The questions every PE interviewer asks — with detailed answers that go beyond the surface. Not one-liners. The actual analysis that separates strong candidates from average ones.
An LBO model has five components: (1) Sources & Uses, which establishes the purchase price and how it's financed; (2) an Operating Model projecting revenue, EBITDA, and free cash flow; (3) a Debt Schedule tracking principal balances, interest expense, and paydown; (4) an Exit analysis computing the enterprise and equity value at sale; and (5) Returns — IRR and MOIC.
The fundamental mechanic is that the sponsor buys a company with mostly debt, lets the company's own cash flow pay down that debt over a hold period, and then sells at a higher equity value than they invested.
Six characteristics: (1) Stable, predictable free cash flow — needed to service debt; cyclical businesses are risky. (2) Low capex requirements — capital-light models generate more FCF for debt paydown. (3) Defensible market position — pricing power and recurring revenue support consistent margins. (4) Hard asset base — collateral for lenders. (5) Identifiable value creation levers — cost cuts, margin improvement, bolt-on M&A. (6) Reasonable entry valuation — you can't LBO a 20x EBITDA company at 6.0x leverage and generate 20% IRR.
The ideal candidate has strong FCF conversion, a defensible niche, and a sponsor-friendly management team.
1. EBITDA growth — Growing EBITDA increases enterprise value at exit (at a fixed multiple). Higher EBITDA also generates more FCF for debt paydown.
2. Debt paydown — Every dollar of debt paid down increases equity value by $1, assuming enterprise value stays constant. Leverage amplifies this effect — the same FCF creates more equity value in a levered structure than an unlevered one.
3. Multiple expansion — Exiting at a higher EV/EBITDA multiple than entry. This is the highest-risk driver because it depends on market conditions, sector re-ratings, and business transformation. Most conservative models don't assume multiple expansion.
Return attribution matters in interviews. Be able to say something like: "In this deal, ~60% of value creation came from EBITDA growth and ~40% from debt paydown — multiple expansion contributed nothing because we entered and exited at the same 9x."
More leverage increases IRR because you invest less equity for the same exit equity value. If a company exits at $1B of equity value, investing $200M (with $800M debt) generates 5.0x MOIC, while investing $400M (with $600M debt) only generates 2.5x MOIC — even though the exit equity is identical.
But leverage stops working (and reverses) when: (1) the cost of debt exceeds the return on assets, (2) coverage ratios breach covenants, triggering default, (3) EBITDA declines mean debt can't be serviced, forcing distressed sales at low multiples, or (4) market conditions close the refinancing window at maturity.
Margin expansion increases IRR through two mechanisms simultaneously: (1) it increases exit EBITDA, which increases exit EV at a fixed multiple; and (2) higher EBITDA generates more FCF each year, which accelerates debt paydown, further increasing exit equity.
Example: A business with $500M revenue, going from 20% to 25% EBITDA margin, increases EBITDA by $25M. At a 10x exit multiple, that's $250M more in exit EV — and the extra $25M/year in FCF has paid down ~$100–125M of additional debt over 5 years. Combined: ~$375M of additional equity value from a 500bps margin improvement.
MOIC is indifferent to time — it just measures how much money you got back divided by how much you put in. A 3.0x MOIC in 3 years vs. 3.0x MOIC in 7 years looks the same on MOIC but dramatically different on IRR (44% vs. 17%).
IRR is an annualized return metric — it penalizes longer holds. This means funds that hold longer must achieve higher absolute returns (higher MOIC) to maintain the same IRR. This is why PE funds have a strong preference for realizing exits as soon as value creation is complete rather than holding longer.
Income Statement: Interest expense increases significantly due to the new debt. This reduces pre-tax income and taxes. EBITDA is unchanged at closing but EBIT and below decline due to added interest. Going forward, D&A may also increase if there's a PP&E step-up through purchase price allocation.
Balance Sheet: New debt added to liabilities. Goodwill and intangibles created from purchase price premium above book value. Equity is reset to reflect the sponsor's initial equity contribution (old equity is wiped out). Cash adjusts for fees and any transaction mechanics.
Cash Flow Statement: Operating CF is unchanged initially (EBITDA unchanged). Financing CF changes drastically — large debt issuance inflow, equity contribution inflow, payment of fees outflow. Going forward, interest payments reduce operating CF.
More D&A decreases taxable income, which reduces taxes — this is a non-cash benefit. In an LBO model, if D&A increases (e.g., from stepped-up PP&E after purchase price allocation), net income falls but the tax shield increases cash flow. EBITDA is unaffected. FCF improves slightly due to lower cash taxes.
In terms of returns: higher D&A is mildly positive because it shields more cash from taxes, increasing FCF available for debt paydown. The magnitude depends on the tax rate and the size of the D&A step-up relative to total EBITDA.
Common mistakes: forgetting to subtract the revolver if it was drawn, using the entry EBITDA instead of exit EBITDA, or using gross debt instead of net debt. Always check your sources & uses and make sure total debt at exit ties to your debt schedule ending balance.
A dividend recap is when the portfolio company takes on additional debt mid-hold to pay a special dividend to the equity holders (the PE sponsor). This returns cash to the sponsor early, which dramatically increases IRR because part of the return is received sooner.
Example: Invest $500M in Year 0, receive $300M dividend in Year 3, and receive $700M at exit in Year 5. Cash flows: (500), 300, 700. IRR is materially higher than receiving $1,000M at Year 5 only — even though the total cash received is the same $1,000M — because $300M was received 2 years earlier.
The downside: the company takes on more debt post-recap, which increases default risk. Lenders must agree to the recap, and covenants typically restrict the ability to pay dividends when leverage is high.
PIK (Payment-in-Kind) is a loan structure where interest accrues to the principal instead of being paid in cash. The borrower chooses it when cash is constrained and they need to preserve liquidity in the early years of the hold. Common in highly levered structures or growth-stage companies with negative FCF.
The cost: PIK interest compounds. A $100M PIK at 12% becomes $176M after 5 years — compared to $60M of cash interest over the same period. PIK lenders charge a higher rate to compensate for the compounding risk and lower priority in the capital structure.
If FCF is negative, the company cannot service its debt from operations. In the model: the revolver gets drawn to cover the shortfall. If the revolver is insufficient, you'd model additional equity injections or a debt restructuring — but these scenarios typically mean the deal is un-investable at the assumed leverage level.
In practice, you'd either: (1) reduce leverage to a level the company can service even in a stress case; (2) use a PIK structure for part of the debt so cash interest is lower; or (3) conclude the business isn't an LBO candidate at this point in its lifecycle.
A MIP (or management equity plan) allocates 7–15% of the exit equity to management through options or direct equity, typically vesting over 4 years with some performance conditions. The purpose is alignment — management benefits from the same value creation the sponsor is pursuing.
From the sponsor's perspective, the MIP dilutes returns but the assumption is that good management creates more value than the dilution costs. If a $500M equity value grows to $1.5B (3x MOIC), a 10% MIP means the sponsor gets $1.35B instead of $1.5B. But if the same management team is what drove that growth, the dilution was worth it.
A reverse LBO starts from a target return (e.g., 20% IRR) and solves backwards for the maximum purchase price. You calculate: (1) exit equity from projected exit EBITDA × exit multiple minus expected remaining debt; (2) the required entry equity = exit equity / required MOIC; (3) maximum purchase price = entry equity + available debt.
Use it when you need to anchor a bid quickly, answer "what price can you get to?", or when determining whether a deal is viable before building a full model.
Working capital changes affect FCF through the cash flow statement. An increase in working capital (e.g., accounts receivable increases as revenue grows) is a use of cash — it reduces FCF available for debt paydown. A decrease in working capital releases cash.
In an LBO model: growing revenue companies typically require working capital investment (negative to FCF). The magnitude depends on the days sales outstanding (DSO), days inventory outstanding (DIO), and days payable outstanding (DPO). A company with negative working capital (e.g., subscription SaaS with upfront payments) is highly attractive for LBOs because growth actually generates cash.