Private equity
LBO and private equity questions
How a leveraged buyout actually makes money, the three levers of return, and why sponsors borrow in the first place.
LBO questions come up in private equity interviews obviously, but also in banking — leveraged finance, sponsors coverage, and any M&A group that works with financial buyers.
Walk me through an LBO
The answer
“A sponsor acquires a company using a large proportion of debt and a relatively small equity cheque — historically something like 60 to 70% debt.
The acquired company’s own cash flows service that debt. Over a hold period of roughly three to five years, the sponsor uses cash generation to pay debt down and works to improve the business operationally.
At exit — a sale, a secondary buyout or an IPO — the sponsor sells the company. Because the debt has been reduced, a larger share of the exit value belongs to the equity, which is where the return comes from.”
What drives returns in an LBO?
Three levers, and a good candidate names all three and says which matters most.
- Deleveraging. Cash flow pays down debt, so equity grows as a share of enterprise value even if the business is worth the same at exit.
- EBITDA growth. Growing revenue or improving margins increases the value of the business itself. This is the lever sponsors publicly emphasise, and the one that survives scrutiny.
- Multiple expansion. Selling at a higher multiple than you bought at. Real, but largely outside the sponsor’s control — and underwriting a deal on the assumption of it is how people lose money.
Why use debt at all?
Because it amplifies the return on the equity. If you buy a business for 100 with 30 of equity and sell it for 130 having paid down 20 of debt, your equity has gone from 30 to 50 — a far better outcome than funding the whole thing in cash. Interest is also tax-deductible, which lowers the effective cost of that capital.
The symmetry matters, and saying so is a mark of a serious answer: leverage amplifies losses just as efficiently. A business that misses its plan may struggle to service its debt, and the equity is first to be wiped out.
What makes a good LBO candidate?
Stable, predictable cash flows above all — debt service is a fixed obligation, so volatility is the enemy. Beyond that: a defensible market position, low ongoing capital expenditure requirements, assets that can support borrowing, an identifiable route to operational improvement, and a credible exit. Early-stage and deeply cyclical businesses are poor candidates for exactly the opposite reasons.
IRR versus MOIC
MOIC (multiple on invested capital) is simply exit equity divided by entry equity — 2.5x means you got two and a half times your money back. IRR is the annualised return, so it is sensitive to time: 2.0x over three years is a far better IRR than 2.0x over seven.
Sponsors care about both, and the two can disagree. A quick early exit can produce a spectacular IRR on a modest MOIC. Typical underwriting targets a 20–30% IRR over a three to five year hold — a number worth knowing precisely, because it gets asked.
Now answer them yourself
Real questions from the Basis curriculum, with the explanation after each one. No account needed.
Common follow-ups
Walk me through an LBO.
What are the three drivers of returns in an LBO?
Why do private equity firms use debt?
What makes a good LBO candidate?
What is the difference between IRR and MOIC?
Drill this properly
Basis teaches the concept first, then tests it — 98 lessons and 449 questions, free in your browser. The Career Accelerator adds DCF, M&A and LBO modules built for front-office interviews.
Start free