LBO, explained simply
Returns come from three sources: repaying debt from cash flow, growing EBITDA and selling at a higher multiple than was paid. Because earnings service the debt, lenders rely heavily on quality of earnings, and an overstated EBITDA leads to covenant breaches.
Leverage is expressed as debt divided by EBITDA. Debt is sized on diligence-adjusted EBITDA and repayment depends on free cash flow.
Sources of funds
IllustrativeAlder Creek Manufacturing, enterprise value $36.8 million, $ millions
Senior debt of 3.5× adjusted EBITDA implies interest of about $1.3 million a year at 8%.
Worked example
Senior bank debt of 3.5 × $4.6 million adjusted EBITDA is $16.1 million, with a $4.0 million seller note and $16.7 million of sponsor equity. At about 8% interest the bank debt costs around $1.3 million a year before any repayment. FY2025 free cash flow was only $1.6 million, reduced by the build-up in receivables, so diligence shows the headroom is thin. The sponsor reduces bank debt to 3.0 times EBITDA and makes collecting receivables a first-100-days priority.
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Why it matters in a deal
In an LBO, debt is sized on adjusted EBITDA and repaid from free cash flow, so the reliability of both is central.
Red flags
- Debt sized on management-adjusted rather than diligence-adjusted EBITDA
- Low cash conversion
- Heavy capex requirements ignored in debt planning