Executive summary
A leveraged buyout acquires a company using a combination of equity and significant debt, which is repaid from the company's cash flows. Equity returns come from three sources: growth in operating profit, a change in the valuation multiple, and debt paydown. A simplified hypothetical transaction illustrates each lever.
Key findings
- 1In the hypothetical deal, equity value grows from $40M to $100M over five years, a multiple of 2.5× invested capital.
- 2Debt paydown and EBITDA growth contribute the entire gain; the illustration assumes no change in valuation multiple.
- 3The same leverage that magnifies gains also magnifies losses when cash flows disappoint.
A simplified hypothetical transaction
All figures are hypothetical and chosen for clarity.
| Entry | Exit (year 5) | |
|---|---|---|
| EBITDA | $10M | $13M |
| EV / EBITDA multiple | 10.0× | 10.0× |
| Enterprise value | $100M | $130M |
| Net debt | $60M | $30M |
| Equity value | $40M | $100M |
Equity grows from $40M to $100M — a 2.5× multiple of invested capital, or roughly a 20% annualised return over five years.
The three levers
- Operating improvement. EBITDA grows from $10M to $13M, adding $30M of enterprise value at a constant multiple.
- Deleveraging. Free cash flow repays $30M of debt, transferring that value from lenders to equity holders.
- Multiple change. Held constant here. In practice, buying at a lower multiple than you sell at can add materially to returns — and the reverse can erase them.
Leverage cuts both ways
If EBITDA instead fell to $8M and the multiple compressed to 8×, enterprise value would be $64M. With $50M of debt still outstanding, equity would be worth $14M — a loss of 65% of invested capital.
Exhibit
Hypothetical equity value bridge ($M)
Source: TIC hypothetical model
Investment considerations
When evaluating a private equity investment or a leveraged acquisition, stress-test the debt service under a decline in operating profit, not only the base case.
Risks and limitations
Real transactions include fees, covenants, refinancing risk and interest-rate risk. Results of individual funds vary widely.
Methodology
Single-scenario illustrative model with constant exit multiple; ignores fees, transaction costs, interest expense timing and taxes.
Facts, assumptions, estimates and opinions
TIC labels the nature of each material claim so you can weigh it appropriately.
- EstimateAll transaction figures are hypothetical.
- Verified factIn an LBO, debt is typically serviced from the acquired company's own cash flows.
- AssumptionThe exit multiple is assumed equal to the entry multiple.
- OpinionOperating improvement is the most durable of the three return levers.
Sources and references
- 01Investment Banking: Valuation, LBOs, M&A, and IPOs — Joshua Rosenbaum and Joshua Pearl, Wiley
Downloads
A downloadable PDF edition of this research has not been published yet.
