Multiple Expansion: Private Equity LBO Return Driver

LBO Multiple Expansion Scenario Example

For instance, let’s say that a financial sponsor acquires a company for 7.0x EBITDA. If the target company’s last twelve months (LTM) EBITDA is $10mm as of the purchase date, then the purchase enterprise value is $70mm.

If the financial sponsor later sells the same company for 10.0x EBITDA, then the net positive difference between the 7.0x and 10.0x is the concept of multiple expansion.

Even if the company’s EBITDA remains unchanged at $10mm, if the sponsor exits the investment five years later but at a 10.0x exit multiple, $30mm of value would have been created – all else being equal.

• (1) Exit Enterprise Value = 7.0x Exit Multiple × $10mm LTM EBITDA @ Exit = $70mm
• (2) Exit Enterprise Value = 10.0x Exit Multiple × $10mm LTM EBITDA @ Exit = $100mm

Multiple Expansion Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

1. LBO Entry Assumptions

First, the entry assumptions we’ll be using are as follows:

• LTM EBITDA = $25mm
• Purchase Multiple = 10.0x

In our hypothetical transaction, the LBO target has generated $25mm in LTM EBITDA, which is the metric upon which the purchase multiple will be applied.

By multiplying our LTM EBITDA by the purchase multiple, we can calculate the purchase enterprise value – i.e. the total purchase price paid to acquire the company.

• Purchase Enterprise Value = $25mm LTM EBITDA × 10.0x Purchase Multiple
• Purchase Enterprise Value = $250mm

Next, we must figure out the initial investment contributed by the financial sponsor, or the private equity firm.

Here, we’re assuming that the total leverage ratio was 6.0x LTM EBITDA and there are no other providers of capital other than the single leverage provider (i.e. debt-holder) and the financial sponsor. Since the purchase multiple was 10.0x, we can deduce the sponsor equity contribution was 4.0x LTM EBITDA (i.e. four turns of EBITDA).

• Sponsor Equity Contribution Multiple = Purchase Multiple – Total Leverage Multiple
• Sponsor Equity Contribution Multiple = 10.0x – 6.0x = 4.0x

We can then multiply the LTM EBITDA by the sponsor equity contribution multiple to figure out how much the financial sponsor had to pay for the deal to close.

• Sponsor Equity = 4.0x × $25mm = $100mm

Before we move onto the exit multiples section, there are two more assumptions for our exercise:

1. Holding Period = 5 Years
2. Cumulative Debt Paydown = 50%

In the five-year holding period during which the acquired LBO target belongs to the sponsor, half of its total debt financing is expected to be paid down.

• Total Debt Paydown = Initial Debt Raised × Debt Paydown %
• Total Debt Paydown = $150mm × 50% = $75mm

On the date of exit, there should be $75mm in debt remaining on the balance sheet of the company.

2. LBO Exit Assumptions

Since our entry assumptions have all been set up, we’re ready to see the impact of the exit multiple on the returns of an LBO.

We’ll be comparing three scenarios with different exit multiples:

1. 8.0x: Multiple Contraction of – 2.0x
2. 10.0x: Purchase Multiple = Exit Multiple
3. 12.0x: Multiple Expansion of 2.0x

To isolate the impact of the exit multiple as much as possible, the LTM EBITDA assumed at exit is going to be the same as the LTM EBITDA on the date of purchase – i.e. no EBITDA growth is assumed throughout the holding period.

Given the unchanged exit $25mm LTM EBITDA, we apply the corresponding exit multiple against this figure.

• Scenario 1: Exit Enterprise Value = $25mm × 8.0x = $200mm
• Scenario 2: Exit Enterprise Value = $25mm × 10.0x = $250mm
• Scenario 3: Exit Enterprise Value = $25mm × 12.0x = $300mm

For each case, we must subtract the $75mm in debt. Note that for simplicity, we are assuming there is no cash remaining on the B/S at exit – thus net debt is equal to total debt.

• Scenario 1: Exit Equity Value = $200mm – $75mm = $125mm
• Scenario 2: Exit Equity Value = $250mm – $75mm = $175mm
• Scenario 3: Exit Equity Value = $300mm – $75mm = $225mm

The difference in the range of outcomes across these three scenarios is $100mm.

3. LBO Returns Analysis Example

In our final step, we can compute the internal rate of return (IRR) and multiple of money (MoM) for each case.

• Scenario 1: IRR = 4.6% and MoM = 1.3x
• Scenario 2: IRR = 11.8% and MoM = 1.8x
• Scenario 3: IRR = 17.6% and MoM = 2.3x

From the exercise we just completed, we can see the extent of how sensitive the returns on n LBO investment are to the purchase multiple and exit multiple.