LBO is the question that separates candidates targeting sponsor coverage and PE from candidates who only know the public-market technicals. The walkthrough is mechanical — sources & uses, debt schedule, exit math — but the follow-ups test commercial judgment: would you finance this business at 6x leverage, where do returns actually come from, and what kills sponsor IRR.
This guide covers the LBO questions you will actually be asked, with the structured answers we drill candidates on inside Banking Prep AI.
What an LBO actually is
An LBO is a financial sponsor (private equity firm) buying a company funded primarily by debt, with the goal of paying down that debt over a 4–6 year hold and exiting at a higher equity value. The debt sits on the target's balance sheet — not the sponsor's — and is serviced by the target's cash flow.
Returns come from three sources: EBITDA growth, debt paydown, and multiple expansion. Sponsors underwriting today rarely model multiple expansion as a base case because it depends on market timing — they underwrite to operating improvement and debt paydown, with multiple expansion as upside.
Sources & uses
Every LBO model starts with sources & uses. Sources are where the money comes from; uses are where it goes. The two must balance — if they don't, the deal is not funded.
| Sources | % | Uses | % |
|---|---|---|---|
| Sponsor equity | 30–40% | Equity purchase price | 70–85% |
| Rolled management equity | 1–3% | Refinanced debt | 10–20% |
| TLB / senior secured | 30–40% | Transaction fees | 2–4% |
| Senior unsecured notes | 10–20% | Minimum operating cash | 1–2% |
| Mezzanine / PIK | 0–10% | ||
| Balance-sheet cash | 0–5% |
Debt schedule and cash sweep
The debt schedule projects each tranche's balance year by year, applying mandatory amortization (typically 1% per year for TLB) and a contractual cash sweep that uses excess FCF to pay down debt faster.
Cash sweep priority: senior secured first, then unsecured, then PIK. The sweep percentage typically steps down as leverage falls — 100% sweep above 5x leverage, 50% between 4x and 5x, 0% below 4x. The sweep is what makes LBO returns work: every dollar of FCF that pays down debt becomes a dollar of equity at exit.
IRR, MOIC, and what drives returns
MOIC = exit equity / entry equity. IRR = annualized return that sets NPV to zero. They're connected by hold period: 2.5x MOIC over 5 years ≈ 20% IRR; 3.0x ≈ 25%; 2.0x ≈ 15%.
Sponsors decompose returns into three buckets: EBITDA growth (operating improvement, revenue growth), debt paydown (cumulative FCF used to reduce debt), and multiple expansion (exit multiple > entry multiple). In a base case, the first two each contribute 40–50% of return; multiple expansion is the wildcard and not underwritten.
Exit Equity = (Exit EBITDA × Exit Multiple) − Net Debt at Exit MOIC = Exit Equity / Entry Equity IRR = MOIC^(1/Hold) − 1 Return bridge: Δ from EBITDA growth ≈ (Δ EBITDA) × Entry Multiple Δ from debt paydown ≈ Cumulative FCF used to pay debt Δ from multiple expansion ≈ Exit EBITDA × (Exit − Entry Multiple)
What makes a good LBO target
Good LBO candidates share six traits: stable and predictable cash flows; strong margins; low capex intensity; underutilized balance sheet (room for leverage); identifiable operating improvements (cost takeouts, pricing power, working capital release); and strategic exit options (sell to a strategic, IPO, or sell to another sponsor).
Bad LBO candidates: cyclical businesses (debt service breaks in a downturn), capex-heavy industries (cash needed for capex can't pay down debt), turnaround stories (operating risk on top of leverage risk), and technology businesses with rapid product obsolescence.
The operating case
The operating case is the sponsor's projection of how the business performs over the hold. Standard structure: revenue growth (organic + M&A bolt-ons), margin expansion (cost program, pricing, mix), capex normalization, working capital release. The base case is what gets shown in the IC memo; the downside case (typically 15–25% lower EBITDA) tests whether the capital structure survives a recession.
Common LBO interview mistakes
- Confusing equity value and EV. Entry EV = entry multiple × entry EBITDA. Equity purchase price = EV − net debt assumed. Don't mix them in sources & uses.
- Ignoring transaction fees. Financing fees, M&A advisory, legal — typically 2–4% of EV. They are a use, not a source, and reduce equity returns directly.
- Forgetting net debt at exit. Exit equity = exit EV − net debt at exit. Many candidates compute exit EV and forget to subtract remaining debt — overstates returns dramatically.
- Not testing downside. Sponsors and lenders both want to see the deal survives a 20% EBITDA drop. A clean LBO answer mentions downside coverage, not just base case IRR.
- Treating multiple expansion as base case. Sponsors do not underwrite multiple expansion. Build the model assuming exit multiple = entry multiple, and treat any expansion as upside.
Worked example: 5-year LBO
Target: $100M LTM EBITDA, $1B EV at 10x entry. Sources: $350M sponsor equity, $650M debt at 7%, no rolled equity. Operating case: EBITDA grows 8% per year to $147M by year 5. Annual FCF after capex, interest and tax averages $50M; cumulative paydown of $250M reduces debt to $400M.
Exit at 10x EBITDA = $1.47B EV. Exit equity = $1.47B − $400M = $1.07B. MOIC = $1.07B / $350M = 3.06x. IRR = 3.06^(1/5) − 1 ≈ 25%. EBITDA growth contributes ~$470M to enterprise value (8% growth × 10x); debt paydown contributes ~$250M to equity directly; no multiple expansion.
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Frequently asked LBO interview questions
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