LBO Mechanics Explained: How Private Equity Funds Really Make Returns
A clean, interview-ready explanation of LBO mechanics—sources & uses, debt schedules, IRR/MOIC, and the real drivers of PE returns (EBITDA growth, deleveraging, multiples)—with a worked example and sample interview Q&A.
Note
Module Reading: This article accompanies the LBO Mechanics & Intuition module in our Private Equity interview prep track.
You know what an LBO is. But do you really understand how PE funds structure them to maximize returns? This article goes beyond the textbook definition to show you the mechanics that actually matter in interviews and on the job.
What an LBO Actually Is
An LBO (Leveraged Buyout) is a company acquisition where the buyer (often a PE fund) uses a lot of debt to fund the purchase. The target's cash flows help service and repay that debt over time. The sponsor's goal is simple:
- Put in less equity upfront
- Grow equity value
- Exit in ~3–7 years with a strong MOIC (multiple) and IRR (annualized return)
The Mental Model
Think of an LBO as a controlled bet on cash flow: if the business reliably produces cash, you can safely add leverage, pay it down, and let equity value "re-rate" upward.
The One Equation That Drives Everything
At entry and at exit, this is the backbone:
Equity Value = Enterprise Value − Net Debtwhere Net Debt = Debt − Cash
EV=Enterprise Value (total business value)Net Debt=Debt minus Cash on handSo if enterprise value grows and/or net debt falls, equity value rises—often a lot, because equity is the smaller slice in a leveraged capital structure.
Sources & Uses (The Deal "Receipt")
Sources & Uses is where most interview candidates either shine or fall apart. This is the foundation of every LBO model.
Uses = What You're Paying For
Typical Uses of Funds
| Term | Definition | Note |
|---|---|---|
| Purchase Enterprise Value | The headline acquisition price | Entry multiple × EBITDA |
| Transaction Fees | Advisory, legal, diligence costs | ~1-2% of deal size |
| Financing Fees | Debt issuance/arrangement costs | Capitalized or expensed |
| Minimum Cash Balance | Cash left on balance sheet | Sometimes required |
Sources = How You Fund It
Typical Sources of Funds
| Term | Definition | Note |
|---|---|---|
| Revolver | Undrawn at close, available for working capital | Usually $0 at entry |
| Term Loan A | Senior secured, amortizing | Bank debt, lower rate |
| Term Loan B | Senior secured, bullet repayment | Institutional, slightly higher rate |
| High Yield / Notes | Unsecured or subordinated debt | Fixed rate, longer tenor |
| Mezzanine | Junior debt, often with equity kicker | Highest debt cost |
| Sponsor Equity | PE fund's cash contribution | 30-40% of deal value |
| Management Rollover | Existing management reinvests | Alignment mechanism |
Interview Tip
Always say: "Sources must equal Uses." It sounds obvious, but interviewers love candidates who treat the model like a balancing system.
A PE firm acquires a company for $500M EV. They raise $300M of debt and the seller rolls over $50M of equity. Transaction fees are $15M. How much new equity must the sponsor contribute?
What "Good" Looks Like in an LBO Target
PE firms prefer businesses that can carry debt safely:
- Stable, predictable cash flows
- Strong margins and pricing power
- Low capex and manageable working capital swings
- Defensible competitive position
- Clear operational upside
Debt Schedules (The Leverage Engine)
Debt isn't just "a number" in an LBO. The model lives or dies by the debt schedule.
The Minimum You Must Model
For each debt tranche, track:
Debt Schedule Components
| Term | Definition | Note |
|---|---|---|
| Beginning Balance | Debt outstanding at period start | |
| Mandatory Amortization | Scheduled principal paydown | Usually % of original balance |
| Optional Prepayment | Extra paydown using excess cash | Cash sweep mechanism |
| Ending Balance | Debt remaining at period end | |
| Interest Expense | Rate × average balance | May have floors/spreads |
Cash Flow Sweep (Why Equity Loves It)
If the company generates extra cash after running the business, lenders often allow (or require) that cash to pay down senior debt early. This:
- Lowers future interest expense
- Accelerates deleveraging
- Increases equity value at exit
What Candidates Forget
Debt paydown is constrained by cash availability and sometimes by covenants, minimum cash requirements, restricted payments, or prepayment penalties (especially on junior debt). Don't assume all excess cash goes to debt paydown.
A PE fund buys a company at 8x EBITDA, grows EBITDA by 50% over 5 years, pays down debt from 5x to 2x EBITDA, but exits at only 7x EBITDA (multiple compression). What happens to equity returns?
Where Returns Come From (The 3 + 1 Drivers)
In practice, PE deal returns usually come from:
1. EBITDA Growth (Operational Value Creation)
This is the most important and most controllable driver:
- Revenue growth, margin expansion, pricing power, product mix
- Cost programs, procurement savings, productivity gains
- Better go-to-market, customer retention, channel strategy
2. Multiple Expansion (Market Re-Rating)
- Buying at 8× and exiting at 10× (same EBITDA) creates huge value
- In tougher markets, multiples can compress—so ops matter more
- Never underwrite to multiple expansion in the base case
3. Deleveraging (Debt Paydown)
- Free cash flow pays down debt over the hold period
- Equity becomes a larger share of the capital structure
- At exit, less debt means more proceeds to equity
+ 1. "Smart Structuring" (Not Magic, But Real)
- Better entry price through competitive process or proprietary deal
- Better debt terms (tenor, covenants, pricing)
- Add-ons / buy-and-build strategy
- Dividend recap (if appropriate and business supports it)
The Clean Return Bridge for Interviews
Equity returns = (EBITDA growth) + (multiple change) + (debt paid down)
…and the reason it works is leverage amplifies equity outcomes—because equity is the residual claim after debt.
A company has $200M Term Loan A (5% interest, 10% annual amortization) and $100M Term Loan B (7% interest, 1% annual amortization). What is the total Year 1 interest expense AND mandatory principal payment?
A Simple Worked Example (With Real Numbers)
Let's do a clean, interview-friendly 5-year LBO example.
Entry Assumptions
Entry Setup
| Term | Definition |
|---|---|
| EBITDA (Year 0) | $100M |
| Entry Multiple | 10.0× |
| Entry EV | $1,000M |
| Debt at Entry | $600M (60% leverage) |
| Equity at Entry | $400M |
Operating & Exit Assumptions
Hold Period Assumptions
| Term | Definition |
|---|---|
| EBITDA Growth | 8% per year |
| Exit Multiple | 10.0× (flat) |
| Debt at Exit | $250M (paid down from $600M) |
| Hold Period | 5 years |
Step 1: Calculate Exit EBITDA & EV
Year 5 EBITDA = 100 × (1.08)^5 ≈ $147MExit EV = 147 × 10.0 = $1,470M
Step 2: Calculate Exit Equity Value
Exit Equity = Exit EV − Exit Net Debt = 1,470 − 250 = $1,220MAssuming minimal cash, net debt ≈ gross debt
Step 3: Calculate MOIC and IRR
Return Calculation
MOIC:
$1,220M / $400M = 3.05×
IRR (simplified, no interim dividends):
3.05^(1/5) − 1 ≈ 25.0%
What This Example Teaches
Even with no multiple expansion, equity can do very well if you get EBITDA growth + strong deleveraging. This is the most reliable path to returns.
How to "Walk Me Through an LBO" (Interview Answer)
Here's a tight, high-scoring structure:
6-Step Framework
- Set the purchase price (usually EBITDA × multiple) → compute EV and equity value
- Build Sources & Uses → decide debt vs equity mix and account for fees
- Project operating performance (revenue → EBITDA → FCF) over ~5 years
- Build debt schedules → interest + mandatory amortization + cash sweep
- Compute exit value (exit EBITDA × exit multiple) and subtract remaining debt
- Calculate returns (MOIC + IRR) and sensitize key drivers
Interview Questions + Model Answers
Key Takeaways
Key Takeaway
- LBO = acquisition funded primarily with debt—target's cash flows service and repay that debt
- Core equation: Equity Value = EV − Net Debt. If EV grows or debt falls, equity value rises
- Sources must equal Uses—the fundamental balance of deal financing
- 3+1 return drivers: EBITDA growth, multiple expansion, deleveraging, plus smart structuring
- EBITDA growth is king—controllable, compounds, affects multiple drivers
- Debt schedules matter—model beginning balance, amortization, cash sweep, interest, ending balance
- Always sensitize—exit multiple and EBITDA growth typically move returns the most
Related Reading
Continue building your LBO knowledge:
- LBO Explained Simply — The fundamentals of leveraged buyouts
- 3 Drivers of LBO Returns — Deep dive into what drives PE returns
- What Makes a Good LBO Candidate? — Characteristics PE firms look for
- Top 20 PE Interview Questions — Practice the most common PE questions