Case 035LBO modelling testsCore

LBO test on a capex-heavy business: EBITDA Rs 90 crore, capex half of EBITDA every year. How much debt can it carry at 2.0x cover of EBITDA less capex over interest at 10%, and what IRR does a sponsor earn at 8x in and out with 8% EBITDA growth?

Warburg PincusNew York · 2017

The situation

Trivikram Cold Chain runs refrigerated warehouses and a fleet of reefer trucks for dairy, frozen food and vaccine distributors. EBITDA is Rs 90 crore and grows 8% a year. Because compressors, insulated panels and trucks wear out fast and every new contract needs new capacity, capex runs at 50% of EBITDA every year. Depreciation is 40% of EBITDA. Tax is 25% and working capital does not move.

A sponsor will pay 8x, Rs 720 crore. Lenders will lend at 10% as long as EBITDA less capex covers interest at least 2.0x. All spare cash repays debt and the sponsor exits after 5 years at 8x.

Your task

Size the debt, run the five years, and give the money multiple and IRR. Why does the answer differ from a capex-light business with the same EBITDA?

Quick check

Roughly how much debt can Trivikram carry under the lenders' test?

Worked solution

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

30-second answerThe answer to give first

About Rs 225 crore of debt, 2.5x EBITDA, and a return of about 1.95x and 14% over five years. Half of EBITDA goes to capex, so only Rs 45 crore is left to cover interest twice. Exit EBITDA of Rs 132 crore at 8x is Rs 1,058 crore; debt falls to Rs 94 crore. Low leverage means most of the return is growth: 8% a year before any debt.

Step 1Why does capex, not EBITDA, set the debt here?

A taxi owner and a tutor can both clear Rs 90,000 a month before costs, but the taxi owner must put Rs 45,000 aside for the next car, and a bank lending against the tutor's income would be wrong to lend the same against the taxi. EBITDA counts the cash before the business replaces what it wears out, so in an asset-heavy business the cash that can actually pay interest is EBITDA less capex. Trivikram earns Rs 90 crore, spends Rs 45 crore on capex, and has Rs 45 crore left. At 2.0x cover, interest can be half of that, Rs 22.5 crore, and at 10% that is Rs 225 crore of debt, 2.5x EBITDA.

Same EBITDA, different debt: capex decides what is left to pay interestTrivikram Cold ChainEBITDA 90capex 45cash for interest 45at 2.0x coverinterest 22.5: Rs 225 crore of debt, 2.5xCapex-light peerEBITDA 90capex 9cash for interest 81at 2.0x coverinterest 40.5: Rs 405 crore of debt, 4.5xThe cold chain can carry 2.5x; the same EBITDA with light capex carries 4.5x.
With the same Rs 90 crore of EBITDA, Trivikram's Rs 45 crore of capex leaves only Rs 45 crore to cover interest and supports Rs 225 crore of debt, while a peer spending Rs 9 crore keeps Rs 81 crore and supports Rs 405 crore, so capex rather than EBITDA sets debt capacity.
Step 2How do the five years run?

Sources and uses first: Rs 720 crore of price, Rs 225 crore of debt, Rs 495 crore of equity, 69% of the price. Then each year: EBITDA grows 8%, capex takes half, interest is 10% of the opening debt, tax is 25% of EBITDA less depreciation and interest. Year 1 free cash flow is 97.2 less 48.6 of capex, 22.5 of interest and 9.0 of tax: Rs 17.1 crore, and it doubles by year 5 as EBITDA grows and interest falls. In total Rs 131 crore of debt is repaid.

YearEBITDACapexInterestTaxCash to debtCoverDebt at year end
197.248.622.59.017.12.2x207.9
2105.052.520.810.621.22.5x186.7
3113.456.718.712.325.73.0x161.0
4122.461.216.114.330.83.8x130.2
5132.266.113.016.636.55.1x93.7
Rs crore. Cover of EBITDA less capex over interest starts at 2.2x and rises to 5.1x as debt falls from Rs 225 crore to Rs 94 crore, so the lenders' test only gets easier after year 1.
Step 3What return does the sponsor earn, and where does it come from?
The relationship
MOIC=8×132.2−93.7495=1.95×IRR=1.951/5−1≈14.3%\text{MOIC} = \frac{8 \times 132.2 - 93.7}{495} = 1.95\times \qquad \text{IRR} = 1.95^{1/5} - 1 \approx 14.3\%
8 x 132.2exit value, Rs 1,058 crore
93.7debt left after five years
495equity at entry
What it says in wordsEquity grows from Rs 495 crore to about Rs 964 crore, 1.95x in five years, about 14% a year.

Now say why it is so modest. With only 2.5x of debt, leverage adds little: the business itself grows 8.0% a year in value at a constant multiple, and the equity earns 14.3%, a gap of under seven points. A sponsor who wants 20% here has to find it in growth, in a lower capex share as the network fills up, or in a cheaper entry. Trying to borrow like a capex-light business does not work: at 4.5x, interest of Rs 40.5 crore against Rs 45 crore of EBITDA less capex is cover of 1.11x and leaves about Rs 1 crore a year of free cash flow, one bad contract from default.

The limit of the test is that it treats all capex as maintenance. In practice some of Trivikram's capex is growth capex for new contracts, which a lender may exclude from the cover test if the contracts are signed. Ask for the split: if half the capex is growth tied to contracted revenue, debt capacity rises, and so does the return.

Where candidates lose it

The common loss is sizing the debt at a market multiple of EBITDA, 4.5x or 5x, without noticing that half of EBITDA never reaches the lenders. The model then runs, but free cash flow is near zero and the cover test fails in year 1.

The second miss is forgetting that capex grows with EBITDA. Holding capex flat at Rs 45 crore overstates cash flow every year and flatters the IRR.

What the interviewer asks next

  • Half of the capex is for signed contracts. How much more debt could a lender allow?
  • What exit multiple does the sponsor need for a 20% IRR?
  • Would a sale and leaseback of the warehouses improve the return, and what does it do to the risk?

Asked at Warburg Pincus, Investment Banking, New York, 2017 (Wall Street Oasis): After those interviews, I had a LBO model test (1 hour).

Company names and figures are illustrative.