The LBO: everything you need to know to excel in interviews

The Leverage Buy-Out (LBO) is a financial strategy that enables the acquisition of a company using a significant amount of debt. It relies on financial leverage to maximize the return on equity invested by shareholders.

LBO Structure: Creation of the NewCo

When a private equity fund or an acquirer seeks to buy a company through an LBO, an intermediate holding company, known as NewCo, is created. This structure plays a key role in securing the necessary debt for the acquisition and ensuring repayment through the target company’s cash flows.

Steps in the LBO process:

1. NewCo is created as the acquisition vehicle.

2. NewCo takes on significant debt to finance the target’s purchase.

3. The target company is acquired by NewCo.

4. Future cash flows of the target are used to progressively repay the debt.

Types of debt used in LBOs

LBO financing relies on different types of debt, structured according to priority and risk level:

• Senior Debt: The safest and most prioritized debt, often provided by commercial banks. It typically represents 50-60% of total financing

• Mezzanine Debt: A hybrid between debt and equity, carrying a higher interest rate. It may include instruments such as convertible bonds or warrants

• Unitranche Debt: A single instrument that combines senior and mezzanine debt, simplifying the financing structure

• PIK (Payment in Kind) Debt: Interests are capitalized and paid in full at maturity rather than periodically.

Financial Leverage: EBITDA Multiples

The debt ratio in an LBO is commonly assessed using the debt-to-EBITDA multiple, which varies based on market conditions and the target company’s profile:

• A multiple of 3 to 5x EBITDA is standard for mid-sized companies

• In stable industries with predictable cash flows, this multiple can be higher

Additionally, the equity-to-EBITDA multiple is analyzed to determine the shareholders’ contribution to the financing. Maintaining a balanced debt-to-equity ratio is crucial for a successful LBO.

Key profitability metrics: IRR and MoM

Two critical indicators measure the performance of an LBO:

• IRR (Internal Rate of Return): This metric assesses the annualized return of the investment, considering cash flows and the exit price. Private equity firms typically seek an IRR above 20%.

• MoM (Multiple of Money): It represents the total return on invested capital. For instance, a MoM of 2.5x means that every euro invested generated 2.5 euros at exit.

The ideal LBO candidate

The best-suited companies for LBOs share specific characteristics that make debt financing viable and attractive to investors. Key criteria include:

• Strong cash flow generation
• High profitability and stable EBITDA
•  Low capital expenditure (Capex-light business model)
• Strong competitive position and market barriers to entry
• Moderate pre-existing debt levels

Example of an ideal LBO target: A SaaS company with recurring revenue, high margins, and minimal Capex requirements.

LBOs are a powerful acquisition and value-creation tool, efficiently combining debt financing and operational performance. However, they require rigorous debt management and strong execution to generate attractive returns for investors.