Where do the returns in an LBO come from?
Returns come from EBITDA growth, debt paydown and multiple expansion. If EBITDA goes from $100 million to $140 million, the multiple from 8x to 9x and debt from $500 million to $300 million, equity gains $660 million, split $320 million, $200 million and $140 million.
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There are three sources. The company earns more, so it's worth more. It pays down debt, so more of the value belongs to the equity. And the buyer at exit pays a higher multiple than the sponsor paid. In short, EBITDA growth, debt paydown and multiple expansion. The sponsor also uses a lot of debt, so the equity check is small and the return on it is high. All three matter, and a good deal has some of each.
What holds it back
The three sources are named and each has a reason, which is a fair start. But nothing is sized, so the interviewer can't tell whether you could split a real deal's gain into the three.
There are three sources. The company earns more, so it's worth more. It pays down debt, so more of the value belongs to the equity. And the buyer at exit pays a higher multiple than the sponsor paid. In short, EBITDA growth, debt paydown and multiple expansion. Let me put numbers on it. Say a sponsor buys a company with $100 million of EBITDA at 8 times, so $800 million, funded with $500 million of debt and $300 million of equity. Five years later EBITDA is $140 million, the exit multiple is 9 times, and debt is down to $300 million. Enterprise value is $1,260 million, so equity is $960 million. That's a gain of $660 million, or 3.2 times the money. Now I split the gain. EBITDA grew by $40 million, and at the entry multiple of 8 that's $320 million. The multiple went up by one turn, and on $140 million of exit EBITDA that's $140 million. Debt fell by $200 million, which goes straight to equity. 320 plus 140 plus 200 is 660, so it adds up.
There are three sources. The company earns more, so it's worth more. It pays down debt, so more of the value belongs to the equity. And the buyer at exit pays a higher multiple than the sponsor paid. In short, EBITDA growth, debt paydown and multiple expansion. Let me put numbers on it. Say a sponsor buys a company with $100 million of EBITDA at 8 times, so $800 million, funded with $500 million of debt and $300 million of equity. Five years later EBITDA is $140 million, the exit multiple is 9 times, and debt is down to $300 million. Enterprise value is $1,260 million, so equity is $960 million. That's a gain of $660 million, or 3.2 times the money. Over five years that's about a 26% IRR. Now I split the gain. EBITDA grew by $40 million, and at the entry multiple of 8 that's $320 million. The multiple went up by one turn, and on $140 million of exit EBITDA that's $140 million. Debt fell by $200 million, which goes straight to equity. 320 plus 140 plus 200 is 660, so it adds up. So about half the gain came from EBITDA growth, 30% from debt paydown and about 20% from the multiple. Two caveats. The split depends on a convention. I valued the growth at the entry multiple and the higher multiple on exit EBITDA, and doing it the other way moves $40 million from the multiple to growth. And the three aren't equally reliable. EBITDA growth and debt paydown come from how the business is run. Multiple expansion depends on the market in the exit year, so I wouldn't back a deal that needs it. In my base case I'd set the exit multiple equal to the entry multiple.
The numbers, step by step
A company with $100 million of EBITDA bought at 8 times with $500 million of debt, sold five years later at 9 times. All figures in $ millions.
- Equity invested$100 × 8 − $500 of debt
- $300 million
- Equity at exit$140 × 9 − $300 of debt
- $960 million
- Gain to equity$960 − $300
- $660 million
- Multiple of money$960 / $300
- 3.2x
- IRR over five years3.2 ^ (1/5) − 1
- about 26%
- From EBITDA growth($140 − $100) × 8
- $320 million
- From multiple expansion(9 − 8) × $140
- $140 million
- From debt paydown$500 − $300
- $200 million
- Check: the three pieces$320 + $140 + $200
- $660 million
What the interviewer listens for
- Do you name all three sources without prompting?
- Can you say why each one raises the value of the equity?
- Can you split a gain into the three so the pieces add up?
- Do you know which source you shouldn't count on?
Common mistakes
- Listing the three drivers and stopping.The usual follow-up is to size them on a simple deal, so practice one set of round numbers.
- Getting pieces that don't add up to the gain.Value growth at the entry multiple and the higher multiple on exit EBITDA, or the other way round, but not both at entry.
- Calling leverage itself a source of return.Borrowing makes the equity check smaller. The gain to equity comes from paying the debt down with the company's cash flow.
- Building the case on a higher exit multiple.It's the one source the sponsor doesn't control.
More finance technicals
- Walk me through the sources and uses in an LBO.
- What is a dividend recapitalization, and why would a private equity firm do one?
- What kinds of debt are used in an LBO?
- How do you decide how much debt a company can support?
- Walk me through a basic LBO.
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