What the interviewer is really testing
Nobody expects a sophomore or junior to have built a 20-tab LBO model. The question tests three things: whether you understand the order of the steps, whether you know why sponsors use debt, and whether you can explain where the return comes from. A structured, confident answer beats an exhaustive one.
A model answer
“In an LBO, a private equity firm buys a company using a combination of its own equity and a significant amount of debt, then uses the company's cash flow to pay that debt down over a few years before selling it.
First, you make assumptions about the purchase price, usually a multiple of EBITDA, and how the deal will be financed: how much debt, at what interest rates, and how much equity the sponsor contributes. That gives you sources and uses.
Second, you project the company's financial statements, or at least its income statement and free cash flow, for the holding period, typically five years.
Third, you build a debt schedule. Each year, free cash flow goes toward interest and required repayments, and any extra cash pays down debt early.
Finally, you assume an exit, usually at a multiple of the final year's EBITDA. You subtract the remaining net debt to get the sponsor's equity value at exit, and compare it with the equity they put in to calculate the returns: the IRR and the multiple of money, or MOIC.”
That's four steps: price and financing, projections, debt paydown and exit and returns. Practice saying it out loud until it takes about 90 seconds.
The logic behind each step
1. Purchase price and sources and uses
The sponsor agrees to pay an enterprise value, for example 8.0x EBITDA. That money has to come from somewhere. The sources are the debt (often several layers, like a senior term loan and subordinated notes) plus the sponsor's equity. The uses are the purchase price plus fees. Sources must equal uses, and the sponsor's equity is the plug.
2. Projections and free cash flow
What matters most is free cash flow available to repay debt: EBITDA minus interest, taxes, capital expenditures and any increase in working capital. Stable, predictable cash flow is why some businesses make good LBO candidates.
3. Debt paydown
Each year, free cash flow first covers required amortization, and excess cash is often “swept” to repay debt early. As debt falls, the equity's share of the company's value rises, even if the business doesn't grow at all.
4. Exit and returns
At exit, enterprise value minus net debt equals the sponsor's equity. Divide that by the equity invested for MOIC. The IRR adjusts that for time. Sponsors often target IRRs around 20% or more, depending on the deal and the fund.
The three return drivers. If you remember one thing, remember this: LBO returns come from EBITDA growth, multiple expansion (selling at a higher multiple than you paid) and debt paydown. Mention them unprompted and you'll stand out.
Follow-up questions to expect
- Why do private equity firms use leverage? Debt is cheaper than equity and interest is tax-deductible, so less equity is needed and returns on that equity are magnified, as long as the business can handle the payments.
- What makes a good LBO candidate? Stable, predictable cash flows, low capex needs, a strong market position, room to improve operations, and a realistic path to exit.
- What happens to returns if you pay a higher purchase multiple? All else equal, returns fall: you invest more equity for the same exit value.
- How would you increase IRR without changing the exit value? Use more leverage, exit sooner, pay dividends during the hold, or buy at a lower price.
- What's the difference between IRR and MOIC? MOIC ignores time; IRR doesn't. See our guide to IRR vs. MOIC.
Common mistakes
- Jumping straight to IRR without explaining how the deal is financed.
- Forgetting to subtract net debt at exit. Enterprise value isn't what the sponsor receives.
- Using net income instead of free cash flow to pay down debt.
- Rambling. Structure (“There are four steps…”) signals that you actually understand it.
Don't just memorize it. Build it.
The free LBO Reps lessons walk you through every step in a live spreadsheet.