What Is a Leveraged Buyout (LBO)? How It Works

Search Fintrev

Search our guides, reviews and glossary.

A leveraged buyout (LBO) is the acquisition of a company paid for mostly with borrowed money, usually through loans and bonds, with the target company’s own assets and future cash flows backing that debt. The buyer, typically a private equity firm, contributes a smaller slice of equity and relies on the acquired business to generate the cash that services and repays the borrowing. Because the equity check is small relative to the purchase price, the buyer can control a much larger company than its own capital would allow.

How a Leveraged Buyout Works

In an LBO, the buyer builds a capital structure that leans heavily on debt. How much debt the deal can carry depends on credit market conditions, lender and investor appetite, and the cash the business is expected to produce after the takeover. The debt is commonly layered: senior bank loans with first claim on assets, then bonds or other junior debt that pays higher interest. Because the company carries a high debt-to-equity ratio, LBO bonds are usually below investment grade, often called high-yield or junk bonds.

The debt sits on the acquired company’s balance sheet, not the sponsor’s. The target’s assets serve as collateral and its operating cash flow pays the interest and principal, so the business effectively funds a large part of its own purchase.

Where the returns come from

Equity investors in an LBO make money in three ways:

1. Deleveraging. As cash flow repays debt, the share of enterprise value belonging to equity holders grows, even if the company’s total value stays flat.
2. Operational improvement. Cutting unnecessary costs, raising prices or growing sales increases earnings, which raises the company’s value.
3. Multiple expansion. Selling the business at a higher valuation multiple than the purchase multiple adds value on top of earnings growth.

Sponsors usually measure the outcome with the internal rate of return (IRR) and the multiple of invested capital, because both reflect the timing and size of the equity cash flows.

Exit routes

Because returns are only realized on exit, sponsors generally hold LBO investments for about 5 to 7 years. Common exits include:

• An initial public offering that takes the company public again
• A sale to a competitor or other strategic buyer
• A sale to another private equity firm, often called a secondary buyout

Example of a Leveraged Buyout

Hypothetical example. Figures are illustrative and ignore fees, taxes and interest timing.

A sponsor buys a company with $50 million of EBITDA at 8 times EBITDA, an enterprise value of $400 million. It funds the deal with $240 million of debt (60%) and $160 million of equity (40%).

Over five years, the company grows EBITDA to $65 million and uses $100 million of free cash flow to cut debt to $140 million. The sponsor sells at the same 8x multiple:

• Exit enterprise value: $65 million × 8 = $520 million
• Equity value: $520 million − $140 million debt = $380 million
• Return: $380 million ÷ $160 million = 2.4x, roughly a 19% annual IRR

The $220 million gain splits into $120 million from EBITDA growth (an extra $15 million × 8) and $100 million from debt paydown. If the exit multiple rises to 9x, equity is worth $445 million, about 2.8x and an IRR near 23%.

Compare an all-equity purchase of the same company at $400 million. The exit value of $520 million plus $100 million of accumulated cash returns $620 million, about 1.55x or a 9% IRR. Leverage turned the same operating result into more than double the annual return.

It works in reverse too. If EBITDA falls to $40 million, the exit multiple slips to 7x and only $40 million of debt has been repaid, the enterprise value is $280 million, debt is $200 million, and the equity is worth $80 million: half of the original investment gone.

An LBO model is the spreadsheet version of this exercise. It projects the target’s cash flows, debt schedule and exit value to show what purchase price and leverage a required return can support. Unlike a discounted cash flow (DCF) valuation, which estimates intrinsic value, an LBO model works backward from a financial buyer’s target return.

When Companies Use an LBO

LBOs are used to take a public company private, to buy a division that a parent company wants to spin off or sell, and to transfer ownership of private businesses, including changes in small business ownership. In a management buyout (MBO), a form of LBO, the company’s existing managers are among the buyers, usually alongside a sponsor.

What Makes a Good LBO Candidate

Sponsors tend to target mature companies in stable industries rather than early-stage or speculative businesses, looking for:

• Predictable operating cash flow to cover interest and repay principal
• Established product lines and market position that limit revenue swings
• A strong management team able to run a leaner business under debt
• Room for improvement in costs or margins
• A viable exit, so the gain can actually be realized
• Assets that lenders will accept as collateral

Notable Leveraged Buyouts

One of the largest LBOs was the 2006 acquisition of hospital operator Hospital Corp. of America (HCA) by KKR, Bain and Merrill Lynch, valued at around $33 billion. Large deals became scarcer after the 2008 financial crisis and returned in the early 2020s: in 2021 a Blackstone-led group agreed to buy medical supply maker Medline at a $34 billion valuation, and in January 2022 Vista Equity Partners and Elliott Investment Management agreed to acquire software company Citrix Systems for $13 billion.

Limitations and Criticism

• Financial fragility. High fixed interest costs leave little cushion if revenue drops or rates rise, raising the risk of default or bankruptcy.
• Refinancing risk. Debt that comes due during a downturn may be expensive or impossible to roll over.
• Pressure to cut. Sponsors need to raise margins quickly, so LBOs are often associated with aggressive cost reduction, including layoffs, which has given private equity a reputation for being predatory.
• Target’s limited say. The target’s assets are pledged to fund its own takeover, and in some deals its board has little ability to resist.
• Dependence on the exit. Much of the projected return relies on selling at a good multiple, which the sponsor does not control.

FAQs

The Bottom Line

LBOs matter to private equity investors, lenders, and the owners, managers and employees of companies that sponsors target. Heavy borrowing can more than double equity returns when a stable business grows and pays down debt. The same leverage can wipe out half the equity if earnings and the exit multiple fall, so predictable cash flow and a viable exit are central to any deal.