How does a leveraged buyout (LBO) model work, and what drives equity returns for the sponsor?

A leveraged buyout is an acquisition financed primarily with debt, where the target's own cash flows service and pay down that debt over time. For CFA Level II, you need to understand the mechanics and the three levers that drive sponsor returns.

LBO Structure:

A PE sponsor typically puts up 30-40% equity and borrows 60-70% of the purchase price. The target company's assets and cash flows secure the debt.

Example — Brightfield Consumer Products LBO:

Entry:

• Purchase price: $500 million (8.0x EBITDA on $62.5M EBITDA)
• Debt: $325 million (65% leverage, 6.5% interest rate)
• Equity: $175 million (35%)

Operating Assumptions (5-year hold):

• EBITDA grows from $62.5M to $82.0M (Year 5)
• Annual free cash flow after interest averages $28M
• Cumulative debt paydown over 5 years: $140M

Exit:

• Exit multiple: 8.0x EBITDA (same as entry — no multiple expansion)
• Exit EV: 8.0 x $82.0M = $656 million
• Remaining debt: $325M - $140M = $185M
• Equity at exit: $656M - $185M = $471M

Sponsor Return:

• Equity invested: $175M
• Equity at exit: $471M
• MOIC (Multiple on Invested Capital): $471M / $175M = 2.69x
• IRR over 5 years: ($471/$175)^(1/5) - 1 = 21.9%

The Three Return Drivers:

1. EBITDA Growth: Operational improvements, revenue growth, and margin expansion increase the value of the business. In our example, EBITDA grew 31%, adding ~$156M in enterprise value.

1. Debt Paydown: As the company generates free cash flow and repays debt, equity absorbs the value that previously belonged to lenders. Each dollar of debt repaid is a dollar of equity created. This accounted for $140M of value creation.

1. Multiple Expansion: If the exit multiple exceeds the entry multiple, equity gets a windfall. If Brightfield exits at 9.0x instead of 8.0x:

• Exit EV = 9.0 x $82M = $738M
• Equity = $738M - $185M = $553M
• MOIC = 3.16x, IRR = 25.9%

Key Sensitivities:

• Higher leverage amplifies both returns and risk
• Faster debt paydown accelerates equity creation
• Multiple contraction can destroy returns even with strong EBITDA growth

Exam Tip: CFA Level II questions typically give you entry assumptions and ask you to calculate exit equity value or IRR under different scenarios. Always compute debt remaining at exit by subtracting cumulative cash flow used for repayment.

Explore private equity valuation in our CFA Level II course.