Basic LBO Technical Question

I could be wrong, but the way I understand your question, the equity value of the company is not increasing as a result of paying down debt with free cash flow. The equity value increases because you have engineered the company, resulting in a leaner operation, meaning higher margins, and as a result, a higher valuation.

This higher valuation is the ultimate IRR generator, as you're exiting the business with a higher multiple than you bought for.

Correct me if I'm wrong.

It might be easier to understand it from just building a simple paper model. You will need to find the entry and exit multiples of the model. Intuitively you have higher equity value since you improve the business, which directly translates into higher EBITDA. The interest payment of debt is the part you have to pay and what's been left is what you get.

The model is always template based, and the hard part is to justify your assumption and balance your financial forecast. But i doubt you will be tested on this unless it's for an associate level job.

Thanks for the comment. I'm not really proficient in LBO's at all, just started learning, but I got the idea of equity value appreciation due to deleveraging from sources like Macabacus and Wall Street Training. For instance Macabacus' section on LBO value generation has this sentence: "As the debt is paid down, the value of the equity increase and healthy returns are generated, as demonstrated below" followed by a diagram. I might be misunderstanding this, but I the way I interpreted the material was that higher returns from operational enhancements and streamlining and higher returns from deleveraging are seperate elements of the higher valuation upon exit.

Equity on the balance sheet normally stays the same, which is the common equity following the LBO, this number in your exit year is not necessarily the number you are basing your returns on. Equity when you exit in regards to how much you have vs. the amount you put in is the difference between for what you sell the whole business minus any oustanding debt (most models would sweep all the cash anyways to pay down debt). In terms of operational value uplift, that will hopefully be seen in your Revenues and/or EBITDA which again drives your returns in the exit year. Ofc you can also play around with your working capital and maybe reduce capex so you have more beneficial cash flows in your profile and can pay down more debt etc. (agreed that multiple uplift mostly difficult to justify).

Equity = Assets - Liabilities

Fund your assets with lots of debt, equity will be small Pay down your debt and equity must appreciate

I don't think it has much to do with operating efficiency. As long as the target is generating enough cashflow to service and pay down the debt, the equity of the target increases to fill the pie. Effectively this is saying more income, generated by the assets, is attributed to / owed to the equity investment, thus making it more valuable.

My thoughts. Maybe an expert will come along and lay it down.

balance sheet equity doesn't really increase unless you're retaining earnings (which you're not in this case). Essentially, you're paying out cash (an asset) to lower debt (a liability). Equity is unchanged. You see the value of this debt pay-down in the exit rather than on the balance sheet (basically, you have a claim to more of the company at the exit than you did at the beginning).

So if I'm understanding this correctly, the equity figure in the financial statements really doesn't change, and the appreciation in equity value is just realized upon exit?

Book value of equity isn't important. The value realisation comes upon exit. Actual value is measured by what someone would pay for the business, which generally has nothing to do with book value of equity. So for example:

Entry:

EBITDA: 100m Multiple: 10x EV: 1,000m Debt: 700m Equity: 300m

Exit:

EBITDA: 130m Multiple: 10x EV: 1,300m Debt: 200m Equity: 1,100m

Ahh I see. That makes sense, thanks so much for all the help guys, I think I'm now one step closer to becoming proficient in the subject!

Equity in an LBO will increase through; - Multiple accretion - Exit > Entry - Hard to justify and difficult for PE to accept. For a pitchbook, keep entry=exit - Improved Revenue growth rates and favourable gains in EBITDA margin - PE will accept this, remove listing expenses and run the business harder - Working Capital Efficiencies - Reduction in Capital Expenditure - Tax Shield advantages - Sale of surplus assets, business divisions

You should not think about equity value from a financial statement point of view. equity value on the balance sheet often has very little (or nothing) to do with the true equity value of a company. Companies can even have negative book values of equity in the case of a leveraged recap or similar situation - point is, you need to look at the market value of the equity to figure out what a company is really worth

Obviously, when a company is LBO'ed, it is no longer currently traded (if it even was in the first place) so you won't have daily movements in stock prices or anything to track market value, but market value comes back into play when a previously LBO'ed company either gets sold to a third party (sponsor or strategic buyer) or IPO'ed back onto the public markets. So hopefully that clears up some of the confusion on this thread.

When talking about paying down debt, it is not that it directly increases value of the company per se, just that the equity holders have claim to more of the pie. What happens is that when you pay down debt with free cash flows, you are reducing the amount that you have to pay back to creditors if for example, the company was sold (example below).

Lets say you bought a company for $100 (70% debt/30% equity). Lets say the company will always be worth $100 to another buyer (no operational improvements - just pure financial engineering). If you resold the company the next day without paying down any of the debt, you would receive $100, then you would have to pay back $70 to your creditors, and keep $30 (0% return). If you held the company for 5 years and were able to pay down $50 in debt in that time, then you would again, sell the company for $100; this time however, you would only have to pay back $20 ($70 borrowed - $50 repayed), and you could keep the $80 (~21% return). This increase in equity value would likely be shown to an extent on the financial statements, as liabilities were decreasing, so the equation A = L + SE would mean that SE was growing, but again, financial statements are not the place to go to track equity value.