Case 021Leveraged buyoutsCore
A paper LBO with a dividend recap in year 3. What exit multiple does the sponsor need for a 25% IRR, and what did the recap really do?
1The situation
A sponsor buys Aushadhkosh Packaging, a maker of blister packs and bottles for pharma companies, at 10.0x EBITDA of Rs 50 crore, Rs 500 crore. It funds 60% with debt, Rs 300 crore at 11%, and puts in Rs 200 crore of equity. EBITDA grows 10% a year. Packaging is light on capex, so cash available for debt service after tax, capex and working capital is 70% of EBITDA, and every rupee left after interest repays debt.
At the end of year 3 the sponsor does a dividend recapitalisation: the company borrows back up to 5.0x that year's EBITDA and pays the difference to the sponsor as a dividend. The sponsor exits at the end of year 5.
2Your task
Build the debt schedule, size the recap dividend, and find the exit multiple that gives a 25% IRR. Then, at a 10.0x exit, say what the recap did to the IRR and to the money multiple.
Quick check
At the same 10.0x exit, what does the year 3 recap do to the sponsor's IRR and money multiple?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The recap pays the sponsor Rs 63.5 crore in year 3, and a 25% IRR then needs an exit at about 10.0x, almost exactly the entry multiple. Debt falls to Rs 269 crore by year 3, is re-levered to Rs 333 crore, and ends year 5 at Rs 297 crore. Without the recap the exit would need 10.29x. At a 10.0x exit the recap lifts IRR from 24.0% to 24.9% while MOIC slips from 2.93x to 2.86x: it changes timing, not the business.
Step 1How much debt is left when the recap arrives?
Run the schedule year by year and say the rounded numbers aloud. Year 1: EBITDA Rs 55 crore, cash before interest Rs 38.5 crore, interest Rs 33 crore, so only Rs 5.5 crore of debt is repaid. The gap widens as EBITDA grows and interest falls. By the end of year 3 debt is down to Rs 269.3 crore against EBITDA of Rs 66.6 crore, about 4.0x, and the lender agrees to go back to 5.0x, Rs 332.8 crore. The difference, Rs 63.5 crore, is the dividend recapA dividend recapitalisation: the company borrows more and pays the proceeds to its owner as a dividend. The owner gets cash back before selling; the company carries more debt. paid to the sponsor. Years 4 and 5 then start from the higher debt, so interest jumps to Rs 36.6 crore and paydown slows.
| Year | EBITDA | Cash before interest | Interest | Debt repaid | Debt at year end |
|---|---|---|---|---|---|
| 1 | 55.0 | 38.5 | 33.0 | 5.5 | 294.5 |
| 2 | 60.5 | 42.4 | 32.4 | 10.0 | 284.5 |
| 3 | 66.6 | 46.6 | 31.3 | 15.3 | 269.3 then 332.8 after recap |
| 4 | 73.2 | 51.2 | 36.6 | 14.6 | 318.1 |
| 5 | 80.5 | 56.4 | 35.0 | 21.4 | 296.7 |
Step 2What exit multiple does a 25% IRR need?
Work in year 5 money. Rs 200 crore growing at 25% for five years must become Rs 610.4 crore. The sponsor already holds Rs 63.5 crore from year 3, which at 25% is worth Rs 99.2 crore by year 5. So exit equity need only be Rs 511.1 crore; add Rs 296.7 crore of debt and the enterprise value is Rs 808 crore, which on EBITDA of Rs 80.5 crore is 10.03x. The sponsor needs to sell at the multiple it paid. Without the recap the full Rs 610.4 crore has to come at exit, debt is lower at Rs 218.5 crore, and the required multiple is 10.29x. Think of a landlord who takes a second loan on a flat and pockets the cash: the flat does not need to sell for more, because part of the profit has already been taken out.
Step 3What did the recap actually do?
Hold the exit at 10.0x and compare. With the recap the sponsor gets Rs 63.5 crore in year 3 and Rs 508.5 crore in year 5, 2.86x and 24.9%; without it, Rs 586.7 crore in year 5 only, 2.93x and 24.0%. The rate rises because money came back two years early; the multiple falls because the extra Rs 14.7 crore of interest in years 4 and 5 is paid by the sponsor's own exit equity. Nothing about the plant, the customers or the growth changed. A recap is a financing decision about when the sponsor sees its money, and it adds risk: at a 9.0x exit the recap case still shows 21.1% against 20.4%, but the company now carries Rs 63.5 crore more debt into year 4 with the same cash flow.
Close with the judgement. The recap is fine if the lender is comfortable at 5.0x on a business whose cash conversion is proven, and it is how a fund returns capital to its investors before the sale. It is a warning sign when it is done because the exit is slipping, because then the sponsor is taking its return out of a company that still has to find a buyer. The interviewer wants you to see that a higher IRR here is bought with timing and leverage, not with a better company, and that the limited partners will ask which of the two they are being paid for.
Where candidates lose it
Candidates forget to re-strike interest on the higher debt in years 4 and 5, so they overstate paydown and understate the exit debt. The recap changes every later line of the schedule, not just year 3.
The other miss is treating the dividend as part of exit proceeds. It arrives in year 3, which is why it counts for more in an IRR; compound it forward, or discount everything back, but never add it to year 5 at face value.
What the interviewer asks next
- If the lender only allows 4.0x at the recap, what is the dividend and the required exit multiple?
- Why might the limited partners prefer a lower IRR with a higher MOIC?
- Growth slows to 5% a year after the recap. What happens to debt at exit?
- How does a recap change the lender's position compared with the day the deal closed?
Asked at Moelis & Company, Generalist, New York, 2023 (Wall Street Oasis): Multiple step paper LBO with several follow-up questions needed to build out further for.
Asked at Moelis & Company, Generalist, New York, 2023 (Wall Street Oasis): Interviews were almost all technical-based and extremely difficult. Paper LBOs, capital structure and debt questions
Company names and figures are illustrative.