What is the primary metric used by sponsors to evaluate the attractiveness of an LBO candidate?

The primary metric used by sponsors to evaluate the attractiveness of a Leveraged Buyout (LBO) candidate is the Internal Rate of Return (IRR). IRR is a crucial measure because it represents the expected annualized rate of return that an investor can anticipate from the investment over time, given the cash flows generated by the target company and the capital structure employed in the buyout.

In an LBO scenario, sponsors typically employ significant amounts of debt to finance the purchase. The IRR calculation incorporates the timing and magnitude of cash flows, including the initial equity investment, operating cash flows generated by the acquired company, and the eventual exit price, typically from a sale or an IPO. A high IRR indicates that the investment is expected to yield substantial returns relative to its cost and the risks associated with it, thereby making it an essential metric for sponsors in assessing potential LBO candidates.

Other metrics, while useful in various contexts, do not capture the specific dynamics of LBOs as effectively as IRR. For example, Net Present Value (NPV) quantifies total value added but does not provide a clear percentage return, making it less effective for comparing investments. Return on Investment (ROI) measures the profit relative to the investment cost, but