Module 18: Leveraged Buyouts (LBOs) & The Cost of Capital

If you work in Private Equity (PE) on Wall Street, the DCF is secondary. PE firms value companies using a Leveraged Buyout (LBO) Model. This model determines the absolute maximum price a PE firm can pay for a target while still guaranteeing a 20% Internal Rate of Return (IRR) for their investors.

1. The LBO Engine

An LBO is a corporate acquisition executed primarily with borrowed money.

The Structure: The PE firm buys the target using 20% Equity (their own cash) and 80% Debt. Crucially, the debt is secured against the target company's assets.
The Paydown: Over 5 years, the PE firm utilizes the target company's own Free Cash Flow to aggressively pay down the massive debt balance.
The Exit: After 5 years, the PE firm sells the company. Because the debt was paid down, the PE firm's equity percentage has massively expanded. They generate astronomical returns without the underlying company actually growing its enterprise value.

2. MOIC and IRR

PE analysts are judged by two metrics:

MOIC (Multiple on Invested Capital): "I put in $100 Million and walked away with $300 Million. My MOIC is 3.0x."
IRR (Internal Rate of Return): Factors in the time value of money. A 3.0x MOIC generated in 3 years yields a massive IRR. A 3.0x MOIC that took 15 years to generate yields a terrible IRR.

Self-Reflection & Assessment

How does utilizing 80% debt in a Leveraged Buyout mathematically magnify the Private Equity firm's return on their equity?
Explain the difference between MOIC and IRR in performance measurement.