LBO - Returns Attribution Analysis
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- čas přidán 9. 07. 2024
- In this tutorial, you’ll learn about what drives the IRR or money-on-money multiple in a leveraged buyout.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
You’ll also see how EBITDA growth, multiple expansion, and debt pay-down and cash generation all play a role - and what drivers make a deal look favorable or less favorable.
Table of Contents:
0:48 How Do PE Firms Make Money?
5:13 Returns Attribution Analysis Formulas
7:43 Setting Up a Simple LBO Model
13:10 IRR and MoM Multiples
14:31 Returns Attribution
How Do PE Firms Make Money?
To make money in a leveraged buyout, one or more of the following must happen:
1) The company's EBITDA must grow.
2) There must be multiple expansion (exit EBITDA multiple is higher than the purchase EBITDA multiple).
3) A significant amount of debt must be used and repaid and/or a significant amount of cash must be generated in the same period.
So yes, you CAN buy a company at one multiple and sell it at the same multiple and still earn a 20% IRR... if you have enough of the two other factors.
Returns Attribution Analysis Formulas
EBITDA Growth:
(Final Year EBITDA - Initial EBITDA) * EBITDA Purchase Multiple
Intuition: How much more do you get for your money?
Multiple Expansion:
(Exit Multiple - Purchase Multiple) * Final Year EBITDA
Intuition: How much more value does the final EBITDA contribute?
Debt Paydown and Cash Generation:
Back into this by subtracting the other two above from the total returns to equity investors in the LBO.
Intuition: “Everything else!”
Setting Up a Simple LBO Model
To test this yourself, look at the template above and fill out the assumptions for revenue, EBITDA, Pre-Tax Income, and Net Income, and then the Cash Flow Statement line items.
Debt repaid each year is equal to MIN(Free Cash Flow, Previous Year's Ending Balance).
Then, debt decreases by the amount that's repaid; cash increases by any FCF that's left over and was NOT used for debt repayment.
IRR and MoM Multiples
Calculate the Exit Enterprise Value with Final Year EBITDA * Assumed EBITDA Exit Multiple, and subtract debt and add cash to get the Proceeds to Equity Investors.
IRR = (Exit Proceeds to Equity Investors / Initial Equity Contribution) ^ (1 / # Years in Model) - 1
MoM Multiple = (Exit Proceeds to Equity Investors / Initial Equity Contribution)
Returns Attribution
Calculate this using the formulas above.
CONCLUSIONS HERE:
Ideally, we would prefer nothing from multiple expansion as it's unreliable and hard to predict or take advantage of.
We would also like to see more from debt paydown, because the company could afford to take on more debt in the model.
If the company's growth rate were slower or its margins were lower, we might have to use additional debt to make the model work.
So back to that question in the beginning: yes, a dividend recap is one way to make a deal work if there's no multiple expansion... but it's not the only way.
Downloadable Resources
youtube-breakingintowallstreet...
I like the way you make complex ideas simple and easy... Awesome video !!!
Thanks for watching!
This is great material.. thank you for putting it tutorial up!
Thanks for watching!
Super helpful! thank you for posting!
Thanks for watching!
This is very practical and useful in work place. Awesome video.
Thanks for watching!
Thanks for sharing!
Thanks for watching!
I really enjoy all of your material and I have purchased the financial modeling course. For interview prep, does your website have any blog that is updated daily on a summary of the latest deals and trends that you can read prior to your interview (potentially with links to external full articles on the news)?
We do not, but there are examples of how to find information on deals and companies in the Interview Guide... or look at the article on Deal Discussions.
Thanks a lot for the video. Quick question: Can you explain why do you need to subtract the change in working capital in the Free Cash Flow calculation?
czcams.com/video/Kkf_eyB3sTI/video.html
Hey! Thanks a lot for the model, super helpful! I just have two quick questions:
- Looking at the way the model is built it looks like you're not counting the 20 of cash in the sources/uses, which I assume is why if one tries to built the deleveraging as Net debt last year - Net debt initial year the figure does not match with the plug
- Why are you attributing the value create by the combined effect of multiple expansion and ebitda growth (there is some standalone value created by the ebitda growing, some created by the multiple expanding and then some created by the combination of a higher multiple with a higher ebitda basis)? Is it just an approximation?
Thank you!!
1) ??? I'm confused because there is no Sources & Uses schedule in this simplified model.
2) I'm also confused by this question. EBITDA Growth and Multiple Expansion are separate line items here, so we're attributing returns to each one separately. To determine how much in returns EBITDA growth contributes, you have to look at how much it has grown and multiply by the original EBITDA multiple paid for the company.
The Multiple Expansion returns are similarly based on how much the multiple has grown, times the final year EBITDA, to represent the sponsor gets more from the company at the end if the exit multiple is higher.
Thanks for the great video! I have a question about the third source of return 'Debt paydown and cash generation'. Instead of calculating the number as a plug, I would like to cross check by calculating from first principles 'Exit net debt - initial net debt'. Exit net debt is -(307-20)=-287 and initial net debt is -(500-20)=-480, which should give me 193 instead of 213. Why do the numbers not match?
It's because the company had an initial cash balance that we did not exclude. It would be better to do this on a debt-free, cash-free basis to avoid that problem, but this was just a simple example from an existing model.
Hey, thanks for this great video!!! I was wondering if PE firm is willing to paid-off debt earlier?
Considering the time value of money which impacts the IRR they probably want to postpone the outflows of cash but on the other hand, if they leave a lot of debt at the exit, their Equity Value will shrink and that also decreases the IRR. Can you comment on that?
Repaying debt early rarely boosts the returns in an LBO so most PE firms do not do this. Money today is worth more than money further into the future, so the PE firm is giving up potential dividends today in exchange for slightly more money in the future, which is usually not a good trade.
is there a textbook that covers this, i have to do a seminar which is about value attribution in lbos. and i would need a textbook that explains the basics of IRR and Times Money a little bit more indept so that i can better understand research papers
+marvin6593 Not that I know of. We cover the time value of money, the money-on-money multiple, and IRR elsewhere in the channel if you look around.
Brian - Where I could find the slides for this video? Someone post them in Course Hero, but I could only see a portion. Thanks.
They're not available for this one, but the Excel file is there if you click on "Show More" and scroll to the bottom.
Hey Brian - Could you help me understand the working capital component of this explanation. When i see a -15% Change in working capital as a percentage of the change in revenue it makes me think that working capital would be decreasing and would be increasing my cash flow for debt repayment? Intuitively it makes since to me why working capital would increase as my revenue increases, but am just trying to reconcile the two. Thanks! Awesome video.
The Change in Working Capital can be either positive or negative. If it's -15% as a % of the Change in Revenue, that means it is negative when revenue is increasing and positive when revenue is decreasing. Ignore anyone who says that you "always subtract the Change in Working Capital" or that the Change in Working Capital is always positive or negative... the signs can vary based on the company.
@@financialmodeling Hey Brian/Chris - I'm still not quite sure I understand this. If when revenue increases (as per the model), and the change of working capital is negative, shouldn't that mean your WC decreased year over year, and if that's the case, you should add that number to arrive at levered CF? Are there cases where net change in working capital can decrease, and your levered CF can increase? Sorry for the confusion, and thanks for the great content.
@@TheHpfan4eva No. If the Change in Working Capital *as shown on the Cash Flow Statement* is negative, that means Working Capital increased. When WC increases, there's negative cash flow. To see why pretend, that WC consists of only one item: Inventory. If the Change in WC is negative on the CFS, it should always reduce any type of Free Cash Flow-based metric.
@@TheHpfan4eva I get what you are saying. It can be confusing depending on how you interpret the 'change of working capital'. I believe in this particular model the (-) for ' change of working capital' should be interpreted with the (-) sign mirroring directly to CASH FLOW STATEMENT. However, strictly speaking, the 'change of NET working capital' on the BALANCE SHEET should actually be (+) and increasing, meaning it is a use of cash. e.g. increasing AR and Inventory
It costs me life to get it but I get it. Thanks for making it simple. 14:21 why did you subtract one at the end? It's because of years?
Because that's how the CAGR calculation works. Try *not* subtracting 1 at the end, and you'll see the problem: you'll get a percentage above 100%.
@@financialmodeling the formula itself. I've started CFA studies. Trying to rebrand myself. So basically, yes, you help me a lot! Thanks :)
Hi there! I watched through the whole video. Great work! I just have one comment to make. When you were trying to derive the free cash flow in the video, you excluded the interest expense (less interest expense), meaning you were getting a levered FCF. When they are discounted back to the PV, basically you would get an equity value instead of enterprise value, in the scenario of DCF analysis. Interestingly, the EV in this video is calculated by EBITDA multiple for LBO return analysis. It seems to me that levered FCF, other than unlevered FCF, is needed in LBO return attribution analysis. Please correct me if I am wrong. Thanks :)
+Bo Knows Better I think you have the concepts confused. In the context of an LBO, "Free Cash Flow" includes interest expense because it is used to determine how much debt principal a company can repay. That metric is solely for assessing debt repayment and has nothing to do with the company's valuation at the end, which is based on Enterprise Value and EBTIDA. You cannot even look at debt paydown and cash generation on a capital structure-neutral basis because those metrics both depend on interest expense.
+Mergers & Inquisitions / Breaking Into Wall Street Thanks for the reply. I think I mixed the concept of free cash flow in LBO and DCF.
This is great! Is the excel model downloadable anywhere?
Click on "Show More" under "Published on Dec 2, 2014." Then click the second link there.
great contents, thanks a lot! I was wondering if an LBO involves initial equity investment into convertible preferred, rather than common equity, how will the return attribution analysis be impacted?
Convertible preferred is considered a form of debt, not equity, so it wouldn't be in the returns attribution analysis at all unless the company somehow repays some of this debt within the holding period. And all LBOs require a certain amount of common equity or lenders will not fund the deal, so...
@@financialmodeling would you better explain the convertible roles in an LBO sources and uses ?
@@giovannipoliti1205 Please see the video on convertible bonds in this channel. There's no real difference in Sources & Uses because it's always debt initially, so it appears like any other form of debt.
Thanks for the video! Why does debt paydown and cash generation act as a plug? Doesn't EBITDA growth contribute to both debt paydown and cash generation? I guess conceptually I'm not understanding why those are the three components of the total return to equity investors.
EBITDA growth does contribute to both, but the difference is that EBITDA directly impacts the Exit Enterprise Value, while Debt Paydown and Cash Generation does not. There is some overlap between the different returns sources, but they are still different enough to justify different categories.
By doing (Exit EBITDA - Entry EBITDA)*Purchase multiple, it doesn't tie out to what is being shown for returns attribution analysis for the 7 days example.
It won't match up because of the treatment of cash in the beginning... you need to adjust for that if you want a match.
Hi, Thanks for your videos. My question is regarding third source of returns in LBO i.e. "pay down debt and cash generation" If you don't pay down that debt and instead accumulate the cash,, ending balance of cash at the end of year 5 will be higher which will make up for the fact that you debt balance in higher. So they both cancel out each other.
If you repay debt
1772 - 307 + 20 = 1484
If you don't pay out debt and accumulate cash instead
1772 - 500 + 193 = 1484
Net impact is same. Can you explain please. Thank you.
??? I'm not sure what there is to explain. You're right that the net impact is the same, so in many cases the multiple and IRR will be about the same regardless of whether the company repays Debt or lets the cash flow accumulate to its Cash balance. The difference is that Debt paydown will reduce the company's interest expense slightly, which further boosts its cash flow and may lead to even higher Debt paydown or Cash generation in future periods. But that may or may not make a big difference depending on the percentage repaid and the interest rate.
Hey there,
late but better then never:
Why does a 1 Dollar debt paydown not create 1 dollar in value? I would have assumed a 1:1 relationship as it is money vs money?
It mostly does, but the issue is that repaying Debt also results in other model impacts, such as reduced interest expense in future periods, and those, in turn, affect the cash balance upon exit. Repaying debt is not 1:1 equivalent to distributing that cash flow as dividends because of the time value of money as well - it boosts the IRR more to distribute excess cash flow as dividends since money today is worth more than money tomorrow (or upon exit).
In the last example where you increased the debt from 50% to 65% you mentioned that now the Debt Paydown and Cash Generation contribute MORE to the returns, but that does not seem to be true. When the debt was at 50% the debt paydown and cash generation was $194 or 31% of the total return to investors, but when you increase the debt to 65% the debt paydown and cash generation decreases to $143 or 25% of the total return to investors, which is LESS than the 31% it was contributing before. Could you please elaborate on this? Am I missing something?
We were comparing this final scenario (10x exit multiple, 7.5% revenue growth, 65% Debt Used) to the first scenario (11x exit multiple, 10.0% revenue growth, 50% debt used). In the final scenario, 25% of the returns come from debt paydown and cash generation vs. only 22% in the first scenario.
If equity proceeds are 1484 why does that not tie to the total return to equity investors? It seems like there’s more money unaccounted for
Total Return to Equity Investors = Exit Equity Proceeds - Equity Contribution = 1484 - 500 = 984.
Shouldnt EBIDTA margin improve over the time in a LBO deal?? i
Not necessarily. It's pretty tough for a mature company to increase its margins substantially. It does happen sometimes, but there has to be justification for it and solid reasoning, along with some type of restructuring expense to make it happen in most cases.
thanks for the answer
Why couldn't the value creation for EBITDA expansion be (Change in EBITDA x Exit EBITDA Multiple) ?
Because you must assume the same Exit and Purchase Multiple to see how much value was created *just* from EBITDA Growth. If you use the Exit Multiple, that calculation will reflect value created from both EBITDA Growth and Multiple Expansion.
Value Change = EV@Exit - EV@Entry = (Multiple@Entry + Multiple Increase) x (EBITDA@Entry + EBITDA Increase) = ( Multiple@Entry x EBITDA@Entry ) + ( Multiple Increase x EBITDA@Entry ) + EBITDA Increase x Multiple@Entry + EBITDA Increase x Multiple Increase. The question is why EBITDA Increase x Multiple Increase is attributed to multiple expansion (NOT EBITDA expansion) when doing the value attribution analysis? If you fixed all variable, the Multiple Expansion should be calculated using the EBITDA@Entry not @Exit right?
EBITDA Increase x Multiple Increase is attributed to Multiple Expansion because *even if the multiple had stayed the same*, EBITDA still would have grown over this period. And it's not really EBITDA Increase, but Exit Year EBITDA. Even if the multiples stayed the same, we would still be exiting based on EBITDA in the final year. If you change it to the method you suggest, you'll immediately see the problem - the returns sources won't add up to the total return. Try it if you don't believe this.
I see your point. Basically we are treating EBITDA as the fundamental and Multiple as the price as result of the fundamentals so the EBITDA Increase x Multiple Increase can only be attributed to Multiple Expansion. My other question would be if this methodology is applied when decomposing EBITDA Increase into Revenue and EBITDA Margin %, how shall we attribute Revenue Expansion and EBITDA Margin % expansion. There is no order of which one is more fundamental or derivative of the other. This is actually why I start to question the value attribution methodology in the first place.
Unfortunately, you're now asking questions that are beyond the scope of what we can answer for free on CZcams (which is just intended to provide some samples and explanations). If you are a client or student of one of our courses, feel free to ask in there and we can point you to examples.
but we are assuming we buy a company with zero debt?
??? It doesn't really matter because the company's existing capital structure is wiped out and replaced in a deal.
@@financialmodeling yes sorry I just saw the video about it, so to be clear the PE firm rises new debt and using all of it (or a part) pay all the existing debt? And It uses the FCFE for its % to repay this debt?
@@giupitex4892 Yes to the first question, I'm not really sure what you're asking about with the second one. In an LBO, anywhere from 0% to 100% of the new debt raised in the transaction could be repaid over the holding period. It all depends on the company's financial profile and the PE firm's plans for it.
Thanks for a very informative and useful video; I have a theoretical question though. If you do an LBO with 100% debt and exit in say 5 yrs time with a profit after repayment of debt, how can you calculate IRR? There is no equity or cash outflow to start with. Abu (abu@agis.ae)
You cannot calculate IRR to equity investors in that case because there are no equity investors. You would only be able to calculate the IRR to debt investors, and this type of analysis would not make any sense since debt investors do not benefit from EBITDA growth or multiple expansion.
+D1Abu You do not own any share in the company, it means the whole process has nothing to do with you.
+D1Abu Sorry, I just mis-understood your question. I want to add some points. Lenders won't give you loan because LBO with 100% debt doesn't align interests. With nothing at risk, the buyer acts differently than if they have equity at risk. Besides, as the portion of debt increases, the financial stress increases. 100% debt is not the best option.