LBO Interview Question
Had a LBO question at an ib interview, wasn't sure how to answer it.
Assume that a PE fund borrows $50 million to LBO a company and sold it at the same entry multiple after 5 years. Assuming that the debt principal payment was not made during the 5 years, what's the IRR?
Of course, the answer is not a specific number answer but of course the IRR has to be positive because you are building up cash from operations without any debt payments and EV grows due to higher EBITDA (when multiplied by exit multiple). Is that all there is to this?
from what i understand, the IRR can be negative if the cash flows generated over the 5 years aren't greater than the interest payments on the $50m principle.
If the FV of your equity investment is less than the PV equity investment, you'll have negative IRR
Wouldn't it depend on the reinvestment rate, ie how much of the cash flows to equity are reinvested in the company vs paid out to the PE firm via dividends? B/C when valuing the firm, you discount FCF, but when calculating your realized IRR you would only count cash flows that entered your (the investor's) pocket, right?
The free cash flow that is reinvested (or just builds up and sits on the BS in the cash account) would not count towards IRR, but the CFs paid out to shareholders would count towards IRR, right?
I could be wrong, though...someone tell me if I'm on the right track here...
You're not providing a lot of information. Has EBITDA grown? Has the sponsor taken dividends? Are there breakage costs on the debt?
I guess the assumption is that since the LBO targets are usually mature companies with steady predictable cash flows, FCFE > interest payments and also the cash is not reinvested back into the company but rather build up as excess cash that is paid out in year 5. EBITDA is also assumed to grow steady over the five years.
Hence the IRR is positive and the magnitude should depend on the growth of the company during the 5 year period.
Anything else to consider?
How do you mentally do that math that 4x growth over 5 years is 32%. rule of 72 on the 2x, but didnt follow what you did for 4x. thx.
There are two things needed to calculated IRR, entry equity value and exit equity value.
if interest payment is greater than FCF, then it means your FCFE is negative, since FCF - interest *(1-tax rate) = FCFE. Therefore in case of a negative FCFE, the target firm must have some sort of revolver arranged to cover the short fall, this means in 5 years time debt will not longer be $50m, but $50m plus revolver. This increase in debt will reduce the exit equity value. However regardless whether your FCFE is negative or not, your exit firm value is the same, since it only depend on exit ebitda and entry multiple.
For swagon: IRR does not depend on the reinvestment rate. Because if you dont reinvest your cash into the target firm, your exit equity value will raise by the same amount. This is because exit equity value = exit firm value - debt + cash (i.e exit firm value - net debt), therefore the more cash you have, the higher your exit equity value. Regardless whether excess cash paid out to shareholder or not over the investment period, IRR stays the same, however ofcouse, the eariler you get the excess cash the better due to time value of money.
The above is what I think is right, anyone feel free to correct me if I am wrong. Thanks
I think your FCFE calc is wrong. FCF already deducts interest expense.
The way to approach this question is through EBITDA growth. Sale price - debt = equity value. If the debt is constant, EBITDA is the only way to increase cash to equity. There are a ton of other variables, but that's the biggest one/easiest to solve for on the spot.
>all things equal, the IRR would be higher if the cash were paid out not reinvested due to CF timing (assuming the cash on your balance sheet grows at rate below your IRR).
FCF does not incorporate interest expense. When I define FCF in my previous post it is EBIT*(1-t) - capex - change in working capital + Depreciation. FCF is total cash flow available to both debt and equity investors, hence interest expense is not deducted.
Strictly speaking, FCFE is FCF - Interest expense * (1-t) + new debt raised - debt repayment, for simplicity, I assumed that new debt raised and debt repayment is zero in my previous post.
you're talking about unlevered FCF then, not FCF.
yes, unlevered FCF, in europe it is simply called fcf, sorry for the confusion.
what is your definition of fcf??
FCF is levered. Generally, net income (or, EBIT less interest, times 1 minus tax rate) plus D&A, additional non-cash expenses (PIK interest, SBC), less change in working capital less capex. That's our standard FCF metric.
huh? FCF is the cash available to all capital providers, so it should not be reduced by interest*(1-tax rate)
I see, so FCF = FCFE? just without the new debt raised and debt repayment parts right?
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