Walk me through a paper LBO. A sponsor buys a company with $100 million of EBITDA at 10 times, funded 60% with debt. EBITDA grows to $150 million over five years, no debt is paid down, and it sells at 10 times.

Go in order: purchase price, debt and equity, exit value, the debt still owed, equity at exit. Here $900 million back on $400 million is 2.25 times, about 17.6% a year, and the whole gain comes from EBITDA growth.

The numbers, step by step

All figures in millions. No fees, no cash at entry or exit, interest paid from cash flow, exit at the end of year five.

Purchase price$100 × 10

$1,000 million

Debt$1,000 × 60%

$600 million

Sponsor equity$1,000 − $600

$400 million

Exit enterprise value$150 × 10

$1,500 million

Exit equity$1,500 − $600

$900 million

Multiple of money$900 ÷ $400

2.25 times

IRR2.25^(1/5) − 1

about 17.6%

Gain from EBITDA growth($150 − $100) × 10

$500 million

What the interviewer listens for

• Do you set out the price, the debt and the equity before anything else?
• Do you subtract the debt at exit to get the sponsor's equity?
• Do you get to 2.25 times and an IRR of about 17 to 18%?
• Can you say where the return came from?

Common mistakes

• Measuring the multiple on enterprise value, $1,500 million over $1,000 million, which is 1.5 times.Returns are measured on the sponsor's equity.
• Dividing the gain by five and calling it 25% a year.Returns compound, so 2.25 times in five years is about 17.6%.
• Forgetting to take the $600 million of debt off the exit value.
• Stopping at the rule of thumb with no check.Interpolate between the anchors, then test it, for example 1.175 to the fifth.

Likely follow-ups

• What if it sells at 9 times instead?The exit value is $1,350 million and the equity $750 million, so about 1.9 times and roughly a 13% IRR. One turn lower costs $150 million of equity.
• What exit multiple do you need for 2 times your money?$800 million of equity plus $600 million of debt is $1,400 million of enterprise value. Over $150 million of EBITDA that's about 9.3 times.
• What if the deal were funded 50% with debt?Equity is $500 million and exit equity $1,000 million, so exactly 2 times and about a 15% IRR. Less leverage, lower return on the same business.

More finance technicals

• What is a leveraged buyout, and why use so much debt?
• How does a private equity firm exit an investment?
• In an LBO, what happens to returns if the exit multiple is one turn lower than the entry multiple?
• How do you back into the most a sponsor can pay for a company if it needs a 20% IRR?
• What is a cash sweep in an LBO?

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