LBO basics

14 min read

Read firstDebt schedules and circularity. Valuation without accounting is memorization.

Buy a company mostly with borrowed money, use the company's own cash flow to repay the borrowing, sell it a few years later. The return comes from three places, only two of which anyone controls, and the is the tool that tells you which one you actually relied on.

Sources and uses

The table that opens every buyout. Where the money comes from on one side, what it pays for on the other, and the two columns are equal by construction. The sponsor equity line is usually the plug.

A $200M EBITDA business at 9x, funded with 5 turns of debt$ millions

	Amount
Debt raised (5.0x EBITDA)	1,000
Sponsor equity	845
Total sources	1,845
Purchase enterprise value (9.0x)	1,800
Transaction fees (2.5%)	45
Total uses	1,845

$845M of equity buys a $1,800M business. That ratio is the whole idea, and it works in both directions.

The returns bridge

Where the equity gain came from. Four buckets that sum exactly to the total, because the attribution is derived rather than plugged.

The algebra behind the bridge

E_1 - E_0 = \underbrace{(D_0 - D_1)}_{\text{deleveraging}} + \underbrace{M_0(B_1 - B_0)}_{\text{growth}} + \underbrace{B_1(M_1 - M_0)}_{\text{multiple}} - \text{fees}

Exit equity less entry equity equals the debt repaid, plus the extra EBITDA valued at the entry multiple, plus the exit EBITDA revalued at the change in multiple, less the fees. The four terms add to the total exactly, so a bridge with a residual line has a mistake in it.

What happens with no growth at all

Set growth to zero, change nothing else, and the same deal still returns 1.05x and 0.9%. The business did not improve by a dollar. All of it came from $86Mof debt repaid with the company's own cash.

That is the mechanism, stripped of narrative. Leverage plus time plus cash generation produces an equity return whether or not anything gets better. It also explains why the industry is so sensitive to the : at a much higher interest rate the same business repays much less, and the deleveraging bucket shrinks.

Build one

Assumptions

Entry EBITDA

Entry multiple

Leverage

Turns of entry EBITDA

Interest rate

Fees, % of EV

EBITDA growth

Cash conversion

EBITDA available after capex and working capital, before interest and tax.

Tax rate

Hold period

Exit multiple

Convention: cash available to repay debt is EBITDA times cash conversion, less interest, taxed at the rate above. That is a simplification of a real debt schedule, and naming it means you can reproduce every number here by hand.

Sources and uses

At close$ millions

	Amount	% of total
Debt raised	1,000	54.2%
Sponsor equity	845	45.8%
Total sources	1,845	100.0%
Purchase enterprise value	1,800
Fees	45
Total uses	1,845

Debt paydown

Simplified schedule$ millions

	Y1	Y2	Y3	Y4	Y5
EBITDA	212	225	238	252	268
Interest	negative 90	negative 88	negative 86	negative 83	negative 79
Cash for paydown	20	27	34	42	51
Debt repaid	20	27	34	42	51
Ending debt	980	954	920	878	826

Returns

Returns bridge

Where the money came from. Three of these four are the story, and only two of them are within a sponsor's control.

DeleveragingDebt repaid with the company's own cash flow

$174M

EBITDA growthExtra profit valued at the entry multiple

$609M

Multiple changeExit EBITDA revalued at the change in multiple

$0M

FeesTransaction costs the sponsor funded at close

-$45M

Equity createdExit equity less the check written at close

$737M

The four buckets sum to $737M against a total of $737M. They add up exactly because the attribution is derived algebraically rather than plugged, and there is a test that runs 200 randomized assumptions through it to keep it that way.

IRR against MoIC

The same money, different time

	MoIC	Years	IRR
Fast and smaller	2.2x	3	30.1%
Slow and larger	3.0x	7	17.0%
Same money, faster	3.0x	5	24.6%

ignores time completely. is time-sensitive and assumes you can reinvest at the same rate, which a fund often cannot. Funds quote both because each hides what the other reveals.

Test yourself

01Why does leverage increase equity returns?

Because the enterprise value grows on the whole business while the debt is fixed in nominal terms, so every dollar of appreciation and every dollar of debt repaid accrues to a smaller equity base. The follow-up is what happens when the business underperforms, and the answer is the same mechanism in reverse: the loss lands entirely on the equity, and a 20% fall in enterprise value on a 5x levered deal can wipe out most of the equity check.

02What makes a good LBO candidate?

Predictable cash flow above everything else, because the debt service is contractual. Then low capital intensity so cash converts, a defensible market position, assets that can be pledged, and a credible exit. Cyclical, capital-hungry, or fast-changing businesses are poor candidates regardless of how cheap they look, because the debt does not care what year of the cycle it is.

03A 3.0x over seven years or a 2.2x over three?

The 2.2x, on IRR. 3.0^(1/7) - 1 is 17.0% a year; 2.2^(1/3) - 1 is 30.1%. The 3.0x returns more money and takes more than twice as long to do it. Which you prefer depends on whether you can redeploy the capital, which is exactly why a fund quotes both figures and why neither alone is enough.

A tutor that knows this lesson. It asks before it explains, and it will not tell you what to do with your own money.

Every figure in this lesson that names a company comes from Target Corporation's Form 10-K for Fiscal 2025, the year ended 2026-01-31, filed 2026-03-11. Educational material, not investment advice.