LBOs: Debt Repayment vs. Dividends?

Just wondering, when modelling LBOs is it market practice to assume you:

a) amortise debt & forsake dividends over the holding period in favour of lower interest expense & a higher equity value at exit,

or

b) pay dividends & forsake debt repayment over the holding period in favour of a (slightly) higher IRR over the life of the investment

I assume it's a) because that slight bump in IRR from taking option b) is not worth the risk in the event the chit hits the fan and your cash flow drops for whatever reason and you struggle to meet your mandatory debt service. Can someone confirm/deny, or even modify my options?

Would especially appreciate insight of people who work in PE.

 
Best Response
gametimehoops:

Depends on your credit agreements and also GPs are incentivized to achieve as high of an IRR as possible

So if the aim is to bump up the IRR, then I assume GPs would want to take much cash as they can out of the business subject to:

1) Firstly of course satisfying any cash needs of the business from an operational standpoint.

2) not breaching covenants (ie. dividend lockup covenants, so for example if one year your achieved DSCR is on track to be 2.5x and your lockup is at 2.0x, you might plan to pay yourself the diference, 0.5x, in dividends )

3) plus any optional debt repayments that you feel it may be prudent to make to minimise future interest costs (and thus as I mentioned before, to minimise the risk of financial stress in an event where cash flow drops)

You know you've been working too hard when you stop dreaming about bottles of champagne and hordes of naked women, and start dreaming about conditional formatting and circular references.
 

In addition to above, if company is performing heroically like doubling your EBITDA in 2 years, you may consider doing a dividend recap. If this is for a case study / practice, fair to say you can assume zero dividend / zero recap and just paydown debt as quickly as possible. If your debt is fully paid off in say, year 3 (pretty unlikely for a traditional company), then by all means build in the dividend.

 

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