How do you back into the most a sponsor can pay for a company if it needs a 20% IRR?

Work backwards: take exit equity, discount it at the target return to find the most equity you can invest, then add the debt lenders will give. With $900 million of exit equity, 20% over five years allows about $360 million.

The numbers, step by step

The deal from the answer, in $ millions: $100 of EBITDA now, $150 in year five, an 8 times exit and 5 times debt at entry, $200 of it repaid.

Exit enterprise value$150 × 8

$1,200

Debt left at exit$100 × 5 − $200

$300

Exit equity$1,200 − $300

$900

Growth needed for 20% over five years1.2^5

2.49x

Most equity today$900 ÷ 2.49

$362

Most the sponsor can pay$362 + $500 of debt

$862

As a multiple of today's EBITDA$862 ÷ $100

8.6x

What the interviewer listens for

• Do you work back from exit equity, not enterprise value?
• Do you compound the target IRR, about 2.5 times for 20% over five years?
• Do you add the debt back to reach a price?
• Do you explain why the debt doesn't rise with the price?

Common mistakes

• Discounting exit enterprise value instead of exit equity.The IRR target applies to the sponsor's equity.
• Treating 20% for five years as 2 times.Compounded, it's about 2.5 times.
• Assuming debt scales with the price.Lenders size it on EBITDA, so a higher price is paid with equity.
• Stopping at the equity check and forgetting to add the debt back to get the price.

Likely follow-ups

• What's the most you can pay for a 25% IRR?1.25 to the fifth is about 3.05, so equity is $900 million over 3.05, about $295 million. With $500 million of debt that's about $795 million, roughly 8 times.
• What if lenders gave 6 times instead of 5?Holding the $200 million of paydown, exit equity is $800 million, so I can invest about $320 million and pay about $920 million in total. In practice the extra interest would trim the paydown a little.
• Why do sponsors often lose auctions to strategic buyers?The sponsor's price is capped by its target return and debt capacity, while a strategic can count synergies and accept a lower return.

More finance technicals

• 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?
• What is the difference between IRR and MOIC?

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