Debt pay down of $1 or EBITDA increase of $1?
Got asked this for a PE interview. What would the right answer be?
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You'd pick the EBITDA increase of $1. Let's say this occurs the year you're planning to exit. Debt pay down of $1 creates $1 of value (equity goes up by corresponding amount). $1 EBITDA increase should get capitalized at some multiple above one, so it should generate over $1 of value. If you exit at 15x EBITDA, then you're exiting at a valuation that is $15 higher.
Wouldn’t a dollar pay down lead to more equity to the sponsor tho?
Let's say you are about to sell a business that you own.
It has $50 of EBITDA and is levered at 6x. You think you can sell it for 15x. $50 * 15 = $750 TEV. Leverage = $50 * 6 = $300. Equity = $450.
Let's say you exited with $1 less of debt. You have $299 of debt at exit instead of $300. TEV is the same. Equity is now $451.
Let's say you had $1 more of EBITDA instead. $51 * 15 = $765. Leverage is still $300. Equity is now $465.
Yes, you'd have $1 more of equity. But the other option would give you $15 more (or $14 more than the other option).
Only in some edge case like if you are a tiny minority shareholder of a low-multiple business and the debt in question is HoldCo / GP leverage that's only against your stake.
This is the correct answer as long as it’s final year / exit year.
Aside from valuation, another aspect is to think about it in terms of credit metrics. As we know, most PE firms will finance their portcos with leverage that will usually contain financial covenants such as a leverage covenant (debt / ebitda). Because EBITDA is on the denominator, and leverage is usually always above 1x, a $1 increase in EBITDA will reduce the leverage ratio more than paying down debt by $1.
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