How a Leveraged Buyout Model Works

A leveraged buyout is a bet that a private equity firm can buy a company mostly with borrowed money, run it for five to seven years, and sell it for enough to pay off the debt and pocket a large multiple on the small slice of cash it put in itself. Sources and uses answers how the purchase is financed on day one; this page answers what happens between the purchase and the exit — the mechanics that turn a levered entry into a return.

The return comes from exactly three places. Debt paydown: the company's cash flow retires debt every year, and every dollar of debt gone becomes a dollar of extra equity value at exit, with none of it needing the business to grow at all. EBITDA growth: a bigger EBITDA at exit means a bigger enterprise value even at the same multiple. Multiple expansion (or contraction): if the exit multiple differs from the entry multiple, that gap is pure re-rating, unrelated to operating performance — and it can just as easily work against the sponsor.

$$\text{Equity value at exit} = (\text{Multiple}_{\text{exit}} \times EBITDA_{\text{exit}}) - \text{Net debt}_{\text{exit}}$$

The return is then measured two ways: MOIC (multiple of invested capital), exit equity divided by entry equity, and IRR, the annualized rate that MOIC implies over the hold period.

A worked example

Entry: EBITDA of $100m, purchase at 8.0x EV/EBITDA gives EV = $800m. Financed with $500m debt and $300m equity (sources and uses). Hold for five years.

Exit: EBITDA has grown to $130m, the sponsor exits at the same 8.0x multiple, so exit EV is $130 \times 8.0 = 1{,}040$, i.e. $1,040m. Debt has been paid down from $500m to $250m using free cash flow. Exit equity is $1{,}040 - 250 = 790$, i.e. $790m.

$$\text{MOIC} = \frac{790}{300} = 2.63\text{x}, \qquad \text{IRR} \approx 2.63^{1/5} - 1 \approx 21.4\%$$

Of the $490m equity gain, $250m came from paying down debt and $240m came from EBITDA growth at a flat multiple — no multiple expansion needed to produce a strong return.