Where an LBO's return actually comes from
A simple buyout, taken apart into the three engines of private equity returns. Debt paydown does more work than most people expect, and multiple expansion less.
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A sponsor buys a business for ten times EBITDA, funds it 60% with debt, and sells five years later. The headline return is easy to compute. The more useful question is why it was earned, because each source of return carries a different kind of risk.
The deal
Exhibit 1Sources and uses at entry
| $m | x EBITDA | |
|---|---|---|
| Sources | ||
| Senior debt | 600 | 6.0x |
| Sponsor equity | 400 | 4.0x |
| Total sources | 1,000 | 10.0x |
| Uses | ||
| Enterprise value (purchase price) | 1,000 | 10.0x |
| Total uses | 1,000 | 10.0x |
For simplicity the business is bought cash-free and debt-free, and fees are ignored.
Over five years, EBITDA grows from 100 to 140, the business pays down debt from 600 to 380, and the sponsor exits at 10.5x.
Splitting the return
Exit enterprise value is 1,470. Less 380 of net debt, the equity is worth 1,090: a 2.7x multiple of money and roughly a 22% IRR. The waterfall shows where the 690 of gain came from.
- Increase
- Total
Source: Author's illustrative model
View data
| Step | Value |
|---|---|
| Entry equity | 400 |
| EBITDA growth | 400 |
| Multiple expansion | 70 |
| Debt paydown | 220 |
| Exit equity |
EBITDA growth is the largest piece: 40 of extra EBITDA, valued at the entry multiple. Multiple expansion contributes only 70, because half a turn on 140 of EBITDA is not much. Debt paydown, 220, is a third of the gain and comes purely from the business’s own cash flow.
Deleveraging is the quiet engine
Source: Author's illustrative model
View data
| Year | Leverage |
|---|---|
| Entry | 6.0 |
| Year 1 | 5.1 |
| Year 2 | 4.4 |
| Year 3 | 3.7 |
| Year 4 | 3.2 |
| Exit | 2.7 |
Leverage falls by more than half without any heroics. That is the part of the return a sponsor controls most directly, and it is also the part that disappears if cash flow disappoints, which is why lenders care about it as much as equity does.