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LBO interview questions and a worked paper LBO

In a leveraged buyout, a private equity firm buys a company using a lot of borrowed money. The company's own cash flow pays the debt down, and the sponsor earns its return when it sells. Returns come from three levers: EBITDA growth, multiple expansion and debt paydown.

Worked example: buy $100 of EBITDA at 10x ($1,000), funded with $600 of debt and $400 of equity. In five years EBITDA is $150, you exit at 10x ($1,500), and debt is down to $300. Exit equity is $1,500 − $300 = $1,200, so MOIC is $1,200 ÷ $400 = 3.0x and IRR is about 25%.

LBO and private equity questions

Basic

Walk me through a basic LBO.

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Basic

Why does a PE firm use leverage?

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Intermediate

What makes a good LBO candidate?

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Intermediate

How do PE firms create value?

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Intermediate

Paper LBO: buy $100 EBITDA at 10x with 60% debt. In 5 years EBITDA is $150, exit at 10x, debt paid down to $300. What are MOIC and IRR?

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Advanced

What is a dividend recap, and how does it affect returns?

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Advanced

How do you protect against downside in an LBO?

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Advanced

Paper LBO: $50 EBITDA bought at 8x with 50% debt. EBITDA grows to $65 in 5 years, exit at 9x, debt falls to $120. MOIC and IRR?

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Quick quiz (12 questions)

In an LBO, the acquisition debt is repaid mainly with:
  1. The sponsor's management fees
  2. The target company's cash flows ✓
  3. New commitments from the fund's LPs
  4. Government grants for the company
The business carries and repays its own debt.
Which company makes the best LBO candidate?
  1. Early-stage biotech that is burning cash
  2. Stable, cash-generating business with low capex ✓
  3. Cyclical miner with heavy capex needs
  4. Pre-revenue software startup
Predictable cash flow supports lots of debt.
In an LBO, the sources and uses table must:
  1. Differ by the fee amount
  2. Always balance ✓
  3. Only include equity
  4. Exclude debt
Every dollar spent must be funded.
In an LBO, most of the purchase price is usually funded with:
  1. The sponsor's equity
  2. Government grants
  3. Debt ✓
  4. The seller's cash
Debt magnifies equity returns.
Why does leverage increase equity returns?
  1. Debt is free, so returns rise automatically
  2. It lowers the company's taxes to zero
  3. A smaller equity check captures the same EV gains ✓
  4. It raises the company's EBITDA directly
Gains on the whole company accrue to a smaller equity base.
What's the main risk of using more debt?
  1. Returns are lower when things go well
  2. The company pays less in taxes when interest expense goes up
  3. The company can't make payments if earnings fall ✓
  4. The company has to cut employees
Leverage cuts both ways.
LBO: entry EBITDA $100 at 10x, funded with $500 debt and $500 equity. In year 5, EBITDA is $130, the exit multiple is 10x and $300 of debt remains. Exit equity is:
  1. $1,300
  2. $1,000 ✓
  3. $800
  4. $500
Exit EV = $130 × 10 = $1,300. Subtract $300 of remaining debt: $1,000 of equity.
You put in $500 of equity and get $1,000 of equity back at exit. MOIC is:
  1. 1.3x
  2. 2.0x ✓
  3. 2.6x
  4. 3.0x
$1,000 ÷ $500 = 2.0x.
Year-5 EBITDA is $130 and $300 of debt remains. At an 11x exit multiple, exit equity is:
  1. $1,130 ✓
  2. $1,100
  3. $1,430
  4. $1,000
$130 × 11 = $1,430 EV, less $300 debt = $1,130.
Paper LBO: EBITDA $50 at 8x. What's the entry enterprise value?
  1. $58
  2. $400 ✓
  3. $350
  4. $450
50 × 8 = $400.
Entry EV is $600 with 60% debt. How much equity?
  1. $360
  2. $600
  3. $400
  4. $240 ✓
40% × $600 = $240.
Entry EV $1,000, debt $600. Entry equity is:
  1. $600
  2. $400 ✓
  3. $1,600
  4. $1,000
1,000 − 600 = $400.

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