Case 055Paper LBOsCore
On-the-spot special situations case: a parts maker with collapsed EBITDA is bought at 5x. If EBITDA recovers by year 3 and the exit is at 6x, what are the MOIC and IRR, and what must the recovery thesis get right?
1The situation
Velankar Auto Components supplies brake assemblies to two truck makers. A downturn in truck sales and the loss of one programme have cut EBITDA from Rs 100 crore to Rs 60 crore. The owner wants out. A special situations fund can buy the business at 5x trough EBITDA, Rs 300 crore, with Rs 180 crore of debt at 12% and Rs 120 crore of equity.
The fund's plan has EBITDA recovering to Rs 70, 80 and 90 crore over three years as truck volumes return and a replacement programme ramps. Cash after interest, capex and working capital repays Rs 10, 13 and 17 crore of debt, Rs 40 crore in total. The exit is at 6x at the end of year 3, once the business looks normal again.
2Your task
Work out the MOIC and IRR on the plan, split the gain into its sources, and say what the recovery thesis has to get right.
Quick check
Before the arithmetic: which of the three engines carries most of this return?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
About 3.3x and an IRR near 49% over three years. Exit EBITDA of Rs 90 crore at 6x is Rs 540 crore; debt is down to Rs 140 crore, so equity is Rs 400 crore on Rs 120 crore in. Of the Rs 280 crore gain, Rs 150 crore is the EBITDA recovery, Rs 90 crore the re-rating and Rs 40 crore paydown. The thesis stands or falls on truck volumes and the replacement programme, so that is where the diligence goes.
Step 1What do you write down first in a three-minute mini case?
Entry equity and exit equity; everything else is detail. Think of buying a flat cheaply because the lift is broken: the gain comes when the lift works and the building is valued like its neighbours again, not from the rent in between. Entry equity is Rs 300 crore less Rs 180 crore of debt, Rs 120 crore; exit equity is 6x Rs 90 crore less Rs 140 crore of debt left, Rs 400 crore. That is 3.33x, and 3.3x in three years is near 49% a year, because 1.5 cubed is about 3.4. Say the rule of thumb, then the number.
Step 2Where does the Rs 280 crore of gain come from?
Split it the standard way and the case explains itself. EBITDA recovery at the entry multiple is Rs 150 crore, 54% of the gain; the re-ratingThe change in the valuation multiple between entry and exit, applied to exit EBITDA. One extra turn on Rs 90 crore of EBITDA is Rs 90 crore of value. from 5x to 6x on exit EBITDA is Rs 90 crore; debt repaid is Rs 40 crore. The three add to Rs 280 crore, which is your check. Notice how little the 12% debt contributes: Rs 21.6 crore of year 1 interest eats most of the cash, so paydown is the smallest engine even though leverage is only 3x.
Step 3What must the recovery thesis get right, and how do you test it before closing?
Two facts carry Rs 150 crore of value. Truck volumes must return, which is a cycle call you can check against order books at the two customers, and the replacement programme must be awarded and ramp on time, which is a contract you can read. A special situations interviewer also wants the structural point: at 5x trough EBITDA the fund paid 3x normalised EBITDA of Rs 100 crore, so the price itself is the margin of safety, and the 6x exit is the market agreeing the business is normal again. Both legs are specific claims, which is what makes this diligence rather than hope.
| Scenario | Exit equity | MOIC | IRR |
|---|---|---|---|
| No recovery, exit 5x | 160 | 1.33x | 10% |
| Recovery to 75, exit 5x | 235 | 1.96x | 25% |
| Recovery to 90, exit 5x | 310 | 2.58x | 37% |
| Recovery to 90, exit 6x | 400 | 3.33x | 49% |
Step 4Why does a cheap price change what you are allowed to get wrong?
Because the downside is cushioned before the thesis is tested. If EBITDA never recovers and the exit is at the same 5x, equity is still Rs 160 crore, 1.33x, as long as the Rs 40 crore of paydown holds. The real loss case is a further fall in EBITDA that stops the paydown and triggers a covenant, which is why a special situations fund sizes debt at 3x trough rather than 3x the plan. The limitation to state: the paydown here is given to you, and in the real model it depends on working capital releasing as volumes fall, which can reverse sharply when volumes return.
Where candidates lose it
The usual loss is pricing the re-rating off trough EBITDA: one turn on Rs 60 crore is Rs 60 crore, but the exit multiple applies to exit EBITDA of Rs 90 crore, so the re-rating is worth Rs 90 crore. The three engines then fail to add up to the gain, and the interviewer sees it.
The second is treating a three-year 3.3x as if it were a five-year one and quoting a 27% IRR. Hold period changes the IRR; say the years before the rate.
What the interviewer asks next
- The replacement programme slips a year, so EBITDA is 70, 70, 80. What is the return?
- Why might the lender insist on a cash sweep rather than scheduled amortisation here?
- What would you pay if the exit were capped at 5x by the sector's history?
- How does the fund protect itself against a second customer loss during the hold?
Asked at HPS Investment Partners, Special Situations Group, London, 2021 (Wall Street Oasis): Technical Interview with VP (involved on the spot mini case, with paper LBO)
Company names and figures are illustrative.