What is a leveraged buyout? A simple worked example

Separate the business value from the owners' equity

In a simplified buyout, enterprise value describes the value of the operating business to its capital providers. Equity value is what remains for shareholders after subtracting net debt. A purchase price of £100 million therefore does not imply that the equity investors contribute £100 million.

The BIS describes buyouts as acquisitions using substantial borrowing, with resilient company cash flows important because the debt needs servicing. Actual transactions include fees, cash balances and other adjustments; the arithmetic below deliberately strips those out so the mechanism is visible.

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Worked example: a £100 million business

Assume a business is bought for £100 million, funded by £60 million of debt and £40 million of equity. Assume no cash, fees, taxes, interim distributions or changes to debt before sale. These are illustrative figures, not an expected return.

If the business is later worth £120 million and the debt remains £60 million, equity proceeds are £60 million. The business value rose 20%, but the £40 million equity investment gained £20 million, or 50%. A fall to £80 million reverses the result: equity proceeds are £20 million, a 50% loss.

Debt repayment can change the result too

Now hold the sale value at £100 million but suppose debt has fallen to £50 million. With no cash or other adjustments, £50 million remains for equity. Compared with the original £40 million contribution, that is a £10 million gain even though the business sells for the same enterprise value.

That repayment has to be funded. Cash used to reduce debt cannot simultaneously fund new equipment, hiring or distributions. Interest, capital spending and working-capital needs affect how much cash is actually available. A plausible exit valuation does not ensure that the business can meet this year's payments.

An LBO value-creation bridge: where did the gain come from?

Start a new, separate scenario with the same £100 million entry value. Annual EBITDA, a measure of earnings before interest, taxes, depreciation and amortisation, is £10 million. A 10x EBITDA valuation gives enterprise value of £100 million. Subtract £60 million of debt and the original equity is £40 million.

At exit, assume EBITDA is £12 million, the valuation multiple is 11x and debt is £50 million. Enterprise value is now £12 million × 11 = £132 million. Equity proceeds are £132 million − £50 million = £82 million. Assume no cash, fees, taxes, interim distributions or additional equity contributions. The bridge below explains the £42 million increase.

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The bridge explains the arithmetic, not all the causes

The split depends on the attribution convention. Applying the multiple change to entry EBITDA first would allocate £10 million to that change and £22 million to EBITDA growth at the exit multiple. Both approaches reach the same £82 million. The £2 million interaction between EBITDA growth and multiple expansion has moved categories; no extra value has appeared.

Nor does the EBITDA bar prove that management caused all the growth. Market conditions or acquired businesses could contribute. If acquisitions required extra investor capital, that contribution must be included when assessing returns. ILPA highlights these limitations of conventional value bridges: they are useful reconciliations, but not a complete measure of a manager's contribution.

Debt reduction still needs cash after the business meets its obligations. EBITDA is not cash available to repay debt: interest, taxes, capital expenditure and working-capital movements can absorb it. The bridge makes the financing change visible; it does not make repayment free.

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Misconception: leverage creates operating value by itself

Borrowing changes financing and exposure; it does not by itself improve products or make customers pay more. In our example, the same £20 million change in business value is concentrated on a smaller equity contribution. Real operating improvements, a different valuation multiple and debt repayment are distinct return drivers.

The illustration also omits time. A 50% gain over one year differs from the same gain over ten years. Interest, fees, taxes, refinancing and the possibility of default can materially change actual returns. This is an explanation of the financing mechanism, not guidance to make a particular investment.