An LBO is the acquisition of a target company by an investor group, which typically includes the target's own management. The investor group takes control of the target's finances the acquisition w/ minimal equity capital from LBO 'sponsors' or equity investors. The primary form of financing is debt collateralized with the assets of the target itself or with its cash flow.

Goal: To use the target to finance the purchase. The greater the borrowing power of the target, the less equity the investor group needs to make the acquisition, thus increasing the return.

Equity typically comprises 35% to 45% of the purchase price. As cash flows generated through the company's operations are used to pay down debt, the equity value of the company increases.

The LBO model

The LBO valuation shows how much a financial sponsor would be willing to pay for the target given constraints on debt levels, required returns, etc. In essence, it establishes the maximum value that can be placed on the business in order for the returns to be achieved under constraints imposed by providers of capital (equity, mezzanine, debt) and an assumption as to an exit route after a number of years. The value is based on debt repayment and return on investment.