In a leveraged buyout, private equity buys a company using mostly borrowed money, loads the debt onto the acquired company, improves operations, and sells it 5-7 years later. Here's how the mechanics actually work.
Educational content only — not personalized financial, legal, or tax advice.
A leveraged buyout (LBO) is the acquisition of a company using a significant amount of borrowed money — typically 60-70% of the purchase price — with the debt secured by the acquired company's assets and repaid from its cash flows. The private equity firm contributes 30-40% in equity capital; the rest comes from bank loans and high yield bonds.
The LBO model made firms like KKR, Blackstone, Apollo, and Carlyle into financial giants. KKR's 1989 buyout of RJR Nabisco for $31 billion was the deal that defined an era. Today, LBOs routinely exceed $10-20 billion. The global PE industry manages approximately $8 trillion in assets.
This connects to how corporate bonds and leveraged finance markets fund LBO transactions and to South Korea's Household Debt Problem.
Step 1 — Target selection: PE firms look for companies with stable, predictable cash flows (to service debt), defensible market positions, potential operational improvements, and motivated sellers. Industries like healthcare, software (recurring revenue), and consumer staples are favored. Highly cyclical businesses (semiconductors, commodities) are less suited to high leverage.
Step 2 — Capital structure: A $1 billion LBO might be structured as:
Step 3 — Debt service: The acquired company — now 'portfolio company' — makes interest payments from its operating cash flow. At 6% average interest on $700M in debt, annual interest is $42M. If EBITDA is $143M and capex is $20M, free cash flow is approximately $123M — well above the $42M interest requirement, leaving cash for debt repayment.
Step 4 — Value creation: PE firms generate returns through three levers:
Step 5 — Exit: After 3-7 years, the PE firm exits through IPO, sale to a strategic buyer, or sale to another PE firm (secondary buyout). Returns are measured as IRR (internal rate of return) and multiple of invested capital (MOIC). A 2.5x MOIC over 5 years = approximately 20% IRR.
PE firms earn in two ways:
Management fees: Typically 1.5-2% annually on committed capital. On a $10 billion fund, that's $150-200 million/year regardless of performance — enough to cover firm operations and guarantee substantial income even before any investments are realized.
Carried interest: 20% of profits above the preferred return (typically 8% hurdle rate). On a $10 billion fund that returns $20 billion, the profit above the hurdle is approximately $8 billion, of which PE partners receive $1.6 billion. Carried interest is taxed at capital gains rates (23.8% max) rather than ordinary income rates (37%), a tax treatment that has been politically controversial for decades.
The critique of LBOs: loading companies with debt restricts their ability to invest in R&D, weather economic downturns, and maintain employment. The bankruptcies of PE-owned companies like Toys R Us, Sears (PE-adjacent), Hertz, and numerous healthcare companies are attributed in part to LBO debt loads.
The defense: PE ownership improves operational efficiency, accelerates decision-making vs. public company bureaucracy, and most PE-owned companies don't go bankrupt. The empirical research is genuinely mixed — PE ownership appears to improve productivity and profitability in aggregate, with a minority of highly leveraged deals failing in recessions.