Case 054Growth equity returnsHard
Paper LBO of a profitable software company: Cloudvik Software is bought at 15x EBITDA with 5x of debt and sold at 15x in year five. What are the MOIC and the IRR?
1The situation
A growth fund buys Cloudvik Software, a profitable billing software company, for 15.0x its EBITDA of Rs 60 crore, so Rs 900 crore. It borrows 5.0x EBITDA, Rs 300 crore, at 11%, with interest charged on the opening balance, and puts in Rs 600 crore of equity. Ignore fees.
EBITDA grows 15% a year. Depreciation and amortisation is Rs 5 crore a year, capex Rs 6 crore a year, and working capital does not move. Tax is 25% of profit after interest. Every rupee of free cash flow repays debt. The fund sells at 15.0x EBITDA at the end of year five.
2Your task
What are the money multiple and the IRR, and where does the return come from?
Quick check
Before the maths: what IRR do you expect?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
About 2.9x the money and an IRR of about 23.7%. EBITDA grows from Rs 60 crore to Rs 120.7 crore, so at 15x Cloudvik is worth Rs 1,810 crore at exit. Five years of free cash flow repay Rs 228.5 crore of the Rs 300 crore debt. Exit equity is about Rs 1,739 crore against Rs 600 crore in. EBITDA growth supplies four fifths of the gain; debt paydown supplies the rest.
Step 1What do you set up before the years?
Write the sources and uses first. At 15x with 5x of debt, two thirds of the price is equity, so this is a light buyout and the return will lean on growth rather than leverage. Buying a flat with a 33% loan is a different bet from buying it with an 80% loan: with the smaller loan, the flat's price rise does most of the work. Say that ratio out loud; it frames every number that follows.
Step 2How does the cash flow each year?
Start from EBITDA, take off Rs 5 crore of D&A to reach EBIT, then interest on the opening debt, then 25% tax. Free cash flow is net income plus D&A minus capex, which here is net income less Rs 1 crore, and all of it goes to the lender. Interest falls as the debt shrinks, so free cash flow grows faster than EBITDA: from Rs 22.2 crore in year one to Rs 73.8 crore in year five.
| Year | EBITDA | Interest | Tax | Free cash flow | Debt at year end |
|---|---|---|---|---|---|
| 1 | 69.0 | 33.0 | 7.8 | 22.2 | 277.8 |
| 2 | 79.3 | 30.6 | 10.9 | 31.8 | 245.9 |
| 3 | 91.3 | 27.0 | 14.8 | 43.4 | 202.5 |
| 4 | 104.9 | 22.3 | 19.4 | 57.2 | 145.3 |
| 5 | 120.7 | 16.0 | 24.9 | 73.8 | 71.5 |
| Total | 228.5 | 71.5 |
Step 3Where does the return come from?
Split the gain into its engines. EBITDA growth at a constant 15x adds Rs 910.2 crore of value and debt paydown adds Rs 228.5 crore; the multiple adds nothing, because it is the same at entry and exit. That is the point of the question: a growth equity return on a software company is mostly about whether the growth arrives. Exit equity of Rs 1,738.7 crore on Rs 600 crore is 2.90x, an IRR of 23.7%.
| 1,810.2 | exit enterprise value, 15x EBITDA of 120.7 |
| 71.5 | debt left at exit |
| 600 | equity put in at entry |
Step 4How sensitive is the answer to the exit multiple?
Software multiples move more than software earnings, so flex the exit. At 14x the IRR falls to 21.9%, and at 12x to 18.1%: each turn of multiple is worth about Rs 121 crore of exit value, a fifth of the gain. The debt adds less than people expect. With no debt at all, Rs 900 crore of equity would earn 2.37x, about 18.9% a year, so 5x of leverage lifts the IRR by about 5 points. That is the honest summary for a partner: a good growth business, a modest leverage kicker, and a return that depends on buying and selling at the same multiple.
Where candidates lose it
The common error is taxing EBITDA or EBIT and forgetting the interest deduction, which understates cash flow and debt paydown every year. Write the income statement lines in order; it takes thirty seconds.
The second is quoting the IRR with multiple expansion baked in by accident, for example exiting at a higher multiple because the company is bigger. The question said 15x at both ends; say so, and give the lower-multiple case as your sensitivity.
What the interviewer asks next
- The fund exits at 18x instead of 15x. What is the IRR, and how much of the return is now multiple?
- Would you rather have 6x of debt at 12% or 4x at 10%?
- How would a dividend recapitalisation in year three change the money multiple and the IRR?
Asked at Sequoia Capital, Venture Capital, San Francisco, 2021 (Wall Street Oasis): Next round was a technical test, asking me about valuations and LBOs, etc.
Company names and figures are illustrative.