What is a leveraged buyout, and why use so much debt?

Define it in one sentence, then explain that debt shrinks the sponsor's check while it keeps all the value above the debt, which raises returns when the business beats the after-tax cost of debt. The limit is servicing the debt in a downside.

Updated October 20, 2026

The numbers, step by step

All figures in millions. Price $1,000, $60 a year of free cash flow before interest, sale for $1,500 after five years. Debt case: $600 at 8%, 25% tax, interest held flat.

All equity: money back$1,500 + 5 × $60 of cash

$1,800 million

All equity: IRR1.8^(1/5) − 1

about 12.5%

After-tax interest$600 × 8% × (1 − 25%)

$36 million

Debt at exit$600 − 5 × ($60 − $36)

$480 million

Levered: equity at exit$1,500 − $480

$1,020 million

Levered: multiple and IRR$1,020 ÷ $400, then ^(1/5) − 1

about 21% on 2.55 times

Downside, levered equity at $800$800 − $480

$320 million on $400

What the interviewer listens for

• Can you define an LBO in one sentence?
• Do you say the smaller equity check is the main reason returns rise?
• Do you give the condition: returns above the after-tax cost of debt?
• Can you show a levered and an unlevered case with numbers?
• Do you name the limit as debt service in a downside?

Common mistakes

• Saying more debt always raises returns.It raises them only when the business earns more than the debt costs, and it magnifies losses.
• Treating the tax shield as the main reason.It helps, but the main effect is the smaller equity base.
• Forgetting that interest reduces the cash left for the equity.The levered case has less cash flow but a much smaller check.
• Saying the limit is only the interest rate.Lenders cap leverage on coverage and on the downside, and covenants bind first.

Likely follow-ups

• What's the after-tax cost of the debt here?8% times one minus 25%, so 6%.
• What if the debt cost 12% instead of 8%?Interest is $72 million, $54 million after tax, leaving $6 million a year to repay debt. Exit equity is $930 million, about 2.3 times and roughly 18%, still above the all-equity case but closer.
• Why don't sponsors use 90% debt?Interest would exceed the cash flow, lenders won't lend that much against the business, and a small fall in value would wipe out the equity.

More finance technicals

• 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?
• Walk me through a basic LBO.

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