When a private equity firm acquires a company, it rarely pays the full price upfront. Instead, it borrows a significant portion of the purchase price—often financing most of the deal with debt. This process is known as a leveraged buyout (LBO), one of the most powerful and debated strategies in modern finance.
Think of it like buying a house: You make a down payment and finance the rest through a mortgage. Private equity firms take a similar approach, but instead of homes, they’re purchasing entire companies. This strategy allows them to acquire larger businesses than their own capital would otherwise permit, while increasing potential returns.
Whether you’re considering a career in private equity, evaluating investment opportunities, or curious about how billion-dollar deals reshape industries, understanding the leveraged buyout model offers a clear view into how modern business acquisitions work. This guide explores the leveraged buyout model and its impact on private equity firms.
What Is the Leveraged Buyout Model?
At its core, the leveraged buyout model answers one critical question: If we buy this company today, how much money could we make when we sell it later?
“The LBO model allows us to evaluate the performance of an investment,” explains Harvard Business School Professor Victoria Ivashina in the online course Alternative Investments.
The leveraged buyout model is a projection tool used to forecast a company’s financial trajectory—typically over a five-year investment horizon—to assess potential returns at exit.
The leveraged buyout model’s flexibility makes it indispensable across private equity. As Ivashina notes in Alternative Investments, “The LBO model is used in the private equity industry to calculate the return on an investment for transactions such as buyouts, growth equity investments, investments in secondaries, and for some private credit transactions.”
Once you understand how it works, the LBO model becomes a powerful decision-making
asset, helping investors compare opportunities, evaluate purchase prices, and estimate potential returns.
5 Steps of the Leveraged Buyout Model
According to Alternative Investments, the leveraged buyout model involves five key steps:
- Project future earnings: Determine the company’s EBITDA (earnings before interest, taxes, depreciation, and amortization) at the time of sale—typically five years ahead.
- Select an exit multiple: Estimate a valuation multiple based on how similar companies are valued in the current market; this helps forecast the future sale of the business.
- Calculate enterprise value: Multiply the projected EBITDA by the exit multiple to find the company’s total value at the time of sale.
- Determine equity value: Subtract any remaining debt from the enterprise value.
- Find the investor’s share: Multiply the equity value by the private equity firm’s ownership stake to calculate its share of proceeds.
After completing these steps, investors can calculate two key metrics:
- Internal Rate of Return (IRR): Measures the profitability and annualized rate of return of the investment
- Multiple of Money (MoM): Indicates how many times the original investment has grown by exit
In short, the leveraged buyout model isn’t just a spreadsheet, but a strategic roadmap. By projecting future performance, firms can identify operational improvements, increase enterprise value, and turn underperforming businesses into profitable companies.
Why Private Equity Firms Use Leveraged Buyouts
Leveraged buyouts are a cornerstone in private equity and a defining strategy in alternative investment categories. Their value lies not only in financing acquisitions but also in shaping how firms structure, manage, and diversify their portfolios.
Here are three primary reasons private equity firms rely on the leveraged buyout model:
1. Managing Debt Strategically
A key component of the LBO model is building a projected debt repayment schedule. Because buyouts depend heavily on borrowed capital, timing and repayment capacity are essential for success.
“Debt schedules are built based on the expected free cash flows of the business and reflect the payment to debt, including interest payments, and debt amortization,” Ivashina explains in Alternative Investments.
By forecasting levered cash flows—cash remaining after expenses and loan repayments—firms can plan debt repayment and maintain financial stability.
2. Amplifying Returns Through Leverage
Using borrowed money allows firms to expand equity returns. With leverage, a private equity firm can control a company much larger than what its capital alone would allow, investing only a small portion of the purchase price while financing the rest with debt.
A real-world example is alternative asset manager Blackstone’s
acquisition of Hilton. At the height of the real estate market in 2007, just before the financial crisis, Blackstone completed a $26 billion leveraged buyout, using substantial borrowed funds alongside its equity. This structure enabled the firm to take control of Hilton while investing only a fraction of the purchase price in its own capital.
When Hilton later went public, the deal became one of the most profitable private equity investments in history, demonstrating how leveraged buyouts can be highly appealing for their ability to significantly enhance returns, yet equally risky, as heavy debt could have led to major losses had the hotel empire collapsed.
3. Creating Enterprise Value
While leveraged buyouts provide financial advantages, successful private equity firms focus on operational improvement—enhancing efficiency, strengthening leadership, and expanding market reach. The LBO model helps track these efforts and measure whether strategic initiatives translate into real value creation.
When executed effectively, leveraged buyouts combine financial insight with strategic transformation, enabling firms to acquire, strengthen, and grow businesses that can thrive across market cycles.
Navigate the World of High-Stakes Finance with HBS Online
Understanding leveraged buyout models opens the door to how transformative business deals are structured and executed. Whether you’re evaluating investment strategies or building a career in private equity, mastering the LBO model provides a decisive competitive advantage.
At the intersection of financial forecasting, strategic thinking, and operational improvement, leveraged buyouts represent high-stakes opportunities. Learning how private equity firms assess risk, structure deals, and generate value through debt equips you with versatile skills that extend across the alternative investments industry and broader finance roles.
Ready to take the next step? Discover how Alternative Investments can help you sharpen the analytical frameworks and strategic mindset needed to excel in finance—and download our free Financial Terms Cheat Sheet to enhance your financial acumen today.
