Why do we assume no multiple expansion upon exit in a LBO analysis?
If the sponsor streamlines costs and accelerates the target's growth rate, shouldn't that be rewarded with a higher exit multiple?
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Your though process is correct but most people generally err on the side of conservatism and use the same entrance/exit multiple. There are times when you would use a higher exit multiple (i.e. buying at a distressed multiple or in a down cycle and then selling into a better environment after making the operating improvements mentioned above)
The problem is that in an LBO model, 90% of the IRR is driven by your purchase and exit multiples... small changes to those generally affect the IRR a lot more than making incremental changes to, say, revenue growth / EBITDA margins.
It's also very hard to predict the future and say, "Aha! This company will be much more efficient in 5 years because of our amazing managerial changes!"
Yes, all PE firms would love for that to happen, but realistically it doesn't always work out that way... in fact most of the time it doesn't, although sometimes firms do get lucky and get a great IRR on investments.
As junkbondswap said, it's best to be conservative and either use the same exit multiple or be even more conservative and do a sensitivity with a range of multiples, some going below the original purchase multiple.
Maybe if you're buying in an industry that you KNOW is cyclical - e.g. semiconductors - then you might assume a higher/lower multiple accordingly, but even that gets into dangerous territory because the length of cycles are difficult to predict.
Great, thanks guys.
Is it more common to achieve desirable IRR returns by paying down the debt, increasing the value of operations, or a combination of both?
Good point, all drivers/multiples should be sensitized. For example, if I anticipated taking my retail company public I would sensitize the EBITDA multiple and use a range of 5x-9x
There are a variety of drivers that affect your IRR (debt paydown, dividends, cost cutting, management changes, macro factors, top-line growth, multiple expansion, etc.) and each of these could be further broken down but again there is no cookie-cutter approach as debt terms, investment time horizons, and other factors drive operational/investment decisions that ultimately determine your IRR.
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