What Is an LBO and Why Does Leverage Increase Returns?

Step 1: Entry Equity Investment

Entry Equity Investment (Levered) = $100m − $60m = $40.0m

Entry Equity Investment (All-Equity) = $100m − $0m = $100.0m

This is the amount of capital the equity investor actually has to put at risk on day one. Debt financing lowers this figure, which is precisely why leverage can boost returns — the investor is buying the same asset with less of their own money.

Step 2: Exit Equity Value

Exit Equity Value (Levered) = $150m − $0m = $150.0m

Exit Equity Value (All-Equity) = $150m − $0m = $150.0m

Because the debt is fully repaid by the exit date in this simplified example, the equity investor in the levered deal captures the entire $150m of exit value with the debt already retired — the same dollar upside as the all-equity buyer, but earned with far less capital committed upfront.

Step 3: Multiple of Money (MoM)

Using the entry equity investment and exit equity value from Steps 1 and 2:

MoM (Levered) = $150.0m / $40.0m = 3.75x

MoM (All-Equity) = $150.0m / $100.0m = 1.50x

MoM measures how many times the investor's original capital came back, independent of how long it took. The levered deal returns 3.75x the initial investment versus 1.50x for the all-equity deal — the identical $50m of enterprise value creation is being split over a much smaller equity base in the levered case, so each dollar invested captures a larger share of it.

Step 4: Approximate IRR

Where: MoM = Multiple of Money from Step 3, Holding Period = number of years capital is invested (5 years in this example).

Plugging in the levered scenario's MoM of 3.75x over a 5-year hold:

IRR (Levered) ≈ 3.75^(1/5) − 1 = 30.5%

Plugging in the all-equity scenario's MoM of 1.50x over the same 5-year hold:

IRR (All-Equity) ≈ 1.50^(1/5) − 1 = 8.4%

IRR annualizes the return, which is what most private equity funds are ultimately judged on because it accounts for how long capital was tied up. Even though both deals generate the exact same $50m of enterprise value growth, the levered deal's IRR is more than 3.5x higher — this is the core intuition interviewers are testing: leverage doesn't create operating value by itself, it concentrates the same dollar of value creation onto a smaller equity check, which mechanically inflates both MoM and IRR.

Final Results

• Entry Equity Investment (Levered): $40.0m
• MoM (Levered): 3.75x
• IRR (Levered): ~30.5%
• IRR (All-Equity): ~8.4%

This leverage effect is the foundation of every private equity buyout model — it's why sponsors care so much about how much debt a target can support (its debt capacity) and why they focus so heavily on picking targets with stable, predictable cash flows that can service that debt.

Would you like to explore how the picture changes if the exit multiple is lower than the entry multiple, or how interest expense and cash sweeps affect the debt paydown assumption used here?