Case 071Screening and ranking businessesCore
A branded spices business earns Rs 90 crore of EBITDA at an 18% margin with low capex and stable demand. Is it an LBO candidate, and would a strategic buyer outbid a sponsor that needs a 20% IRR?
1The situation
Pushkala Spices sells branded spice blends and pastes through grocery stores across south and west India. Revenue is Rs 500 crore and EBITDA Rs 90 crore, an 18% margin. Capex is about 2% of revenue, demand barely moves with the economy, and after tax and capex about 55% of EBITDA turns into free cash flow. The founders are selling, and the plan has EBITDA growing 8% a year.
A sponsor can borrow 5x EBITDA at 10%, would put all cash after interest towards the debt, plans to exit at 10x in year 5 and needs a 20% IRR; ignore the tax saving on interest. A listed packaged foods company is also looking. It accepts a 10% return, values cash flows beyond year 5 growing at 4% a year, and expects cost and distribution synergies of 20% of Pushkala's EBITDA before tax, half of them in year 1, with Rs 30 crore of integration cost.
2Your task
Say whether Pushkala is a good LBO candidate, then work out the most each buyer can pay and explain where the difference comes from.
Quick check
Before the synergies are counted, which buyer can pay more?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Pushkala is a textbook LBO candidate, but a strategic can pay far more: about 14.0x EBITDA against the sponsor's 9.4x. Stable demand, an 18% margin and low capex mean steady cash to repay 5x of debt. A 20% IRR caps the sponsor at about Rs 842 crore. The strategic, needing 10%, values the business alone at about Rs 1017 crore and adds about Rs 241 crore of synergies: about Rs 1,258 crore. Most of the gap is the cost of capital, not the synergies.
Step 1What makes a business a good LBO candidate, and does Pushkala qualify?
A business qualifies when it can carry debt through a bad year and still pay it down. Think of who gets a home loan most easily: a salaried person with a steady job and few other bills, not the person with the highest but most volatile income. Pushkala has the three things lenders and sponsors look for: demand that does not swing with the economy, a margin wide enough to absorb a cost shock, and capex of about 2% of revenue, so 55% of EBITDA becomes cash. What it lacks is an obvious operational lever, and that matters for the second half of the question: a sponsor's edge over a strategic usually comes from changing the business, and a well-run spices brand leaves less to change.
Step 2What is the most the sponsor can pay and still earn 20%?
Solve the LBO backwards: fix the exit, fix the debt, and find the entry price that makes the IRR exactly 20%. Exit EBITDA of Rs 132.2 crore at 10x is Rs 1,322 crore; debt falls from Rs 450 crore to about Rs 347 crore; so exit equity is about Rs 975 crore, and 20% a year for five years needs entry equity of no more than about Rs 392 crore. Add the Rs 450 crore of debt and the ceiling is about Rs 842 crore, 9.4x EBITDA. At any higher price the sponsor's return falls below its target.
| Rs crore | Sponsor at its ceiling | Strategic |
|---|---|---|
| Required return | 20% IRR | 10% |
| Value of the plan alone | 842 | 1017 |
| Synergies, net of Rs 30 crore integration | none | +241 |
| Most it can pay | 842 | 1,258 |
| As a multiple of Rs 90 crore EBITDA | 9.4x | 14.0x |
Step 3What can the strategic pay, and why is the gap so large?
Value the same plan at the strategic's cost of capital. Five years of free cash flow at 55% of EBITDA, discounted at 10%, plus a terminal value growing at 4%, is about Rs 1017 crore before any synergy; synergies of 20% of EBITDA after tax, phased in, less Rs 30 crore of integration cost, add about Rs 241 crore. The interview answer people expect is that strategics win because of synergies. Here the bigger reason is that a listed company with a 10% cost of capitalThe return a buyer needs to earn on its money to satisfy its own investors. A lower cost of capital lets the buyer pay more for the same cash flows. can pay Rs 175 crore more than a fund that must earn 20%, before a rupee of synergy. Check the implied exit too: the strategic's terminal value is about 9.5x year 5 EBITDA, close to the sponsor's 10x, so the two are valuing the same future.
Step 4So what should the sponsor do?
Not chase the price. In an open auction with a strategic at the table, a sponsor bidding 9.4x will lose, and stretching to win means accepting a return below its target. It has three honest routes: find a reason the strategic will not bid, such as competition approval risk or a strategic that is already digesting another deal; offer the founders something a strategic cannot, such as a minority stake that lets them keep running the brand; or find an operational lever the plan does not include, for example new states or exports, that raises the exit EBITDA. The limitation to state: the strategic's 10% is its own hurdle, and listed buyers often overpay for synergies they do not deliver, so the sponsor should also be ready for the strategic to walk away and the asset to come back.
Where candidates lose it
The usual loss is answering yes, it is a good LBO candidate, and stopping. The question has a second half: whether a strategic would pay more, and why. A strong answer prices both and finds that the gap is about Rs 416 crore.
The second is crediting the whole gap to synergies. On these numbers the strategic can outbid the sponsor by about Rs 175 crore before any synergy, simply because it needs a lower return.
What the interviewer asks next
- The sponsor can borrow 6x instead of 5x. How much does its ceiling rise?
- Which synergies would you discount most heavily, and why?
- A founder offers to keep 30% and roll it into the sponsor's deal. How does that change the bidding?
- What would make Pushkala a poor LBO candidate even with the same margins?
Asked at Warburg Pincus, Private Equity, San Francisco, 2014 (Wall Street Oasis): If not, why do you like it and why is it not a strong LBO candidate? Would a strategic buyer be interested?
Company names and figures are illustrative.