LBO returns and fund economics
Work through a simple leveraged buyout, split the returns into their sources, and calculate fees and carry.
Industry brief, with a one-minute summary: Private equity and venture capitalKey takeaways
- In a leveraged buyout, the fund pays for a company with some equity and a lot of debt.
- Enterprise value (EV) is the value of the whole business, usually a multiple of EBITDA (earnings before interest, tax, depreciation, and amortization).
- MOIC ignores time; IRR rewards speed. Doubling in 3 years is about 26 percent a year, while doubling in 7 years is about 10 percent a year.
Key idea
In a leveraged buyout, the fund pays for a company with some equity and a lot of debt. If the company grows its earnings and pays down debt, the equity value grows much faster than the company's value.
Enterprise value (EV) is the value of the whole business, usually a multiple of EBITDA (earnings before interest, tax, depreciation, and amortization). EV is split between debt and equity. Two return measures matter. MOIC (multiple on invested capital) is the money received divided by the money invested. IRR (internal rate of return) is the yearly return rate that turns the investment into the money received, so it rewards speed. Doubling money in 3 years is an IRR of about 26 percent; in 5 years, about 15 percent.
Worked case
A simple leveraged buyout of a European services company
The prompt
A PE fund buys a business services company in Europe with EBITDA of EUR 100 million, paying 10 times EBITDA. It funds the deal with EUR 500 million of debt and the rest in equity. Over 5 years EBITDA grows to EUR 130 million and the company uses its cash to repay EUR 200 million of debt. The fund sells at the same 10 times multiple. What are the MOIC and roughly the IRR, and where did the return come from?
The structure
- Equity value at exit versus equity invested
- Entry: EV = EBITDA x multiple; equity = EV minus debt
- Exit: EV = new EBITDA x exit multiple; equity = EV minus remaining debt
- Return sources: EBITDA growth, multiple change, debt paydown
Working it through
1. Entry value
10 times EUR 100 million.
Entry EV (EUR millions):100 × 10 = 1,0002. Equity invested
EV minus EUR 500 million of debt.
Equity at entry (EUR millions):1,000 - 500 = 5003. Exit value
10 times EUR 130 million.
Exit EV (EUR millions):130 × 10 = 1,3004. Equity at exit
Debt is now 500 minus 200, which is 300.
Equity at exit (EUR millions):1,300 - (500 - 200) = 1,0005. MOIC
Equity out divided by equity in.
MOIC (times):1,000 ÷ 500 = 26. IRR check
An IRR of about 14.87 percent grows money 2 times in 5 years: 1.1487 to the power of 5 is about 2.
Growth factor over 5 years at 14.87 percent:1.1487 × 1.1487 × 1.1487 × 1.1487 × 1.1487 = 27. Return from EBITDA growth
EBITDA rose 30 at a multiple of 10.
Value from EBITDA growth (EUR millions):(130 - 100) × 10 = 3008. Bridge ties out
EBITDA growth 300, multiple change 0, debt paydown 200: together the 500 gain in equity.
Total equity gain (EUR millions):300 + 0 + 200 = 500
The recommendation
The fund should do the deal but build its plan on EBITDA growth, because it doubles its money, a 2.0 times MOIC, for an IRR of about 15 percent over 5 years. First, three fifths of the EUR 500 million gain comes from growing EBITDA from EUR 100 million to EUR 130 million, worth EUR 300 million at 10 times. Second, the other two fifths comes from repaying EUR 200 million of debt; none comes from a higher multiple. The risk is a lower exit multiple: at 8 times, MOIC falls to about 1.5. As a next step, test each EBITDA growth assumption in the plan.
Risks: If the exit multiple falls from 10 to 8 times, exit EV is 1,040 and equity is 740, a MOIC of only about 1.5 times; High debt makes the company fragile if earnings drop; Interest costs reduce the cash available to repay debt.
A PE fund in India invests INR 300 crore of equity in a healthcare company and sells its stake 4 years later for INR 750 crore. What is the MOIC?
A USD 500 million buyout fund generates USD 1,100 million of total proceeds over its life, before carried interest. Carried interest is 20 percent of profit, and assume the hurdle is met and fully caught up, so carry is 20 percent of all profit. Ignore fees. How much carry does the GP earn, in USD millions?
Fund A returns 2 times its money in 3 years. Fund B returns 2 times in 7 years. Which is true?
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and frameworks
My notes on this lesson
0 of 5,000 characters. Saves automatically.
Try the 3 remaining checks and drills above to complete this lesson (0 of 3 done).
Spotted something wrong or out of date? Report a mistake. We check every report and correct the page.