LBO model: impact of raising entry an exit multiples on IRR
why does IRR decrease if both entry and exit multiples increase equally? eg from 6x to 8x each.
Is it because more equity is needed as the leverage ratios stay constant requiring a higher equity % to purchase..
because cash flows
What an insightful response.
You are putting in a larger equity check for the same cash generation profile.
Let’s take a simple example: 10mm EBITDA, 6.0x leverage, and 10x entry multiple. For simplicity let’s say you pay down 20mm in debt over 5 years. So debt has decreased from 60mm to 40mm. Let’s assume you exit at 10x (your entry multiple) so you’re exiting at 150mm. So you invested 40mm in equity upfront (100mm purchase price – 60mm debt) and get 110mm in equity at exit (150mm selling price – 40mm debt), generating a 2.75x MOI.
Ok so let’s increase the entry and exit multiple for 12x but keep everything else the same. Now you’ve initially invested 60mm in equity (120mm purchase price – 60mm debt) and at exit you receive 140mm (180mm selling price – 40mm debt), generating a 2.33x MOI. So as the entry and exit multiple increased the MOI decreased from 2.75x to 2.33x. IRR will similarly move down. While there are a few more moving pieces than what I’ve mentioned above the key takeaway is that investing more equity initially dilutes your IRR and cash-on-cash returns.
Note this assumes that you have maxed out your leverage in both scenarios at 6.0x (no incremental debt with the increase in entry and exit multiple), which is a good reflection of reality.
Value Investor beat me to it... spot on.
That works.
It won't necessarily.
To clarify... if you hold leverage ratios constant (i.e., if we were going to be financing the transaction with 40% equity and 60% debt - and we hold that true regardless of the entry multiple) and up the entry multiple, you won't necessarily see a decrease in IRR; however, if you are saying we were financing the transaction with 4x senior, 2x sub, and the rest equity, you are correct - IRR will go down as entry multiple goes up, because you are kicking in proportionately more cash vs. debt.
Think about it intuitively...
Scenario A (to keep it easy, assume all debt is repaid): Acquire at 6x 2x Equity (cash) 4x Debt When we exit, our cash is now essentially 6x or 3 times what we put in.
Scenario B (same debt repayment assumption): Acquire at 8x 4x Equity (cash) 4x Debt When we exit, our cash is now essentially 8x or 2 times what we put in (higher total return, lower relative return or IRR).
By upping the entry multiple and not adding any debt, you are essentially de-levering the investment - which will decrease your IRR.
Try it with 2x vs 100x and you will see a difference. @"More Leverage" already pointed this out, of course, but I didn't want it to go unnoticed.
So If I'm thinking right, the flaw in Kirk's logic is that by assuming all debt is repaid in either scenario he's implicitly assuming that cash flows over the investment period will adjust depending on leverage. So in reality holding cash flow fixed, even if you enter at the same ratio of debt-to-equity but different valuation multiples (i.e. Scenario 1: 8x EBITDA, 6x debt/ebitda, and scenario 2: 12x EBITDA, 9x debt/EBITDA), if you assume under scenario 1 cash flow is enough to pay down all debt during the holding period, then under scenario 2 you will be left with debt remaining at the end. I.e., if there is no EBITDA growth, in Scenario 1 you exit earning (8/2 = 4x Cash multiple) and in Scenario 2 you exit earning (12-(9-6))/3 = 3x Cash multiple.
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