How does a private equity buyer use an LBO to set the maximum price it can pay, and why is this a valuation floor?
A core Valuation interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
A sponsor runs the LBO backwards: fix the required return (say 20–25% IRR over five years), assume an exit multiple and exit EBITDA, and solve for the maximum entry equity that still hits the return given the debt the business can raise. Entry equity plus debt funded equals the max purchase price. It's described as a 'floor' because strategics can usually pay more — they capture synergies and don't need a financial return on a standalone basis — so the LBO-affordable price tends to sit below strategic value. In an auction, the LBO price tells you what the financial sponsors in the room can bid, anchoring the lower end of the range.
WHAT INTERVIEWERS LISTEN FOR
- ✓Solve LBO backwards from required IRR and exit
- ✓Max price = affordable equity + debt capacity
- ✓Strategics pay more via synergies → LBO is a floor
- ✓Anchors the low end of the football field
COMMON MISTAKES
- ✗Calling LBO the highest valuation method
- ✗Forgetting it's return-driven not synergy-driven
- ✗Not linking to debt capacity
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