Case 043Leveraged finance and LBO financingHard

A sponsor is buying Tarvik Education at 9x EBITDA of Rs 150 crore with 5x debt, and the cost of debt rises from 9% to 11% before signing. How does that move the sponsor's IRR, and how much less must it pay to keep a 20% IRR?

Houlihan LokeyLos Angeles · 2025

The situation

A sponsor has agreed to buy Tarvik Education, a chain of test preparation centres, for 9.0x EBITDA of Rs 150 crore, Rs 1,350 crore. It planned Rs 750 crore of debt, 5.0x, at 9%. EBITDA grows 6.5% a year, depreciation equals capex at Rs 15 crore, working capital is flat and tax is 25%, so all net income repays debt. The sponsor exits after five years at 9.0x and needs a 20% IRR.

Before signing, lenders reprice the debt to 11%. They also hold to their rule that EBITDA must cover interest at least 2.0 times at closing.

Your task

Show how the IRR moves, separate the two ways a higher cost of debt hurts, and work out the entry price that restores 20%.

Quick check

Keeping debt at 5.0x, roughly how much does a 2-point rise in the debt cost take off the IRR?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The IRR falls from 20.4% to about 18.6%, and the sponsor must pay about 8.74x, roughly Rs 39 crore less, to keep 20%. The dearer interest alone costs under a point. The larger effect is that 5.0x at 11% fails 2.0x cover, so lenders cut debt to 4.55x and the sponsor must write a bigger equity cheque. A higher cost of debt comes straight off the price a sponsor can pay.

Step 1How does a higher cost of debt reach the sponsor's IRR?

A family buying a flat with a home loan feels a rate rise twice: the EMI goes up, and the bank, testing the EMI against salary, lends less, so the family must bring more of its own money. For a sponsor, a higher cost of debt cuts returns through the interest bill and through debt capacityThe most a lender will advance, set by tests such as interest cover and leverage; a higher rate lowers it because each rupee of debt costs more to carry., and the second channel is usually bigger. In WACCWeighted average cost of capital: the blended cost of debt and equity funding a business. terms, cheaper debt is replaced by dearer equity.

Step 2What is each effect worth here?

At 9% the deal returns 20.4%: debt falls from Rs 750 crore to about Rs 330 crore by exit. Reprice to 11% on the same Rs 750 crore and debt at exit is about Rs 385 crore, the IRR 19.5%. But 5.0x at 11% means Rs 82.5 crore of interest on Rs 150 crore of EBITDA, cover of 1.82x, so lenders cut debt to 4.55x, Rs 682 crore, and the IRR falls to 18.6%. The equity cheque rises from Rs 600 crore to about Rs 668 crore.

Two separate hits from the same 2-point rise in the cost of debtIRR, debt at 9%20.4%Dearer interest-0.9 ptsLess debt allowed-1.0 ptsIRR, debt at 11%18.6%20% hurdleaxis starts at 17%
At a 9.0x entry the IRR falls from 20.4% to 19.5% from the dearer interest alone, and to 18.6% once lenders cut debt to 4.55x to hold 2.0x cover, below the 20% hurdle.
Step 3What price restores a 20% IRR?

Hold the exit at 9.0x and solve for the entry multiple that gives 20%. With debt at 11% and capped at 4.55x, 20% needs an entry of about 8.74x, Rs 1,311 crore, about Rs 39 crore below the agreed Rs 1,350 crore. At 9% the sponsor could have paid up to 9.07x, so the repricing has cut its maximum price by about Rs 50 crore in all. Buying cheaper also creates a little multiple expansion at the 9.0x exit, which is why a modest price cut restores the return.

The dearer debt moves the whole IRR line down; 20% now needs a lower price16%18%20%22%24%8.0x8.5x9.0x9.5xEntry multiple of EBITDA8.74x9.07x9% debt, 5.0x11% debt, 5.0x11% debt, cover caps it at 4.55xsponsor's 20% hurdle
IRR falls as the entry multiple rises; with 9% debt at 5.0x the sponsor clears 20% up to 9.07x, but with 11% debt capped at 4.55x by cover it must enter at about 8.74x, roughly Rs 39 crore below the agreed price.

The limits of the answer matter in the room. The model holds the exit multiple at 9.0x, but higher rates tend to lower exit multiples too, which would hurt more than either effect here. Say that the sponsor has three levers, renegotiate price, accept a lower return, or find cheaper or more flexible debt such as a PIK tranche, and that the first is the one lenders' repricing usually forces.

Where candidates lose it

The common error is computing only the higher interest cost and concluding the effect is small. It is, on a fixed amount of debt; but lenders do not lend the same amount at a higher rate when cover tests bind, and the lost debt is the bigger hit.

The second is saying WACC rises so value falls, and stopping. Interviewers want the channel traced: interest, then debt capacity, then equity cheque, then the price.

What the interviewer asks next

  • If the exit multiple also falls to 8.5x, what entry price keeps 20%?
  • Would a sponsor rather cut price or accept 18%, and who decides?
  • How would a PIK second lien change the debt capacity at 11%?
  • Why do falling rates tend to push up LBO prices?

Asked at Houlihan Lokey, Debt Capital Markets, Los Angeles, 2025 (Wall Street Oasis): WACC changes and how it affects LBO

Company names and figures are illustrative.