Case 058Paper LBOsCore

Paper LBO under time pressure: EBITDA Rs 80 crore at 7.5x, 4x debt, flat earnings, Rs 30 crore a year of paydown, exit at 7.5x. Then the interviewer tweaks it live: one more turn at exit, then two more years. MOIC and IRR each time.

Carlyle GroupWashington · 2015

The situation

Sahyog Steel Fabricators makes structural steel for warehouses and factories. EBITDA is Rs 80 crore and is expected to stay flat; the market is steady and the plant is at capacity. A fund buys it for 7.5x, Rs 600 crore, with 4x of debt, Rs 320 crore, and Rs 280 crore of equity.

After interest, tax and capex the business generates Rs 30 crore a year, all of which repays debt. The base exit is at 7.5x after five years. The interviewer gives you ninety seconds, then starts changing assumptions.

Your task

Give MOIC and IRR for the base case, then with the exit multiple one turn higher, then with the hold two years longer at the base exit multiple. Say what each change teaches.

Quick check

The interviewer extends the hold from five to seven years at the same exit multiple. What happens?

Worked solution

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

30-second answerThe answer to give first

Base: 1.54x and 9%. One more turn at exit: 1.82x and 13%. Two more years: 1.75x but only 8%. With flat EBITDA and no change in multiple, the whole base return is Rs 150 crore of paydown on Rs 280 crore of equity. A turn of exit multiple adds Rs 80 crore of equity at once; two more years add Rs 60 crore slowly, raising the multiple and lowering the rate.

Step 1What is the ninety-second version?

Entry equity, exit debt, exit equity, done. Think of buying a shop with a loan and paying it down from the till while the shop itself is worth the same at the end: your gain is exactly the loan you cleared. Equity in is Rs 280 crore; five years of Rs 30 crore cut debt from Rs 320 crore to Rs 170 crore; exit at 7.5x is Rs 600 crore, so equity out is Rs 430 crore, 1.54x. 1.5x in five years is about 8 to 9% a year; say 9% and move on. Flat EBITDA at an unchanged multiple means paydown is the only engine, and a 4x deal with Rs 30 crore of cash cannot pay down fast.

Step 2What does one more turn at exit do?

It adds Rs 80 crore to the exit value and every rupee goes to equity, because the debt does not change. Equity rises from Rs 430 crore to Rs 510 crore, 1.82x, and the IRR to about 13%. That is the first lesson of the tweak: multiple expansionSelling at a higher multiple of EBITDA than you paid. The gain is the extra turns times exit EBITDA, and it goes entirely to equity. is worth more than two years of operating cash flow here, and the fund does not control it. An interviewer who adds a turn is checking whether you notice that the gain is not the company's doing.

Step 3Why does a longer hold raise the multiple and lower the rate?

Because the extra years earn less per year than the first five. Years 6 and 7 add Rs 60 crore of paydown, lifting equity to Rs 490 crore and MOIC to 1.75x, but Rs 30 crore on equity already worth about Rs 430 crore is roughly a 7% year, below the 9.0% the first five years averaged, so the IRR slips to 8.3%. MOIC counts money; IRR counts money against time. Funds are paid carry on money but judged on IRR, which is why a sponsor with a flat business sells rather than waits.

The same deal tweaked live: MOIC and IRR move together, until they do notBase7.5x exit, 5 years1.54xMOIC9.0%IRREquity 430 on 280the reference+1x exit multiple8.5x exit, 5 years1.82xMOIC12.7%IRREquity 510: +80 from the turnboth measures rise+2 years of hold7.5x exit, 7 years1.75xMOIC8.3%IRREquity 490, but over 7 yearsMOIC up, IRR down
Sahyog returns 1.54x and 9.0% in the base case; one more turn of exit multiple lifts both to 1.82x and 12.7%; two more years of hold lift MOIC to 1.75x but cut the IRR to 8.3%, because the extra paydown is a lower annual rate on a larger equity base.
CaseYearsExit EVDebt at exitExit equityMOICIRR
Base, 7.5x exit56001704301.54x9.0%
Exit at 8.5x56801705101.82x12.7%
Seven-year hold, 7.5x76001104901.75x8.3%
Both tweaks76801105702.04x10.7%
Rs crore on Rs 280 crore of equity. The turn of exit multiple adds Rs 80 crore of equity at once, the two extra years add Rs 60 crore over time, and only the first raises the IRR; with both tweaks the deal reaches 2.04x and 10.7%.
Step 4What do you say about the deal itself once the tweaks are done?

That it is a thin deal, and why. A 9% base case on a flat business is below most funds' hurdle, and the upside case depends on a buyer paying more than the fund did. The honest pitch for Sahyog would need a growth lever the case did not give you: a second plant, a move into higher-margin design work, or bolt-ons at lower multiples. Say that a paper LBO with flat EBITDA is a test of arithmetic, not an investment thesis, and the interviewer will usually give you the next assumption to play with.

Where candidates lose it

The usual loss is assuming a longer hold must raise the IRR because there is more paydown. It raises the money multiple; the IRR falls because the later years earn a lower rate on a bigger equity base. Saying both move together is the mistake the live tweak is designed to catch.

The second is recomputing from scratch for each tweak. Only one line moves each time, exit value or years, so update that line and keep the rest.

What the interviewer asks next

  • EBITDA grows 5% a year instead of staying flat. Rework the base case.
  • The lender charges 12% instead of 10% and the paydown falls to Rs 22 crore. What is the IRR?
  • At what exit multiple does the base case reach a 20% IRR?
  • Would you rather have a dividend recap in year 3 or the longer hold?

Asked at Carlyle Group, Industrials, Washington, 2015 (Wall Street Oasis): Paper LBO with a very quick time frame and live tweaking afterwards

Company names and figures are illustrative.