In an LBO, what happens to returns if the exit multiple is one turn lower than the entry multiple?

Say the debt is fixed, so a one-turn drop in exit enterprise value comes entirely out of equity. In the example, one turn on $120 million of EBITDA cuts equity by 40%, from 2.2 times to 1.8 times the money.

The numbers, step by step

The deal from the answer, in $ millions: $100 of EBITDA bought at 8 times with $500 of debt, growing to $120 by year five with $300 of debt left.

Equity at entry$100 × 8 − $500

$300

Exit equity at 8 times$120 × 8 − $300

$660

Multiple at 8 times$660 ÷ $300

2.2x

IRR at 8 times2.2^(1/5) − 1

17.1%

Exit equity at 7 times$120 × 7 − $300

$540

Multiple at 7 times$540 ÷ $300

1.8x

IRR at 7 times1.8^(1/5) − 1

12.5%

Equity lost as a share of the check($660 − $540) ÷ $300

40%

What the interviewer listens for

• Do you say the full loss lands on the equity because the debt is fixed?
• Do you size one turn on exit EBITDA?
• Do you show returns before and after with numbers?
• Do you say leverage magnifies the percentage hit?

Common mistakes

• Saying returns fall by the 12.5% change in the multiple.The equity falls far more because the debt doesn't shrink.
• Valuing the lost turn on entry EBITDA.It's one turn on exit EBITDA, here $120 million, not $100 million.
• Assuming the deal loses money.A one-turn drop can still leave a solid return when EBITDA grew and debt came down.

Likely follow-ups

• What exit multiple gets you back to 2 times?$600 million of equity plus $300 million of debt is $900 million, and over $120 million of EBITDA that's 7.5 times.
• Can a sponsor still do well selling below its entry multiple?Yes, if growth and paydown outweigh it. Buy $100 million of EBITDA at 10 times with $600 million of debt, grow it to $160 million, cut debt to $300 million and sell at 9 times five years later, and that's 2.85 times and about 23%.
• Why might exit multiples come in below entry?Growth slows as the business matures, market valuations or rates move against you, or the sponsor paid a full price in a competitive auction.

More finance technicals

• How do you back into the most a sponsor can pay for a company if it needs a 20% IRR?
• What is a cash sweep in an LBO?
• Walk me through a basic LBO.
• What makes a company a good LBO candidate?
• Why private equity?

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