In LBO valuation, what is primarily determined to set the maximum purchase price a Private Equity firm can pay?

In a leveraged buyout (LBO) valuation, the maximum purchase price a Private Equity (PE) firm can pay is mainly influenced by the minimum internal rate of return (IRR) that the firm aims to achieve from the investment. The IRR is critical in determining how much capital can be put to work while still meeting the firm's return expectations over the investment horizon.

The PE firm will model out cash flows of the target company, factoring in the anticipated operational performance and leveraging structures. By establishing a target IRR, the firm can backtrack from the expected cash flows and determine how much debt it can take on, the equity component needed, and thus set a cap on what it is able to pay for the target firm. The higher the required IRR, the lower the price that can be justified, as the firm needs to ensure that the cash flows will adequately cover both the debt repayment and the expected returns to equity holders.

While factors like market demand trends, comparative equity ratios, and balance sheet liabilities can influence the deal environment and structure, they do not directly influence the target return requirement, which is the most decisive metric in setting the maximum purchase price in an LBO scenario.