Leveraged Buyouts

What is an "ideal" candidate for an LBO?

"Ideal" candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt. The most important part is stable cash flow.

Walk me through a basic LBO model.

"In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume something about the company's operations, such as Revenue Growth or Margins, depending on how much information you have. Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required. Step 3 is to adjust the company's Balance Sheet for the new Debt and Equity figures, and also add in Goodwill & Other Intangibles on the Assets side to make everything balance. In Step 4, you project out the company's Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments. Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm."

How could a private equity firm boost its return in an LBO?

1. Lower the Purchase Price in the model. 2. Raise the Exit Multiple / Exit Price. 3. Increase the Leverage (debt) used. 4. Increase the company's growth rate (organically or via acquisitions). 5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.). Note that these are all "theoretical" and refer to the model rather than reality - inpractice it's hard to actually implement these.

Tell me about all the different kinds of debt you could use in an LBO and the differences between everything.

Here's a handy chart to explain all of this. Note that this chart does not cover every single feature or every single type of debt in the universe - just the most important ones, and what you're likely to be asked about in finance interviews: [SEE CHART ON BIWS GUIDES] "Tenor" is just the fancy word for "How many years will this loan be outstanding?" Each type of debt is arranged in order of rising interest rates - so a revolver has the lowest interest rate, Term Loan A is slightly higher, B is slightly higher, Senior Notes are higher than Term Loan B, and so on. "Seniority" refers to the order of claims on a company's assets in a bankruptcy - the Senior Secured holders are first in line, followed by Senior Unsecured, Senior Subordinated, and then Equity Investors. "Floating" or "Fixed" Interest Rates: A "floating" interest rate is tied to LIBOR. For example, L + 100 means that the interest rate of the loan is whatever LIBOR is at currently, plus 100 basis points (1.0%). A fixed interest rate, on the other hand, would be 11%. It doesn't "float" with LIBOR or any other rate. Amortization: "straight line" means the company pays off the principal in equal installments each year, while "bullet" means that the entire principal is due at the end of the loan's lifecycle. "Minimal" just means a low percentage of the principal each year, usually in the 1-5% range. Call Protection: Is the company prohibited from "calling back" - paying off or redeeming - the security for a certain period? This is beneficial for investors because they are guaranteed a certain number of interest payments.

What actions or strategies can you take to improve the IRR in an LBO?

IRR (internal rate of return) is one of the most used metrics to determine the success of an LBO. There are several actions that a firm can take to improve the IRR, which include: ● Lowering the initial purchase price of the company, which reduces the cash investment ● Improving the exit multiple, which increases the funds received ● Increasing leverage, which reduces the amount of upfront investment required ● Conducting a dividend recapitalization ● Exiting the investment earlier ● Accelerating the company's growth, which should increase EBITDA and the exit multiple ● Improving margins, which has the same effects as faster growth ● Realizing synergies with other portfolio companies or rolling in new acquisitions

Why would a PE firm prefer high-yield debt instead?

If the PE firm intends to refinance the company at some point or they don't believe their returns are too sensitive to interest payments, they might use high-yield debt. They might also use the high-yield option if they don't have plans for major expansion or selling off the company's assets.

Why might you use bank debt rather than high-yield debt in an LBO?

If the PE firm or the company is concerned about meeting interest payments and wants a lower-cost option, they might use bank debt; they might also use bank debt if they are planning on major expansion or Capital Expenditures and don't want to be restricted by incurrence covenants.

What are some examples of incurrence covenants? Maintenance covenants?

Incurrence Covenants: • Company cannot take on more than $2 billion of total debt. • Proceeds from any asset sales must be earmarked to repay debt. • Company cannot make acquisitions of over $200 million in size. • Company cannot spend more than $100 million on CapEx each year. Maintenance Covenants: • Total Debt / EBITDA cannot exceed 3.0 x • Senior Debt / EBITDA cannot exceed 2.0 x • (Total Cash Payable Debt + Capitalized Leases) / EBITDAR cannot exceed 4.0 x • EBITDA / Interest Expense cannot fall below 5.0 x • EBITDA / Cash Interest Expense cannot fall below 3.0 x • (EBITDA - CapEx) / Interest Expense cannot fall below 2.0 x

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

Primarily to boost returns. Remember, all else being equal, more leverage means a higher return to the firm. With a dividend recap, the PE firm is "recovering" some of its equity investment in the company - and as we saw earlier, the lower the equity investment, the better, since it's easier to earn a higher return on a smaller amount of capital.

What variables impact an LBO model the most?

Purchase and exit multiples have the biggest impact on the returns of a model. After that, the amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as revenue growth and EBITDA margins.

If a company could service debt up to 7X EBITDA, why would it only take debt up to 5X EBITDA?

Raising the maximum amount of debt is not always in the best interest of a company. Some of the reasons that make additional debt unattractive include, but are not limited to: ● It may be a bad secular debt market and it may be hard to raise capital right now. Interest rates could be comparatively higher than the future, which might make it better to defer raising debt ● Raising more debt would hurt cash flows, which increases the overall company risk and compromises its profitability ● Additional debt may impact the company's perception among potential investors or credit agencies, potentially leading to a reduction to the company's credit rating

Why are Goodwill & Other Intangibles created in an LBO?

Remember, these both represent the premium paid to the "fair market value" of the company. In an LBO, they act as a "plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.

What are the three ways investors can retrieve funds or capital in an LBO?

There are three major ways an LBO investor can retrieve cash or funds from an LBO investment: ● Exit: The sale of the investment at the end of the holding period is the largest inflow of capital for the sponsor as all gains are realized at this point ● Dividend Recapitalization: A dividend recapitalization is when the LBO candidate pays out a special dividend to the sponsors, funded through additional debt. This increases leverage of the company and typically increases IRR because of the time value of money ● Dividends. Yes, although this is very similar to a dividend recapitalization, it is important to recognize these two things as distinctly different actions

Why you would you use PIK (Payment In Kind) debt rather than other types of debt, and how does it affect the debt schedules and the other statements?

Unlike "normal" debt, a PIK loan does not require the borrower to make cash interest payments - instead, the interest just accrues to the loan principal, which keeps going up over time. A PIK "toggle" allows the company to choose whether to pay the interest in cash or have it accrue to the principal (these have disappeared since the credit crunch). PIK is more risky than other forms of debt and carries with it a higher interest rate than traditional bank debt or high yield debt. Adding it to the debt schedules is similar to adding high-yield debt with a bullet maturity - except instead of assuming cash interest payments, you assume that the interest accrues to the principal instead. You should then include this interest on the Income Statement, but you need to add back any PIK interest on the Cash Flow Statement because it's a non-cash expense.

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

Usually you would look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. You would look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

Do you need to project all 3 statements in an LBO model? Are there any "shortcuts?"

Yes, there are shortcuts and you don't necessarily need to project all 3 statements. For example, you do not need to create a full Balance Sheet - bankers sometimes skip this if they are in a rush. You do need some form of Income Statement, something to track how the Debt balances change and some type of Cash Flow Statement to show how much cash is available to repay debt. But a full-blown Balance Sheet is not strictly required, because you can just make assumptions on the Net Change in Working Capital rather than looking at each item individually.

Explain how a Revolver is used in an LBO model.

You use a Revolver when the cash required for your Mandatory Debt Repayments exceeds the cash flow you have available to repay them. The formula is: Revolver Borrowing = MAX(0, Total Mandatory Debt Repayment - Cash Flow Available to Repay Debt). The Revolver starts off "undrawn," meaning that you don't actually borrow money and don't accrue a balance unless you need it - similar to how credit cards work. You add any required Revolver Borrowing to your running total for cash flow available for debt repayment before you calculate Mandatory and Optional Debt Repayments. Within the debt repayments themselves, you assume that any Revolver Borrowing from previous years is paid off first with excess cash flow before you pay off any Term Loans.

How do you use an LBO model to value a company, and why do we sometimes say that it sets the "floor valuation" for the company?

You use it to value a company by setting a targeted IRR (for example, 25%) and then back-solving in Excel to determine what purchase price the PE firm could pay to achieve that IRR. This is sometimes called a "floor valuation" because PE firms almost always pay less for a company than strategic acquirers would.

What are factors that would make an LBO more difficult to perform on a private company?

1) First, the financials of a private company are much more opaque than public companies. Private companies are not legally required to publish audited financials, which can make it much more difficult to gauge the health and attractiveness of a company. These financials would be necessary to determine the potential returns a firm could generate and the target's ability to service debt. 2) Second, the absence of floating shares on public exchanges can make it difficult for a firm to acquire a controlling stake in the company. Private equity firms that conduct LBO's can only do so because they hold a controlling stake in the company and can force the target to assume a greater quantity of debt. Without direct access to these shares, the private equity firm would have to directly solicit shareholders. 3) Finally, obtaining debt can be difficult because of a lack of information, history, and credit rating. Public debt markets are difficult to access for private companies because of the above and also because they simply don't have the scale for a major issuance.

Why would a revolver have the lowest interest rate?

A revolver is the cheapest form of debt in an LBO. A revolver acts similarly to a credit card, as it is drawn upon if the company has cash shortfalls and is also the first thing paid down. Revolver interest rates are the lowest because they are pledged against collateral, which reduces its riskiness. Concurrently, revolvers have the lowest interest rate because commercial banks and lenders treat it as a sweetener in a deal and compete for a company's business based on how low the rate is.

What is the internal rate of return (IRR)?

Academically speaking, the IRR is the rate at which the present value of an asset's cash inflows and outflows is equal to 0. Practically speaking, IRR is the compound rate you can expect to earn on an investment into an asset. A lower initial investment means that the cash outflow is lower, which would increase the IRR. Higher returns in the future means that the cash inflows are higher, which would also increase the IRR. If there is only one initial cash outflow and one final inflow, the IRR is simply the compound annual growth rate on the investment. This can be used to sometimes estimate the IRR of projects.

How would an asset write-up or write-down affect an LBO model? / Walk me through how you adjust the Balance Sheet in an LBO model.

All of this is very similar to what you would see in a merger model - you calculate Goodwill, Other Intangibles, and the rest of the write-ups in the same way, and then the Balance Sheet adjustments (e.g. subtracting cash, adding in capitalized financing fees, writing up assets, wiping out goodwill, adjusting the deferred tax assets / liabilities, adding in new debt, etc.) are almost the same. The key differences: • In an LBO model you assume that the existing Shareholders' Equity is wiped out and replaced by the equity the private equity firm contributes to buy the company; you may also add in Preferred Stock, Management Rollover, or Rollover from Option Holders to this number as well depending on what you're assuming for transaction financing. • In an LBO model you'll usually be adding a lot more tranches of debt vs. what you would see in a merger model. • In an LBO model you're not combining two companies' Balance Sheets.

Why would a private equity firm buy a company in a "risky" industry, such as technology?

Although technology is more "risky" than other markets, remember that there are mature, cash flow-stable companies in almost every industry. There are some PE firms that specialize in very specific goals, such as: • Industry consolidation - buying competitors in a similar market and combining them to increase efficiency and win more customers. • Turnarounds - taking struggling companies and making them function properly again. • Divestitures - selling off divisions of a company or taking a division and turning it into a strong stand-alone entity. So even if a company isn't doing well or seems risky, the firm might buy it if it falls into one of these categories.

Why would an LBO not be relevant for the metals and mining industry?

An ideal LBO candidate has dependable cash flows, low capital expenditures and is not exposed to commodity risk. The metals and mining industry embodies the opposite of this; high initial investments, continual capital expenditures, and direct exposure to unpredictable commodity fluctuations. During periods of weak commodity prices, senior miners are forced to sell their assets with high cash costs, while junior miners do not have enough money to fuel their capital expenditures. Accordingly, mergers are more common in the metals and mining industry.

Walk me through how you calculate optional repayments on debt in an LBO model.

First, note that you only look at optional repayments for Revolvers and Term Loans - high-yield debt doesn't have a prepayment option, so effectively it's always $0. First, you check how much cash flow you have available based on your Beginning Cash Balance, Minimum Cash Balance, Cash Flow Available for Debt Repayment from the Cash Flow Statement, and how much you use to make Mandatory Debt Repayments. Then, if you've used your Revolver at all you pay off the maximum amount that you can with the cash flow you have available. Next, for Term Loan A you assume that you pay off the maximum you can, taking into account that you've lost any cash flow you used to pay down the Revolver. You also need to take into account that you might have paid off some of Term Loan A's principal as part of the Mandatory Repayments. Finally, you do the same thing for Term Loan B, subtracting from the "cash flow available for debt repayment" what you've already used up on the Revolver and Term Loan A. And just like Term Loan A, you need to take into account any Mandatory Repayments you've made so that you don't pay off more than the entire Term Loan B balance. The formulas here get very messy and depend on how your model is set up, but this is the basic idea for optional debt repayments.

Can you explain how the Balance Sheet is adjusted in an LBO model?

First, the Liabilities & Equities side is adjusted - the new debt is added on, and the Shareholders' Equity is "wiped out" and replaced by however much equity the private equity firm is contributing. On the Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Other Intangibles are used as a "plug" to make the Balance Sheet balance. Depending on the transaction, there could be other effects as well - such as capitalized financing fees added to the Assets side.

There are two companies with identical growth prospects, margins, business models, etc. The only difference is that one company has 50% debt-to-total capitalization, while the other has 0%. If you were a PE firm and were going to bring the company's debt-to-total capitalization to 70%, which investment would yield a higher IRR (assuming that the equity purchase price is the same)?

First, we make the assumption that the ability to service debt is the same for both companies, so the interest rates, covenants and debt tolerance for both firms is identical. With that out of the way, we recognize that the two company's initial debt-to-total capitalization is irrelevant from a returns basis. It does not matter if you are the firm who raised the debt or if the debt was refinanced from before, the IRR and returns will be the same mathematically. At 70% debt-to-total capitalization, the EV of the two companies would be the same, implying that the IRR would be the same as well. However, this assumes that the purchase EV is the same in both situations. This is not entirely correct because sponsors typically have to pay a premium on equity (control premium), which does not apply to debt. In this case, the company with the higher debt will result in a higher IRR because it will have a lower purchase price.

Normally we care about the IRR for the equity investors in an LBO - the PE firm that buys the company - but how do we calculate the IRR for the debt investors?

For the debt investors, you need to calculate the interest and principal payments they receive from the company each year. Then you simply use the IRR function in Excel and start with the negative amount of the original debt for "Year 0," assume that the interest and principal payments each year are your "cash flows" and then assume that the remaining debt balance in the final year is your "exit value." Most of the time, returns for debt investors will be lower than returns for the equity investors - but if the deal goes poorly or the PE firm can't sell the company for a good price, the reverse could easily be true.

What is a dividend recapitalization ("dividend recap")?

In a dividend recap, the company takes on new debt solely to pay a special dividend out to the PE firm that bought it. It would be like if you made your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds. As you might guess, dividend recaps have developed a bad reputation, though they're still commonly used.

Just like a normal M&A deal, you can structure an LBO either as a stock purchase or as an asset purchase. Can you also use Section 338(h)(10) election?

In most cases, no - because one of the requirements for Section 338(h)(10) is that the buyer must be a C corporation. Most private equity firms are organized as LLCs or Limited Partnerships, and when they acquire companies in an LBO, they create an LLC shell company that "acquires" the company on paper.

We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that's the case, why would a PE firm want to use debt in an LBO?

It's a different scenario because: 1. The PE firm does not intend to hold the company for the long-term - it usually sells it after a few years, so it is less concerned with the "expense" of cash vs. debt and more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront. 2. In an LBO, the debt is "owned" by the company, so they assume much of the risk. Whereas in a strategic acquisition, the buyer "owns" the debt so it is more risky for them.

What is leverage and how do its mechanics amplify returns in an LBO?

Leverage and the act of "levering up a company" refers to taking on debt or other forms of borrowed capital in order to increase a company's returns. LBO's use leverage to improve returns for the investor, which is possible because of three key functions of debt: ● Taking on debt gives you access to other people's capital that you would otherwise not be able to use. A greater resource pool allows you to purchase a greater quantity of productive assets while reducing the up-front cash investment ● Using the company or asset's cash flows to repay debt principal produces a better return than just keeping the cash. This is partially a result of the tax shield that is applied to interest, which is a function of how governments and regulators treat debt. Similarly, allowing interest to be tax-deductible makes debt a cheaper source of capital than equity ● Typically a business experiences growth in EBITDA so the exit price is higher than the entry price even at the same multiple. Since the sponsor typically pays back a lot of the debt, a much larger portion of the exit price belongs to the sponsor, creating high returns. For example, entering and exit at an EV of $100, a sponsor may only invest $25 in cash, but receive $80 upon exit, simply by paying down debt

How would a dividend recap impact the 3 financial statements in an LBO?

No changes to the Income Statement. On the Balance Sheet, Debt would go up and Shareholders' Equity would go down and they would cancel each other out so that everything remained in balance. On the Cash Flow Statement, there would be no changes to Cash Flow from Operations or Investing, but under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change.

What is the interest tax shield?

The interest tax shield is a phenomenon that makes debt a cheaper vehicle of capital than equity. Interest is tax-deductible, as it appears higher than the tax line on the income statement and is treated as a cash expense. Mechanically, the greater the amount of expenses that a company has, the less tax it has to pay, which provides financial benefits for the company. The interest tax shield is one of the reasons that debt is such an attractive financing vehicle and is also the reason we calculate after-tax cost of debt for the WACC. The PV of a tax shield is Debt Amount x Tax Rate.

How would you adjust the Income Statement in an LBO model?

The most common adjustments: • Cost Savings - Often you assume the PE firm cuts costs by laying off employees, which could affect COGS, Operating Expenses, or both. • New Depreciation Expense - This comes from any PP&E write-ups in the transaction. • New Amortization Expense - This includes both the amortization from written-up intangibles and from capitalized financing fees. • Interest Expense on LBO Debt - You need to include both cash and PIK interest here. • Sponsor Management Fees - Sometimes PE firms charge a "management fee" to a company to account for the time and effort they spend managing it. • Common Stock Dividend - Although private companies don't pay dividends to shareholders, they could pay out a dividend recap to the PE investors. • Preferred Stock Dividend - If Preferred Stock is used as a form of financing in the transaction, you need to account for Preferred Stock Dividends on the Income Statement. Cost Savings and new Depreciation / Amortization hit the Operating Income line; Interest Expense and Sponsor Management Fees hit Pre-Tax Income; and you need to subtract the dividend items from your Net Income number.

Give an example of a "real-life" LBO.

The most common example is taking out a mortgage when you buy a house. Here's how the analogy works: • Down Payment: Investor Equity in an LBO • Mortgage: Debt in an LBO • Mortgage Interest Payments: Debt Interest in an LBO • Mortgage Repayments: Debt Principal Repayments in an LBO • Selling the House: Selling the Company / Taking It Public in an LBO

What is the rule of 72? What is the rule of 114?

The rule of 72 and 114 are two mental math tricks you can use to determine the IRR of an LBO transaction. Whenever you are asked to derive an actual number for an IRR, you can typically use these rules. The rule of 72 stipulates that the time it takes to double an investment is 72 divided by that time period. Although not 100% accurate, it will suffice in an interview setting. For example, the rate you get if an investment doubles in 3 years is 24%; 4 years is 18%; 5 years is 14.4%, etc. The rule of 114 stipulates that the time it takes to triple an investment is 114 divided by that time period. For example, the rate you get if an investment triples in 3 years is 38%; 4 years is 28.5%, 5 years is 25%, etc.

How do you pick purchase multiples and exit multiples in an LBO model?

The same way you do it anywhere else: you look at what comparable companies are trading at, and what multiples similar LBO transactions have had. As always, you also show a range of purchase and exit multiples using sensitivity tables. Sometimes you set purchase and exit multiples based on a specific IRR target that you're trying to achieve - but this is just for valuation purposes if you're using an LBO model to value the company.

What is the difference between bank debt and high-yield debt?

This is a simplification, but broadly speaking there are 2 "types" of debt: "bank debt" and "high-yield debt." There are many differences, but here are a few of the most important ones: • High-yield debt tends to have higher interest rates than bank debt (hence the name "high-yield"). • High-yield debt interest rates are usually fixed, whereas bank debt interest rates are "floating" - they change based on LIBOR or the Fed interest rate. • High-yield debt has incurrence covenants while bank debt has maintenance covenants. The main difference is that incurrence covenants prevent you from doing something (such as selling an asset, buying a factory, etc.) while maintenance covenants require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times). • Bank debt is usually amortized - the principal must be paid off over time - whereas with high-yield debt, the entire principal is due at the end (bullet maturity). Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt. Again, there are many different types of debt - this is a simplification, but it's enough for entry-level interviews.

You have the option of either receiving $200M now or $40M each year for 5 years. What IRR would you need to make the value of these two options equal?

This is a trick question, which is tipped off slightly as it is very difficult to mentally calculate an IRR to gauge two investment options. Here, we remember that IRR makes all future cash flows equal 0 when discounted to the present value. If any of the five future $40M payments are discounted, the sum of their present value would be less than $200M. If any of the five future $40M payments are appreciated, the sum of their present value would be greater than $200M. The only mathematical possibility is if the IRR is 0.

Let's say we're analyzing how much debt a company can take on, and what the terms of the debt should be. What are reasonable leverage and coverage ratios?

This is completely dependent on the company, the industry, and the leverage and coverage ratios for comparable LBO transactions. To figure out the numbers, you would look at "debt comps" showing the types, tranches, and terms of debt that similarly sized companies in the industry have used recently. There are some general rules: for example, you would never lever a company at 50x EBITDA, and even during the bubble leverage rarely exceeded 5-10x EBITDA.

Why might a private equity firm allot some of a company's new equity in an LBO to a management option pool, and how would this affect the model?

This is done for the same reason you have an Earnout in an M&A deal: the PE firm wants to incentivize the management team and keep everyone on-board until they exit the investment. The difference is that there's no technical limit on how much management might receive from such an option pool: if they hit it out of the park, maybe they'll all become millionaires. In your LBO model, you would need to calculate a per-share purchase price when the PE firm exits the investment, and then calculate how much of the proceeds go to the management team based on the Treasury Stock Method. An option pool by itself would reduce the PE firm's return, but this is offset by the fact that the company should perform better with this incentive in place.

What is meant by the "tax shield" in an LBO?

This means that the interest a firm pays on debt is tax-deductible - so they save money on taxes and therefore increase their cash flow as a result of having debt from the LBO. Note, however, that their cash flow is still lower than it would be without the debt - saving on taxes helps, but the added interest expenses still reduces Net Income over what it would be for a debt-free company.

Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.

This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes. Sometimes in LBO models, increasing the leverage increases the IRR up to a certain point - but then after that the IRR starts falling as the interest payments or principal repayments become "too big." For this scenario to happen you would need a "perfect storm" of: 1. Relative lack of cash flow / EBITDA growth. 2. High interest payments and principal repayments relative to cash flow. 3. Relatively high purchase premium or purchase multiple to make it more difficult to get a high IRR in the first place.

Why would you use leverage when buying a company?

To boost your return. Remember, any debt you use in an LBO is not "your money" - so if you're paying $5 billion for a company, it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money. A secondary benefit is that the firm also has more capital available to purchase other companies because they've used leverage.

If you purchased a company for $100M and sold it for $200M after 5 years, what was your IRR?

Whenever asked a question about IRR, you must first clarify how much debt the company had at the beginning of the holding period and how much debt it had at the end of the period. The company's debt at the start of the period reduces the amount of initial investment and what the cash outflows are, while the company's debt at the end of the period must be paid down before returns can be realized. Now armed with the rule of 72, we can recognize that this is simply a doubling of an investment over 5 years. Assuming that the company had no debt throughout the entire investment, the IRR would be approximately 14.4% (actually closer to 15%).

In an LBO model, is it possible for debt investors to get a higher return than the PE firm? What does it tell us about the company we're modeling?

Yes, and it happens more commonly than you'd think. Remember, high-yield debt investors often get interest rates of 10-15% or more - which effectively guarantees an IRR in that range for them. So no matter what happens to the company or the market, that debt gets repaid and thedebt investors get the interest payments. But let's say that the median EBITDA multiples contract, or that the company fails to grow or actually shrinks - in these cases the PE firm could easily get an IRR below what the debt investors get.