Case 052LBO modelling testsHard

Build an LBO from scratch in two hours: revenue, margin, two debt tranches with different repayment, tax, capex and a 8.5x exit. What are the returns, and what is the thesis you defend afterwards?

TPGSan Francisco · 2018

The situation

You have a blank spreadsheet and two hours. Zenovar Industrial Pumps makes pumps for water utilities and chemical plants and earns a large share of its profit from spares and service. Revenue is Rs 1,000 crore, EBITDA is Rs 150 crore, a 15% margin, and both grow 7% a year. Depreciation is 3% of revenue and capex 3.5% of revenue; working capital holds flat. Tax is 25%.

The fund buys at 8.5x EBITDA, Rs 1,275 crore. It borrows a term loan of 4x EBITDA, Rs 600 crore at 8.5%, which can be prepaid and takes all spare cash, and senior notes of 1.5x, Rs 225 crore at 10.5%, which cannot be repaid before maturity. Interest is charged on opening balances. The exit is at 8.5x after five years.

Your task

Build the model, give the MOIC and IRR, and be ready to defend why this business can carry 5.5 turns of debt.

Quick check

Both tranches charge interest. Which one shrinks over the five years?

Worked solution

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

30-second answerThe answer to give first

About 2.7x and an IRR of roughly 22%. EBITDA grows to Rs 210 crore, worth Rs 1,788 crore at 8.5x. Five years of free cash flow repay about Rs 271 crore of the term loan, leaving Rs 554 crore of debt including the untouched notes, so equity is about Rs 1,235 crore on Rs 450 crore in. Growth at a constant multiple is the larger engine; the sweep is the smaller one because interest eats half the cash.

Step 1In what order do you build when the clock is running?

Sources and uses, then the operating lines, then the debt schedule, then returns, and only then formatting. The order matters because the debt schedule is circular with interest, and you want that circularity in a block you can switch off and check by hand. Think of cooking a meal for guests: chop everything first, then cook in the order dishes take longest, and plate last. Entry is Rs 1,275 crore, funded with Rs 600 crore of term loan, Rs 225 crore of notes and Rs 450 crore of equity, 35% of the price.

Step 2How does cash get from revenue to the lenders?

Follow one year through. EBITDA less depreciation and both interest lines is taxable profit; tax at 25% comes off; then add depreciation back, deduct capex, and what is left is free cash flow, all of which prepays the term loan. In year 1 that is Rs 35.0 crore on EBITDA of Rs 160.5 crore, because interest of Rs 74.6 crore and capex above depreciation take most of it. The cash sweepA loan term that sends all free cash flow to repay the loan, rather than letting the company keep it. only touches the tranche that allows prepayment.

The one-hour build as a flow, year 1, Rs croreRevenue1070EBITDA at 15%160.5less D&A 3%(32.1)less TL interest 8.5%(51.0)less notes interest 10.5%(23.6)less tax 25%(13.4)Net income40.3add back D&A+32.1less capex 3.5%(37.5)Free cash flow35.0Term loan600 to 565.0Senior notes225, untouchedOnly the prepayable tranche takes the sweep;the notes carry 10.5% interest for five yearsWorking capital held flat; interest on opening balances
In year 1 Zenovar turns revenue of Rs 1070 crore into EBITDA of Rs 160.5 crore, pays Rs 74.6 crore of interest on two tranches and Rs 13.4 crore of tax, and after capex is left with Rs 35.0 crore of free cash flow, every rupee of which prepays the term loan while the notes stay at Rs 225 crore.
YearRevenueEBITDAInterestTaxFree cash flowTerm loan, closeTotal debt
11,070160.574.613.435.0565.0790.0
21,145171.771.716.443.6521.4746.4
31,225183.867.919.853.2468.3693.3
41,311196.663.423.563.8404.4629.4
51,403210.458.027.675.7328.7553.7
Total335.7100.7271.3553.7
Rs crore. Interest is 8.5% on the opening term loan and 10.5% on Rs 225 crore of notes. Free cash flow rises from Rs 35.0 crore to Rs 75.7 crore as EBITDA grows and term loan interest falls, repaying Rs 271.3 crore in total and leaving Rs 553.7 crore of debt at exit.
Step 3Where does the return come from, and why is the sweep the smaller engine?

Split the gain. EBITDA growth from Rs 150 crore to Rs 210 crore at a constant 8.5x adds Rs 513 crore; debt paydown adds Rs 271 crore; the multiple adds nothing because entry equals exit. The sweep is small because 5.5 turns of debt at a blended rate near 9% costs about Rs 75 crore a year, close to half of EBITDA, and capex runs above depreciation. That is the honest picture of a fully levered deal: the debt is there to shrink the equity cheque, not to be repaid.

Two tranches, one sweep: debt at each year end, Rs crore825600225Entry790565225Year 1746521225Year 2693468225Year 3629404225Year 4554329225Year 5Term loan, 8.5%, takes every rupee of free cash flowSenior notes, 10.5%, bullet at exitAt exitEV 8.5x 2101788less debt(554)Equity1235on 450 in2.74x, IRR 22%
The notes sit at Rs 225 crore in every year while the term loan falls from Rs 600 crore to Rs 329 crore, so total debt at exit is Rs 554 crore against an enterprise value of Rs 1,788 crore, leaving equity of Rs 1,235 crore, 2.74x the Rs 450 crore invested.
The relationship
MOIC=1,788−554450≈2.74×IRR=2.741/5−1≈22.4%\text{MOIC} = \frac{1,788 - 554}{450} \approx 2.74\times \qquad \text{IRR} = 2.74^{1/5} - 1 \approx 22.4\%
1,788exit enterprise value, 8.5x EBITDA of 210
554debt at exit: 329 of term loan plus 225 of notes
450equity invested at entry
What it says in wordsThe money multiple is exit equity over entry equity, and the IRR is the yearly rate that compounds one into the other over five years.
Step 4What is the thesis discussion that follows the model?

The interviewer will ask why a pump maker can carry 5.5 turns. The defensible answer is the installed base: pumps are sold once and serviced for twenty years, and spares and service carry higher margins and do not move with the capex cycle of utilities. Then the risks you would diligence: the share of revenue from new equipment against aftermarket, customer concentration among a few utilities, and the pricing of spares against unbranded copies. A 22% IRR with entry equal to exit is a sound base case; the upside is a bolt-on in a neighbouring category bought below 8.5x, and the downside is a lost utility tender in year 2 that strands the term loan interest.

Where candidates lose it

The usual loss is sweeping both tranches. The notes are a bullet at 10.5% and stay at Rs 225 crore for five years; repaying them in the model overstates paydown and the IRR, and the interviewer wrote the two tranches in precisely to test it.

The second is forgetting that capex runs above depreciation, so free cash flow is below net income. Using net income as the sweep adds about Rs 31 crore of paydown that never happened.

What the interviewer asks next

  • Exit falls to 7.5x. What is the IRR, and which engine did it hurt?
  • The notes allow prepayment at 103 from year 3. Would you use the sweep to repay them?
  • Working capital is 10% of revenue growth. Rebuild free cash flow.
  • What covenant would you expect the term loan lenders to set, and how much headroom does year 1 give?

Asked at TPG, Leveraged Buyouts, San Francisco, 2018 (Wall Street Oasis): including building an LBO from scratch and other technical questions

Company names and figures are illustrative.