
5. Debt repayment schedule and interest costs
* Faster debt paydown improves equity value at exit
* Lower interest rates reduce cash outflows, increasing free cash flow and IRR
- How do you pick purchase multiples and exit multiples in an LBO model?
Both the purchase multiple and exit multiple (typically EV/EBITDA) are key assumptions that have a major impact on returns — so they must be chosen carefully.
1. Purchase multiple (entry multiple):
Based on:
* Precedent transactions involving similar companies
* Public trading multiples of comparable companies
* Industry norms and current market conditions
Adjusted for:
* Company size, growth, and risk
* Negotiation and deal structure
Example:
If comparable companies are trading at 8× EBITDA, the PE firm may negotiate to buy the target at 7× or 9×, depending on competition and outlook.
2. Exit multiple:
Often set equal to or slightly lower than the purchase multiple
A conservative model assumes “no multiple expansion” (i.e. same entry and exit multiple)
If the PE firm believes:
* Market conditions will improve → assume higher exit multiple
* Valuations may contract → assume lower exit multiple
Example:
If the entry multiple was 8×, a model might test exit multiples of 7×–9× to see how sensitive IRR is to market conditions.
- What is an “ideal” candidate for an LBO?
An ideal LBO target is a company that can support high leverage and generate strong returns without excessive risk. PE firms look for companies that are stable, cash-generative, and undervalued.
Key characteristics of an ideal LBO candidate:
1. Strong, predictable cash flows
* Reliable free cash flow is needed to service and repay debt
* Recurring revenue models are ideal (e.g. subscription, B2B services)
2. Low existing debt
* Gives the PE firm room to add new debt
* Companies with little or no leverage are more attractive
3. Stable, defensible business model
* Low volatility in revenue and earnings
* Strong market position, loyal customers, or high switching costs
4. Potential for operational improvement
* Opportunities to cut costs, increase margins, or drive growth
* PE firms often improve performance through efficiency and strategic focus
5. Clear exit opportunities
* Likely to attract strategic buyers or be suitable for an IPO after 3–7 years
* Exit optionality boosts the chance of a strong return
Bonus traits:
* Asset-light or capital-efficient business
* Experienced management team (or ability to install new one)
- How do you use an LBO model to value a company, and why do we sometimes say that it sets the “floor valuation” for the company?
An LBO model can be used to value a company by determining the maximum price a private equity firm can pay while still hitting its target return (IRR) — usually 20–25%.
How it works:
1. Input a target IRR (e.g. 20%)
Assume:
* Purchase price
* Leverage (debt % and terms)
* Holding period (e.g. 5 years)
* Exit multiple (e.g. 8× EBITDA)
2. Solve for the purchase price that gives exactly that IRR
→ This becomes the maximum price a PE firm could justify paying
Why it’s called the “floor valuation”:
Strategic buyers (corporates) may be willing to pay more because:
* They can realise synergies
* They don’t need to hit a strict IRR
* They may have longer-term goals
But a financial buyer (PE firm) is purely return-focused
→ So the LBO sets the lowest valuation that makes financial sense in a deal
→ Thus, it’s often called the “floor” valuation
- Give an example of a “real-life” LBO.
A well-known real-life LBO example is the 2007 acquisition of Hilton Hotels by Blackstone.
Deal summary:
Buyer: Blackstone Group (a leading PE firm)
Target: Hilton Hotels Corporation
Purchase price: ~$26 billion
Financing:
~$5.6 billion in equity
~$20+ billion in debt
→ Classic LBO structure: ~80% debt, ~20% equity
Exit:
Hilton went public again via IPO in 2013
Blackstone eventually exited with over $14 billion in profit
Why it’s a textbook LBO:
* Blackstone used significant leverage to fund the deal
* Focused on improving operations and cutting costs
* Benefited from a market recovery and IPO exit
* Achieved a high IRR and MoIC on its equity investment
Other famous LBO examples:
Dell (2013) – Michael Dell and Silver Lake took Dell private in a $24B LBO
Heinz (2013) – Berkshire Hathaway and 3G Capital acquired Heinz for $28B
Toys “R” Us (2005) – KKR, Bain, and Vornado bought it in a high-profile LBO (which later failed)
Alternative success:
1. Dunkin’ Brands – Successful LBO + IPO Exit
Deal summary:
Buyer: Bain Capital, Carlyle Group, and Thomas H. Lee Partners
Target: Dunkin’ Brands (owner of Dunkin’ Donuts and Baskin-Robbins)
Purchase price: ~$2.4 billion in 2006
Financing: Significant debt (~70% debt, 30% equity typical)
Exit: IPO in 2011, then sold to Inspire Brands in 2020 for $11.3B
Return: Strong IRR and MoIC for the sponsors
Why it succeeded:
* Resilient brand with stable cash flow
* Focused on franchise model → asset-light and scalable
* Successful cost control and growth strategy post-buyout
* Strong public market interest in consumer brands
Alternative failure:
Toys “R” Us – Famous Failed LBO
Deal summary:
Buyer: KKR, Bain Capital, and Vornado Realty Trust
Target: Toys “R” Us
Purchase price: ~$6.6 billion in 2005
Financing: Over $5 billion of debt (~80% debt, 20% equity)
Exit attempt: Filed for IPO in 2010 and again later — never completed
Final outcome: Filed for bankruptcy in 2017 and liquidated most U.S. operations
Why it failed:
* Excessive leverage
o The company started with $5B+ in debt, and interest payments ate into profits
o It had little room to invest in operations or innovation
* E-commerce disruption
o Couldn’t compete with Amazon and Walmart, which offered toys online with lower prices and faster delivery
o Failed to build an effective digital presence
* Operational neglect
o Most cash flow went to servicing debt, not improving stores or customer experience
o Stores became outdated and uncompetitive
* No successful exit
o The business stagnated, and the IPO was repeatedly shelved
o Eventually filed for Chapter 11 and was broken up
- Can you explain how the Balance Sheet is adjusted in an LBO model?
Yes — in an LBO, the Balance Sheet undergoes several key changes at the time of the transaction to reflect the new ownership and capital structure.
Step-by-step Balance Sheet adjustments in an LBO:
1. Wipe out the target’s existing equity
* The target’s existing shareholders are bought out, so their equity is removed
* The new equity from the private equity firm is recorded instead
2. Add new debt
* The debt used to finance the acquisition is added to the Balance Sheet
* This increases the liabilities side, often substantially
3. Create or adjust Goodwill and Intangibles
* The purchase price is usually higher than the book value of net assets
* The difference becomes Goodwill and Other Intangible Assets
4. Adjust cash
* If cash was used to finance part of the deal, the cash balance is reduced
5. Add transaction and financing fees
* Transaction fees (e.g. legal, advisory) are usually expensed immediately
* Financing fees (e.g. for issuing debt) are capitalised and amortised over the life of the loan
6. Update capital structure
* The new Balance Sheet reflects:
o New debt
o New equity (from the PE firm)
o Reduced cash
o New intangible assets
- We saw that a strategic acquirer will usually prefer to pay for another company in cash – if that’s the case, why would a PE firm want to use debt in an LBO?
A PE firm uses debt not out of necessity, but by design — because it’s the key to amplifying returns in a leveraged buyout.
Key reasons why PE firms prefer debt in LBOs:
1. Boosts return on equity (IRR)
* The less equity the firm puts in, the higher the potential return if the company grows in value
* Debt magnifies the upside (and risk), allowing strong equity multiples even with modest performance
2. Limits the PE firm’s capital at risk
* The firm commits less of its own capital, freeing it up for other investments
* If the investment underperforms, losses are smaller in dollar terms
3. Interest is tax-deductible
* Debt interest creates a tax shield, reducing taxable income and increasing cash flow
* Makes debt an efficient form of financing
4. Debt provides discipline and forces cash generation
* Having regular debt repayments pushes the company to:
* Focus on efficiency and profitability
* Avoid wasteful spending or unnecessary reinvestment
- Let’s say we’re analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?
- Leverage Ratio: Debt / EBITDA
This tells you how many times the company’s EBITDA covers its total debt. It’s the primary way to size the initial debt load.
Typical range:
3.0× – 4.0× for conservative deals
5.0× – 6.0× for more aggressive sponsor-backed LBOs
Sometimes even higher (6.5×+) in frothy credit markets - Interest Coverage Ratio: EBITDA / Interest Expense
This shows whether the company can afford to pay interest on the debt — a key check for lenders.
Typical range:
> 2.0× is the minimum threshold for comfort
2.5× – 3.0× is common in well-structured LBOs
Lower than 2.0× raises red flags about financial risk
Other factors to consider:
* Industry norms — stable, cash-rich industries (e.g. utilities, business services) can handle higher leverage
* Cash flow visibility — the more predictable the cash, the more debt it can support
* Debt type and terms — more flexible structures (e.g. high-yield bonds) may allow higher leverage but come at a higher cost
- What is the difference between bank debt and high-yield debt?
Bank debt and high-yield debt are both used in LBOs, but they differ in cost, risk, flexibility, and structure.
Bank Debt (a.k.a. Senior Debt or Term Loans)
* Lower interest rate (typically floating, like LIBOR/SOFR + spread)
* Shorter maturity (usually 5–7 years)
* Secured by company assets
* Often includes maintenance covenants (e.g. minimum EBITDA, leverage ratio)
* Requires amortisation (principal repaid over time)
High-Yield Debt (a.k.a. Subordinated Debt or Junk Bonds)
* Higher interest rate (typically fixed, 7%–10% or more)
* Longer maturity (often 7–10 years)
* Unsecured or subordinated — paid after senior debt in bankruptcy
* Usually has incurrence covenants only (e.g. can’t issue more debt above a threshold)
* No amortisation — repaid as a lump sum at maturity
- Why might you use bank debt rather than high-yield debt in an LBO?
You might choose bank debt over high-yield debt when you want lower borrowing costs and are willing to accept stricter terms.
Key reasons to use bank debt:
1. Lower interest rates
* Bank debt is typically cheaper (floating rates + small spread)
* Helps maximise cash flow available for debt repayment or reinvestment
2. More senior and secured
* Bank lenders are first in line if the company defaults
* Lenders are more comfortable lending larger amounts at lower cost
3. Amortisation reduces risk over time
* With regular repayments, the company gradually reduces debt burden
* Good for more conservative capital structures
4. Less risky businesses can support tighter terms
* In industries with stable, predictable cash flow, covenants are less of a concern
* Bank lenders are comfortable imposing tighter conditions
- Why would a PE firm prefer high-yield debt instead?
A private equity firm might choose high-yield debt in an LBO when it values flexibility and delayed repayment more than low interest cost.
Key reasons to use high-yield debt:
1. More operational flexibility
* High-yield bonds usually have incurrence covenants only (e.g. can’t issue more debt above a certain level)
* No maintenance covenants like bank debt (e.g. no need to maintain leverage ratios each quarter)
2. No amortisation required
* The company doesn’t have to repay principal over time — just pays interest until maturity
* → More cash available in the early years for:
o Expansion
o Acquisitions
o Strategic investments
3. Longer maturity
* Typically 7–10 years, providing a longer runway before refinancing or repayment is needed
4. More appropriate for higher-risk or cyclical companies
* If the company’s cash flows are less predictable, high-yield debt avoids the pressure of tight covenants and fixed repayment schedules
- Why would a private equity firm buy a company in a “risky” industry, such as technology?
A private equity firm might invest in a “risky” industry like tech if it sees strong potential for outsized returns that justify the higher risk.
Key reasons:
1. High growth potential
* Riskier industries often offer faster revenue and EBITDA growth
* Even modest improvements in performance or valuation multiples can drive strong returns
2. Valuation arbitrage
* The PE firm may identify undervalued or overlooked assets
* It may believe the company can grow into a higher valuation multiple (e.g. from 8× to 12× EBITDA)
3. Operational improvement opportunity
* The company may be poorly managed or lacking strategic focus
* → The PE firm brings in a new management team or optimises operations
4. Platform strategy / roll-ups
* PE may buy a risky but scalable “platform” business and bolt on smaller acquisitions to build scale and reduce risk
5. Access to innovation and disruption
* Investing in riskier sectors (like tech, fintech, healthtech) gives PE firms exposure to future industry winners
* May result in a very high return on one successful exit, even if others underperform
But they’ll typically:
* Use less leverage (to reduce financial risk)
* Structure the deal to limit downside
* Focus on cash-flowing or proven tech businesses (not early-stage)
- How could a private equity firm boost its return in an LBO?
A PE firm can boost its return (IRR and MoIC) by improving cash flow, valuation, and capital structure — either by growing the business or optimising the deal.
Main ways to boost LBO returns:
1. Grow EBITDA
* Increase revenue through organic growth or M&A
* Improve margins by cutting costs or increasing efficiency
* → Higher EBITDA = higher exit value (since EV = EBITDA × multiple)
2. Reduce the purchase price (entry multiple)
* Negotiate a lower valuation
* Enter during market downturns or buy underperforming assets at a discount
→ Lower upfront cost boosts MoIC and IRR
3. Raise the exit multiple
* Sell the company for a higher multiple than it was acquired at
* Can be achieved through:
o Improved business quality
o Better market conditions
o Stronger investor appetite at exit
4. Use more debt (leverage)
* Higher leverage = less equity invested
* Magnifies returns if the business performs well
* Riskier — so must be used carefully
5. Accelerate debt repayment
* Use excess cash flow to pay down debt quickly
* Reduces interest costs and increases equity value at exit
6. Dividend recapitalisations
* Extract cash during ownership (via new debt) without waiting for an exit
* → Increases cash return to the PE firm before the exit happens
- What is meant by the “tax shield” in an LBO?
The tax shield in an LBO refers to the reduction in taxable income that results from interest expense on debt. Because interest is tax-deductible, using debt creates a tax benefit — which improves cash flow and boosts returns.
Why it matters:
* In an LBO, the PE firm uses a large amount of debt to fund the acquisition
* That debt generates interest payments, which are deducted from EBIT to calculate taxable income
* This reduces the company’s tax bill and increases net cash flow
Example:
EBIT = $100 million
Interest expense = $40 million
Tax rate = 25%
Without debt:
→ Taxable income = $100M → Tax = $25M
With debt:
→ Taxable income = $60M → Tax = $15M
Tax shield = $10M → cash saved due to interest deductibility
Why it helps PE returns:
* More post-tax cash flow available for debt repayment and value creation
* Improves IRR and reduces the burden of financing
- What is a dividend recapitalization (“dividend recap”)?
A dividend recapitalization (or dividend recap) is when a private equity firm takes cash out of a portfolio company by having the company issue new debt and use the proceeds to pay a dividend to the PE owner.
How it works:
1. The portfolio company borrows more money (raises new debt)
2. It uses that cash to pay a special dividend to the PE firm
3. The company’s equity value doesn’t change immediately, but it now has more debt on the Balance Sheet
Why PE firms do it:
* To realise some return before the final exit
* To recover part of their initial investment early
* Useful when market conditions are favourable and the company can borrow cheaply
Risks:
* Increases the company’s leverage and financial risk
* May reduce flexibility or affect credit ratings
* Could weaken the company’s ability to invest or weather downturns
Example:
PE firm invested $300M in equity to buy a company
After a few years, the company performs well and takes on $150M in new debt
That $150M is paid as a dividend to the PE firm — they’ve now recovered half their investment even before selling the business
- How would a dividend recap impact the 3 financial statements in an LBO?
A dividend recap affects all three financial statements, primarily by increasing debt and reducing equity, while leaving operating performance unchanged.
1. Income Statement:
No immediate change to revenue, EBITDA, or net income
But over time:
Interest expense increases due to the new debt
This reduces net income in future periods
2. Balance Sheet:
Cash decreases (used to pay the dividend)
Debt increases (newly raised to fund the dividend)
Equity decreases (since cash is returned to shareholders via dividend)
So, the capital structure becomes more leveraged (higher debt, lower equity).
3. Cash Flow Statement:
Financing activities:
Inflow: New debt raised
Outflow: Dividend paid to equity holders (PE firm)
Net cash flow ≈ zero (the inflow funds the outflow)
