Case 064Paper LBOsWarm up

Paper LBO: EBITDA Rs 100 crore bought at 8x with 5x debt. EBITDA grows 8% a year, cash before interest is 45% of EBITDA, all cash after interest repays debt, exit at 8x in year 5. MOIC and IRR?

Warburg PincusNew York · 2014

The situation

Tarlok Precision Tools makes cutting tools for machine shops. EBITDA is Rs 100 crore and grows 8% a year. A fund buys it at 8x, Rs 800 crore, with 5x debt, Rs 500 crore at 8% on the opening balance, and Rs 300 crore of equity.

Cash before interest, after capex, tax and working capital, is 45% of EBITDA; everything left after interest repays debt. The fund sells at 8x at the end of year 5. No calculator; round as you go and say what you are rounding.

Your task

Walk through the five years out loud, then give the money multiple and the IRR.

Quick check

Before working it: with 5x debt at 8% and 45% cash conversion, how much of the Rs 500 crore gets repaid in five years?

Worked solution

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

30-second answerThe answer to give first

About 2.6x and an IRR of roughly 21%. EBITDA grows to about Rs 147 crore, worth Rs 1,175 crore at 8x. Cash after interest repays about Rs 96 crore over five years, leaving Rs 404 crore of debt, so equity is about Rs 771 crore on Rs 300 crore in. Nearly all the gain, Rs 375 crore, is EBITDA growth at a constant multiple; paydown adds Rs 96 crore, because 5x debt at 8% absorbs most of the cash.

Step 1What is the first thing you say?

The equity cheque, because the whole answer is a ratio with that cheque at the bottom. Think of buying a Rs 80 lakh flat with a Rs 50 lakh loan: your return is on the Rs 30 lakh you put in, and the rest is the bank's. Rs 800 crore less Rs 500 crore of debt is Rs 300 crore of equity, 37.5% of the price. Then state the two things that will change by exit: EBITDA, which grows, and debt, which shrinks. The exit equityWhat the sponsor receives on sale: the exit enterprise value less whatever debt is still outstanding. is one minus the other.

Step 2How does the debt move, year by year?

Cash before interest, less interest, repays debt, and both lines move in the sponsor's favour each year. Year 1: EBITDA Rs 108 crore, cash Rs 48.6 crore, interest Rs 40 crore, repay Rs 8.6 crore; by year 5 EBITDA is Rs 147 crore, cash Rs 66.1 crore, interest Rs 34.8 crore, repay Rs 31.3 crore. On paper, round to 9, 13, 18, 24 and 32: about Rs 96 crore in all, so debt ends near Rs 404 crore. Say you are rounding; the interviewer cares about the method, not the decimals.

Year	EBITDA	Cash before interest	Interest at 8%	Debt repaid	Debt at year end
1	108.0	48.6	40.0	8.6	491.4
2	116.6	52.5	39.3	13.2	478.2
3	126.0	56.7	38.3	18.4	459.8
4	136.0	61.2	36.8	24.4	435.4
5	146.9	66.1	34.8	31.3	404.1
Total		285.1	189.2	95.9	404.1

Rs crore. Interest on the opening balance falls from Rs 40 crore to Rs 34.8 crore while cash before interest rises from Rs 48.6 crore to Rs 66.1 crore, so the repayment grows every year and Tarlok ends year 5 with Rs 404.1 crore of debt.

Step 3What is the exit worth, and what is the return?

Exit EBITDA at the exit multiple, less the debt that is left. Rs 147 crore at 8x is Rs 1,175 crore; less Rs 404 crore of debt is Rs 771 crore of equity on Rs 300 crore in, 2.57x. For the IRR use the rule of thumb: 2x in five years is about 15%, 2.5x is about 20%, 3x is about 25%; 2.6x sits a little above 2.5x, so say 21%. On paper, 100 growing 8% for five years is about 147, which a candidate can reach by adding 8, 9, 9, 10 and 11.

Tarlok is bought for Rs 800 crore with Rs 500 crore of debt and Rs 300 crore of equity; cash after interest cuts the debt to Rs 404 crore over five years while EBITDA growth lifts the exit value to Rs 1,175 crore, so exit equity is Rs 771 crore, 2.57x the entry equity and an IRR of about 21%.

The relationship

\text{MOIC} = \frac{1,175 - 404}{300} \approx 2.57\times \qquad \text{IRR} \approx 2.57^{1/5} - 1 \approx 21\%

1,175	exit enterprise value, 8x EBITDA of 147
404	debt remaining after 96 of repayment
300	equity invested at entry

What it says in wordsThe money multiple is what the equity is worth at exit divided by what was put in, and the IRR is the yearly rate that compounds the one into the other over five years.

Step 4Where does the gain come from, and what does that tell the interviewer?

Almost entirely from growth. EBITDA rising from Rs 100 crore to Rs 147 crore at a constant 8x adds Rs 375 crore of equity; paydown adds Rs 96 crore; the multiple adds nothing. That split is the follow-up question in disguise: a deal whose return is 80% growth is a bet on the plan, and the questions after the arithmetic will be about whether a cutting-tool maker can really grow 8% a year for five years, what capex that needs, and whether the 45% conversion survives it. The limitation of a paper LBO is that it assumes the answer to all three is yes.

Where candidates lose it

The usual loss is repaying debt with all of the Rs 49 crore of cash and forgetting the interest, which overstates paydown by about Rs 189 crore and the IRR by several points. Interest comes first; only the remainder repays.

The second is applying the exit multiple to year 0 EBITDA. The exit value is 8x the year 5 EBITDA of about Rs 147 crore, not 8x Rs 100 crore, and the difference is most of the return.

What the interviewer asks next

Exit at 7x instead of 8x. What is the IRR now?
Debt is 6x at 9% instead of 5x at 8%. Does the IRR rise or fall?
What would the IRR be with no debt at all, and what does that tell you about the value of leverage here?
Why might the fund prefer a dividend recap in year 3 to waiting for the exit?

Asked at Warburg Pincus, Private Equity, New York, 2014 (Wall Street Oasis): Walk me through an LBO of a company, using these assumptions (EBITDA, purchase multiple, growth rate, capital structure etc)

Company names and figures are illustrative.