Case 023Growth equity returnsCore

Explain the value added in a deal: a fund bought Kosvik Packaging at 12x EBITDA with Rs 300 crore of net debt and sold it five years later at 14x a larger EBITDA with less debt. Split the equity gain into EBITDA growth, multiple expansion and debt paydown.

General AtlanticLondon · 2021

The situation

A growth fund bought Kosvik Packaging, a maker of flexible food packaging, five years ago at 12x EBITDA of Rs 100 crore, with Rs 300 crore of net debt on the balance sheet. It has just sold the company at 14x EBITDA of Rs 170 crore, with net debt down to Rs 150 crore after five years of cash generation. The fund owned all of the equity and took no dividends.

The partner wants a one-page explanation of where the gain came from for the fund's annual letter, and a view on how much of it the fund can claim as its own work.

Your task

Compute the equity at entry and exit, the money multiple and IRR, and split the gain into EBITDA growth, multiple expansion and debt paydown. Then say which parts are value the fund added and which are the market.

Quick check

Of the equity gain, how much is explained by EBITDA growth from Rs 100 crore to Rs 170 crore, measured at the entry multiple of 12x?

Worked solution

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

30-second answerThe answer to give first

Equity went from Rs 900 crore to Rs 2,230 crore, 2.48x and an IRR of about 20%. Of the Rs 1,330 crore gain, EBITDA growth supplied Rs 840 crore, multiple expansion Rs 340 crore and debt paydown Rs 150 crore. Growth and paydown, 74% of the gain, came from running the business; the other 26% came from buyers paying more per rupee of profit at exit. Sold at the 12x it paid, the fund would still have made 2.10x.

Step 1What did the fund pay and what did it receive?

Start from enterprise value and take off the debt, both times. At entry, 12x Rs 100 crore is an EV of Rs 1,200 crore; less Rs 300 crore of net debt, the fund paid Rs 900 crore for the equity. At exit, 14x Rs 170 crore is Rs 2,380 crore; less Rs 150 crore, the equity is Rs 2,230 crore. The fund turned Rs 900 crore into Rs 2,230 crore in five years, 2.48x, which compounds to about 19.9% a year. Net debt fell from 3.0x EBITDA to 0.9x along the way.

Step 2How do you split the gain into its three sources?

Think of a flat you bought for Rs 90 lakh with a Rs 30 lakh loan, let out, and sold five years later. You gained because the rent rose, because flats in that area now sell for more rent-multiples, and because the tenant's rent repaid part of the loan. The same three things happen in a buyout. Hold the entry multiple fixed and the extra EBITDA is worth Rs 70 crore times 12x, Rs 840 crore. Then let the multiple move: two extra turns on the exit EBITDA of Rs 170 crore is Rs 340 crore. Debt paydown is the Rs 150 crore by which net debt fell. The three sum to Rs 1,330 crore, the full gain, with nothing left over.

The relationship
ΔE=(170−100)×12+(14−12)×170+(300−150)=840+340+150=1,330\Delta E = (170-100)\times 12 + (14-12)\times 170 + (300-150) = 840 + 340 + 150 = 1{,}330
(170-100) x 12EBITDA growth at the entry multiple, Rs crore
(14-12) x 170multiple expansion on exit EBITDA, Rs crore
300-150net debt paid down, Rs crore
What it says in wordsPrice the extra profit at what you paid, then price the change in multiple on what you sold, then add the debt that went away; the pieces add exactly to the equity gain.
Kosvik: from Rs 900 crore of equity to Rs 2,230 crore, in three pieces, Rs crore5001,0001,5002,000900Entry equity+840EBITDA growth+340Multiple 12x to 14x+150Debt paydown2,230Exit equityOperations (growth plus paydown) supplied Rs 990 crore, 74% of the gain;the market's higher multiple supplied Rs 340 crore, 26%.The multiple step is measured on exit EBITDA, so the three pieces add exactly to Rs 1,330 crore.
The Rs 1,330 crore rise in Kosvik's equity from Rs 900 crore to Rs 2,230 crore splits into Rs 840 crore of EBITDA growth, Rs 340 crore of multiple expansion and Rs 150 crore of debt paydown, so operations supplied 74% of the gain and the market 26%.
SourceRs croreShare of gainWhose work
EBITDA growth, 100 to 170 at 12x84063%Management and the fund
Multiple expansion, 12x to 14x on 17034026%The market, mostly
Net debt paydown, 300 to 15015011%The business's cash flow
Total equity gain1,330100%
EBITDA growth is the largest piece at Rs 840 crore, and together with Rs 150 crore of debt paydown it accounts for 74% of the gain, leaving Rs 340 crore, 26%, to a higher exit multiple the fund did not control.
Step 3Which parts can the fund claim as value it added?

EBITDA growth of 11.2% a year is the part a fund's letter should dwell on, and only if it can say how: new lines, pricing, a bolt-on, a cost programme. Debt paydown is real but it is the company's cash flow doing the work; the fund's contribution was choosing a business that generated it and not stripping it out as dividends. Multiple expansion is the piece the fund cannot honestly claim. Buyers paid 14x instead of 12x because packaging multiples rose, and the same two turns would have been a loss if they had gone the other way.

The same five years of work, sold at 14x and at the 12x the fund paidSold at 14x (as happened)900Entry2,230Exit2.48x moneyIRR 19.9%over five yearsSold at 12x (no multiple expansion)900Entry1,890Exit2.10x moneyIRR 16.0%over five yearsTwo turns of multiple are worth Rs 340 crore of equity and 3.9 points of IRR; nobody at the fund made them happen.
Sold at the 12x the fund paid instead of 14x, the same EBITDA growth and debt paydown would have produced Rs 1,890 crore of equity, 2.10x and an IRR of 16.0% rather than 19.9%, which is the honest measure of what the fund's own work was worth.

The view for the letter: a 2.48x deal of which about three quarters was earned and one quarter was given by the market. State both, because an LP who sees the split trusts the next letter more. The limitation of the bridge is the ordering: measuring the multiple on exit EBITDA gives Rs 340 crore, measuring it on entry EBITDA gives Rs 200 crore and pushes the difference into growth. Neither is wrong; say which convention you used, and use the same one in every letter.

Where candidates lose it

The usual loss is working on enterprise value and forgetting the debt at both ends. EV rose from Rs 1,200 crore to Rs 2,380 crore, but the fund bought and sold equity, and the debt paydown is a source of gain that only appears when you subtract net debt each time.

The second is measuring EBITDA growth at the exit multiple and multiple expansion on exit EBITDA, which counts the overlap twice and gives a bridge that overshoots the gain by Rs 140 crore. Pick one ordering and the pieces add exactly.

What the interviewer asks next

  • Kosvik paid Rs 80 crore of dividends to the fund in year three. How does that change the multiple, the IRR and the bridge?
  • What would the bridge look like if EBITDA had grown to Rs 170 crore but the exit multiple had fallen to 10x?
  • How would you check whether the EBITDA growth came from volume, price or a change in accounting for leases?

Asked at General Atlantic, Private Equity, London, 2021 (Wall Street Oasis): Explanation of the value added to a deal.

Company names and figures are illustrative.