Walk me through a basic LBO.

In an LBO, a private equity firm buys a company using a large share of debt, improves it over a few years, and sells it. The first step is the purchase price and the sources and uses. I'd assume an entry multiple of EBITDA to get the price. The uses are the purchase price plus fees, and the sources are the different layers of debt plus the sponsor's equity, which fills the gap. Then I'd project the company's cash flows for about five years. The company uses its free cash flow to pay down the debt. That's the cash left after interest, taxes, capital expenditures and working capital. At the end I assume an exit, usually a sale. I'd apply a multiple to year five EBITDA to get an exit enterprise value, and after subtracting the remaining net debt I get the sponsor's equity proceeds. Comparing those proceeds with the equity invested gives the two return measures, IRR and multiple of invested capital.

In an LBO, a private equity firm buys a company using a large share of debt, improves it over a few years, and sells it. The debt is what makes the returns work, because the firm puts in less of its own money. The first step is the purchase price and the sources and uses. I'd assume an entry multiple of EBITDA to get the price. The uses are the purchase price plus fees, and the sources are the different layers of debt plus the sponsor's equity, which fills the gap. Then I'd project the company's cash flows for about five years. The company uses its free cash flow to pay down the debt. That's the cash left after interest, taxes, capital expenditures and working capital. So I'd build the income statement down to net income, get to free cash flow, and run a debt schedule year by year. At the end I assume an exit, usually a sale. I'd apply a multiple to year five EBITDA to get an exit enterprise value, and after subtracting the remaining net debt I get the sponsor's equity proceeds. Comparing those proceeds with the equity invested gives the two return measures, IRR and multiple of invested capital. Returns come from three places: paying down debt, growing EBITDA, and selling at a higher multiple than you paid. As a rough check, doubling your money in five years is about a 15% IRR, and tripling it is about 25%.