Case 032LBOHard
Paper LBO: three years in, the sponsor can relever the company and pay itself a dividend. Compare the money multiple and the IRR with and without the recap.
1The situation
A sponsor bought Pravarsh Logistics at 9.0x EBITDA of Rs 80 crore, Rs 720 crore, with Rs 400 crore of debt at 10% and Rs 320 crore of equity. By the end of year 3 EBITDA is Rs 110 crore and debt has been paid down to Rs 300 crore.
Lenders will now refinance up to 5.0x EBITDA, and the excess can be paid to the sponsor as a dividend. The sponsor plans to exit at the end of year 5 at 9.0x EBITDA of Rs 130 crore. Without the recap, debt falls to Rs 200 crore by exit, Rs 50 crore a year. With it, the extra debt carries 10% interest, so less is repaid; tax is 25%.
2Your task
What are the money multiple and IRR in each case, and is the recap worth doing?
Quick check
What does the recap do to the sponsor's numbers?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The recap lowers the money multiple from 3.03x to 2.91x but raises the IRR from 24.8% to 27.8%. Relevering to 5.0x of Rs 110 crore raises Rs 550 crore, so Rs 250 crore goes to the sponsor in year 3. The extra debt costs about Rs 19 crore a year after tax, so exit equity falls from Rs 970 crore to Rs 682.5 crore. Whether that trade is worth it depends on the risk taken on.
Step 1What is a dividend recap actually doing?
Think of a family that has paid down half its home loan and then tops the loan back up to take cash out for something else. A dividend recapBorrowing new debt against a company the sponsor already owns and paying the proceeds out to the owners as a dividend. borrows against the value the sponsor has already built and hands part of its equity back early. Pravarsh has grown EBITDA to Rs 110 crore and repaid Rs 100 crore of debt. At 5.0x it can carry Rs 550 crore, so Rs 250 crore of new borrowing, above the Rs 300 crore it owes, can go straight to the sponsor.
Step 2How do the two equity cash flow streams compare?
Write the streams out year by year. Without the recap the sponsor puts in Rs 320 crore and gets Rs 970 crore back in year 5; with it, Rs 250 crore comes back in year 3 and Rs 682.5 crore in year 5. Exit enterprise value is the same Rs 1,170 crore either way. What differs is the debt at exit: the extra Rs 250 crore costs Rs 25 crore of interest a year, Rs 18.75 crore after tax, so repayment slows from Rs 50 crore to Rs 31.25 crore a year and debt at exit is Rs 487.5 crore rather than Rs 200 crore.
| Rs crore | No recap | Recap in year 3 |
|---|---|---|
| Equity in, year 0 | (320) | (320) |
| Dividend, year 3 | 250 | |
| Exit EV, 9.0x of 130 | 1,170 | 1,170 |
| Debt at exit | (200) | (487.5) |
| Exit equity | 970 | 682.5 |
| Total cash back | 970 | 932.5 |
| Money multiple | 3.03x | 2.91x |
| IRR | 24.8% | 27.8% |
Step 3Why do the multiple and the IRR move in opposite directions?
Because they measure different things. The money multiple counts rupees and ignores time; the IRR is a rate, so a rupee returned in year 3 is worth more to it than a rupee in year 5. The recap swaps Rs 287.5 crore of exit equity for Rs 250 crore two years sooner. A fund that is measured on IRR and wants to show its own investors cash back likes that; a fund measured on multiple sees it lose Rs 37.5 crore. On paper you can say it in one line: an early dividend shortens the clock, and IRR is very sensitive to the clock.
Close on risk, because that is what the extra IRR is paying for. The recap puts Pravarsh back at entry leverage just as the sponsor has de-risked it, so a downturn in years 4 or 5 now lands on a company with interest cover of about 2.0x instead of 3.7x. If you had used the Rs 450 crore exit debt that a quick sketch suggests, ignoring the extra interest, the IRR would read 28.8% and the multiple would be unchanged, which overstates the recap. A sensible view: worth doing if the business is stable and the sponsor wants early distributions, with the caveat that the lower multiple and the higher leverage are the price.
Where candidates lose it
The common loss is assuming the recap is free: same exit debt plus the dividend, so the multiple is unchanged and the IRR simply rises. The new debt carries interest for two years, and that cost comes out of exit equity.
The second is treating the higher IRR as proof that the recap creates value. It moves value through time and adds leverage; it does not make Pravarsh worth more, and an interviewer will ask what happens if EBITDA falls after the recap.
What the interviewer asks next
- What if EBITDA falls to Rs 100 crore in year 4 after the recap? What is leverage then?
- Why do lenders agree to fund dividend recaps, and what protections do they ask for?
- At what exit multiple does the recap leave the sponsor with the same money multiple as no recap?
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, etc.
Company names and figures are illustrative.