An LBO model follows the cash. Each year, the company’s free cash flow goes into repaying debt, and at the end the business is sold and the debt is subtracted to find what the owners keep. Two numbers measure success: MOIC, how many times the money came back, and IRR, the yearly rate of return. In this example $400 million becomes $994.1 million in five years, which is 2.49 times the money and a 20.0% yearly return, with no help from a higher sale multiple.
Why it matters: A return can come from paying down debt and growing earnings, without relying on a higher sale price.
Summary: An LBO model runs free cash flow through a debt schedule, sweeps it into debt repayment, and values the equity at exit; MOIC and IRR then measure the result. The rebuilt deal turns $400 million into $994.1 million in five years, 2.49x and a 20.0% IRR, with no multiple expansion.
- Free cash flow = EBITDA − interest − taxes − capex − working capital; it repays $264.1 million of debt over five years.
- The gain bridges exactly: $360.0 million from EBITDA growth, $264.1 million from paydown, $0 from multiple, minus $30 million of fees.
- Scenarios range from 1.06x (1.2% IRR) in a recession to 3.11x (25.5%) in a strong exit.
- The base case needs an 8.01x exit for 20%; the downside returns capital at 6.79x.
- A two-year slip in exit cuts the IRR from 20.0% to 13.9%.
Once the deal closes, the model projects the target’s cash flow forward for the sponsor’s expected holding period (typically 5 years), using each year’s free cash flow to pay down the debt raised at entry. At the end of the holding period, the model assumes an exit — usually a sale to a strategic buyer or another PE firm, or an IPO — at an exit multiple applied to the target’s EBITDA in that final year. Two figures then measure the sponsor’s return:
| Metric | What It Measures |
|---|---|
| MOIC (Multiple of Invested Capital) | Total cash returned to the sponsor at exit, divided by the equity originally invested — e.g., a 2.5x MOIC means every $1 invested returned $2.50 |
| IRR (Internal Rate of Return) | The annualized percentage return, accounting for the time value of money — a 2.5x MOIC over 5 years is a very different IRR than the same 2.5x over 3 years |
Inputs (the deal of Section 2.6: The LBO Model — Sources & Uses, US dollars in millions): sponsor equity $400; Term Loan B $330 at 7.50% floating, 1% a year mandatory amortization and a 100% cash sweep (all free cash flow repays the loan); senior notes $220 at 8.50%, repaid only at exit; EBITDA growing from $115 to $160 over five years; D&A $20, capex $25 and working-capital investment $5 a year; tax 25%, with deductible interest capped at 30% of EBITDA and the excess carried forward. Interest is charged on opening balances.
Each year: free cash flow = EBITDA − cash interest − cash taxes − capex − Δworking capital. Year 1: 123 − 43.5 − 16.5 − 25 − 5 = $33.0, all of which repays the term loan. Taxes are 25% × (123 − 20 − 36.9) = $16.5, because only 30% × 123 = $36.9 of the $43.5 interest is deductible that year.
| Year | EBITDA | Interest | Cash taxes | Free cash flow (debt repaid) | Term loan, year-end | Total debt, year-end | Debt ÷ EBITDA |
|---|---|---|---|---|---|---|---|
| 0 | 115 | — | — | — | 330.0 | 550.0 | 4.78x |
| 1 | 123 | 43.5 | 16.5 | 33.0 | 297.0 | 517.0 | 4.20x |
| 2 | 131 | 41.0 | 17.9 | 42.1 | 254.9 | 474.9 | 3.62x |
| 3 | 140 | 37.8 | 19.5 | 52.7 | 202.2 | 422.2 | 3.02x |
| 4 | 150 | 33.9 | 23.0 | 63.1 | 139.1 | 359.1 | 2.39x |
| 5 | 160 | 29.1 | 27.7 | 73.2 | 65.9 | 285.9 | 1.79x |
Exit and returns. Exit EV = 8.0 × 160 = $1,280.0. Exit equity = 1,280.0 − 285.9 = $994.1. MOIC = 994.1 ÷ 400 = 2.49x. With one cash flow out and one back, IRR = 2.4851/5 − 1 = 20.0% a year, right at the 20% rule-of-thumb target for buyouts.
Where the $594.1 of gain came from. Entry equity value is EV less net debt: 920 − 550 = $370. Then: EBITDA growth (160 − 115) × 8.0 = $360.0; debt paydown 550 − 285.9 = $264.1; multiple expansion (8.0 − 8.0) × 160 = $0. Check: 370 + 360.0 + 264.1 + 0 = 994.1. The sponsor paid $400, not $370, so fees cost $30: gain = 360.0 + 264.1 + 0 − 30 = $594.1.
Try it yourself: LBO returns with a five-year debt paydown
Pre-filled with the illustrative Section 2.6 deal from the worked example above (USD millions): 8.0x entry on $115 of EBITDA, $30 of fees, a $330 term loan and $220 of notes, so sponsor equity is $400. The first results match the text: exit equity $994.1, MOIC 2.49x, IRR 20.0%. Every default is illustrative.
- MOIC
- 2.49xexit equity $994.1m ÷ sponsor equity $400.0m
- IRR, 5 years
- 20.0%one cash flow in, one out: MOIC^(1/5) − 1
- Exit equity
- $994.1mexit EV $1,280.0m − net debt $285.9m
- Sponsor equity
- $400.0mEV $920.0m + fees $30.0m − new debt $550.0m
Debt schedule, USD millions (interest on opening balances)
| Year | EBITDA | Interest | Cash taxes | Free cash flow | Debt repaid | Cash kept (cumulative) | Term loan, year-end | Total debt, year-end | Debt ÷ EBITDA |
|---|---|---|---|---|---|---|---|---|---|
| 0 | 115.0 | — | — | — | — | — | 330.0 | 550.0 | 4.78x |
| 1 | 123.0 | 43.5 | 16.5 | 33.0 | 33.0 | 0.0 | 297.0 | 517.0 | 4.20x |
| 2 | 131.0 | 41.0 | 17.9 | 42.1 | 42.1 | 0.0 | 254.9 | 474.9 | 3.62x |
| 3 | 140.0 | 37.8 | 19.5 | 52.7 | 52.7 | 0.0 | 202.2 | 422.2 | 3.02x |
| 4 | 150.0 | 33.9 | 23.0 | 63.1 | 63.1 | 0.0 | 139.1 | 359.1 | 2.39x |
| 5 | 160.0 | 29.1 | 27.7 | 73.2 | 73.2 | 0.0 | 65.9 | 285.9 | 1.79x |
Where the exit equity came from, USD millions
| Step | Amount |
|---|---|
| Entry equity value: EV − new debt | 370.0 |
| + EBITDA growth × entry multiple | +360.0 |
| + Multiple expansion × Year-5 EBITDA | 0.0 |
| + Net debt paydown | +264.1 |
| = Exit equity | 994.1 |
| Sponsor equity paid (includes fees) | 400.0 |
| Sponsor gain | +594.1 |
How to read this: Each year, free cash flow = EBITDA − interest − cash taxes − capex − working-capital investment. It first pays the mandatory amortization, then the sweep share of what is left repays the term loan; anything not swept stays as cash and reduces net debt at exit. The notes are repaid only at exit. The bridge splits exit equity into the entry equity value, EBITDA growth, multiple expansion and debt paydown.
Assumptions: interest on opening balances (no circularity), no interest earned on cash kept, tax losses not carried forward, a single entry and exit five years apart with no dividends, no exit costs and no management options. All defaults are the illustrative Section 2.6 deal, not a real transaction.
Same structure and $400 million of equity; only the EBITDA path and the exit multiple change. US dollars in millions.
| Scenario | EBITDA, Years 1–5 | Exit multiple | Exit EV | Net debt at exit | Exit equity | MOIC | IRR |
|---|---|---|---|---|---|---|---|
| Downside | 108, 105, 110, 115, 120 | 7.0x | 840.0 | 415.1 | 424.9 | 1.06x | 1.2% |
| Base | 123, 131, 140, 150, 160 | 8.0x | 1,280.0 | 285.9 | 994.1 | 2.49x | 20.0% |
| Upside | 126, 139, 152, 165, 175 | 8.5x | 1,487.5 | 242.8 | 1,244.7 | 3.11x | 25.5% |
Flip points. In the base case the sponsor needs an exit multiple of 8.01x for a 20% IRR, so the plan has no margin for a lower exit; at 6.82x the IRR drops to 15%, and only below 4.29x would the sponsor lose money. In the downside case, the sponsor gets its money back (MOIC 1.0x) at an exit multiple of 6.79x; below that, equity is lost. Leverage peaks at 4.90x in the downside's first year, inside a 6.00x covenant, so the deal survives the recession but earns almost nothing. The spread between 1.2% and 25.5% from modest changes in inputs is leverage at work.
Three levers drive every LBO return: debt paydown (deleveraging), EBITDA growth (operational improvement), and multiple expansion (exiting at a higher multiple than entry — the least controllable of the three, since it depends on market conditions at exit). PE professionals are trained to decompose a projected return across exactly these three levers, because a return driven mainly by hoped-for multiple expansion is a far riskier bet than one driven by debt paydown and operational improvement the sponsor can actually control.
Underwrite with the exit multiple at or below the true entry multiple. Accept the deal only if the base case meets the fund's target IRR without multiple expansion and the downside case still returns at least 1.0x with covenants intact. In the return bridge, if more than about a third of the value created comes from multiple expansion, reprice or walk away: that lever belongs to the market at exit, not to you. Treat the one-third threshold as a heuristic.
Ignoring time. The same 2.49x MOIC earned over five years is a 20.0% IRR; if the exit slips to Year 7 at the same equity value, the IRR is 2.4851/7 − 1 = 13.9%, below a 15% hurdle. Exits slip exactly when markets are weak, so a model that assumes a Year-5 exit in every scenario overstates returns in the scenarios that matter most. Run the base case at five and seven years.
What is a good IRR for an LBO?
A common rule of thumb is about 20% gross IRR on a deal, and a deal that reaches it only through multiple expansion is weaker than one that reaches it through cash flow. Investors compare the IRR with the MOIC: 20% over five years is about 2.5x, while 20% over two years is only 1.44x, which pays far less in total dollars.
What is the difference between MOIC and IRR?
MOIC measures how many dollars come back per dollar invested, ignoring time; IRR is the annual rate that equates the cash flows, so it rewards speed. A quick 1.5x can show a higher IRR than a slow 3.0x. Limited partners eventually spend dollars, not percentages, so serious investors report both.
What is a cash sweep?
A cash sweep is a loan term requiring the borrower to use some or all of its excess free cash flow to prepay debt, usually the term loan, instead of building cash or paying dividends. The example sweeps 100%, repaying $264.1 million over five years; real credit agreements usually sweep a set percentage of "excess cash flow" that steps down as leverage falls.
Where do LBO returns come from?
From three levers: EBITDA growth, debt paydown and multiple expansion, minus fees and other deal costs; a disciplined sponsor wants the first two to dominate. In the example, EBITDA growth contributes $360.0 million and paydown $264.1 million of the $594.1 million gain, with no multiple expansion and $30 million of fees.
The debt schedule converts five years of free cash flow into $264.1 million of debt repayment, and an exit at the entry multiple of 8.0x leaves $994.1 million of equity: 2.49x and a 20.0% IRR on $400 million. The return bridges exactly to EBITDA growth and paydown less fees, and the scenarios show how quickly leverage moves the result between 1.2% and 25.5%.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A sponsor invests $300 million. After five years, EBITDA is $200 million, the exit multiple is 7.5x and net debt is $900 million. What are the MOIC and IRR?
- 2.0x and about 14.9%
- 5.0x and about 38.0%
- 3.0x and about 24.6%
- 2.0x and about 20.0%
Reveal Answer
Answer: A. Exit equity = 7.5 × 200 − 900 = $600 million; MOIC = 600 ÷ 300 = 2.0x; IRR = 2.0^(1/5) − 1 ≈ 14.9%.
2. In the chapter's return bridge, how much of the $594.1 million gain came from debt paydown?
- $30.0 million
- $264.1 million
- $594.1 million
- $360.0 million
Reveal Answer
Answer: B. Net debt fell from $550 million to $285.9 million, contributing $264.1 million; EBITDA growth added $360.0 million, multiple expansion nothing, and fees cost $30 million.
3. The deal's 2.49x MOIC is reached in Year 7 instead of Year 5, at the same exit equity. What is the IRR?
- About 20.0%
- About 16.4%
- About 12.1%
- About 13.9%
Reveal Answer
Answer: D. IRR = 2.485^(1/7) − 1 ≈ 13.9%. The same dollars two years later fall below a 15% hurdle.
4. Why were Year-1 cash taxes $16.5 million rather than 25% × (123 − 20 − 43.5)?
- Interest on the senior notes is never tax-deductible
- Depreciation cannot be deducted in a buyout's first year
- Only $36.9 million of interest was deductible
- Mandatory loan amortization counts as taxable income
Reveal Answer
Answer: C. The 30% cap allows 0.30 × 123 = $36.9 million of the $43.5 million interest; taxes = 25% × (123 − 20 − 36.9) = $16.5 million, with the rest carried forward.