How a leveraged buyout works

Follow the money before calculating a return

An acquisition model starts with uses of funds: what must be paid at completion? These may include the purchase consideration, refinancing existing debt and transaction fees. Sources explain how those uses are funded: new borrowing, investor equity and any other documented funding. Total sources must equal total uses.

Enterprise value describes the value of the operating business to its capital providers. Equity value is the amount attributable to shareholders after the relevant debt, cash and other adjustments. An LBO return calculation must ultimately follow cash invested and cash received by the equity investor, not simply the movement in enterprise value.

Worked example: buying the business

Assume a simplified debt-free, cash-free business has £10m EBITDA and is acquired for 8 times EBITDA: enterprise value of £80m. Fees are £4m, so total uses are £84m. New acquisition debt provides £48m and the investor contributes £36m. Sources and uses both equal £84m.

Entry debt is 4.8 times EBITDA. This ratio describes leverage, not affordability. The company must still fund interest, taxes, capital expenditure and working capital before cash is available to repay principal. EBITDA excludes several of those cash requirements and is not a bank balance.

Operating performance must support the debt

For one illustrative year, suppose EBITDA is £12m, cash interest £4m, cash tax £1m, capital spending £2m and additional working capital £1m. Ignoring other items, £4m remains for debt repayment: £12m − £4m − £1m − £2m − £1m.

If EBITDA falls to £8m with the same other cash requirements, nothing remains to repay debt. If interest also rises by £1m, there is a £1m funding gap. A model should show that gap, rather than allowing a negative repayment to quietly create new debt without an available borrowing facility.

The OCC’s leveraged-lending handbook discusses evaluating debt against recurring cash generation and testing assumptions under different conditions. This is useful background on credit analysis, not a statement of UK transaction rules: https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/leveraged-lending/pub-ch-leveraged-lending.pdf.

Worked example: selling after five years

Assume the business reaches £14m EBITDA after five years, remaining debt is £28m and the exit multiple is still 8 times. Exit enterprise value is £112m; with no excess cash or other claims, equity proceeds are £84m. The £36m initial equity investment becomes £84m.

The multiple of invested capital is £84m ÷ £36m = 2.33 times. With one initial outflow and one inflow exactly five years later, annualised return is (84 ÷ 36)^(1 ÷ 5) − 1, approximately 18.5%. This simplified calculation excludes interim distributions, exit fees and investor-level taxes.

The £48m increase over initial equity can be understood as £32m of enterprise-value growth plus £20m of debt reduction, less the £4m entry fees. That reconciliation explains where the return came from. The investor did not receive an extra £20m cash distribution during ownership; repayment reduced the debt deducted at exit.

Stress the exit and timing

Keep £14m exit EBITDA but reduce the multiple to 6 times. Enterprise value becomes £84m, equity proceeds £56m and the five-year annualised return approximately 9.2%. A growing business can therefore produce a much weaker equity result if its sale valuation changes.

Alternatively, keep the original £84m equity proceeds but delay exit to year seven. The money multiple stays 2.33 times while the annualised return falls to approximately 12.9%. Both measures are needed: one describes cash scale, the other incorporates timing.

Common mistakes, limitations and next step

Avoid assuming that all EBITDA can repay debt, applying an optimistic exit multiple without a downside case, or forgetting fees in the initial equity contribution. Do not subtract debt twice by confusing enterprise and equity purchase prices. Model debt repayments against cash available and contractual terms.

This example omits multiple debt tranches, financing fees, minimum cash, detailed tax rules, covenants and management incentives. Real transactions require those details where relevant. Use the LBO learning model to test operating performance, financing and exit assumptions separately, then explain the weakest part of the case in a short investment memo.