LBO question (modeling margin contraction)
Currently working on an LBO modeling test, where EBITDA growth is significant (6x) over the 5 year investment horizon.
Typically on these models I assume entry=exit muliple.....but when EBITDA growth is this high, your IRR becomes pretty insane over the 5 year horizon. To counter this, would you model multiple contraction from entry to exit (i.e. you get in at a 15x EBITDA and exit at a 10x EBITDA)? Logic behind the contraction being that you pay a higher multiple at entry for the upcoming higher growth, but then exit at a lower multiple due to lower future projected growth. Does this make sense at all?
Of course without knowing the details of the business it’s hard to answer precisely, however yes you are right.
I worked on a deal where growth in the plan was double digit (highly fragmented market so significant consolidation opportunity) and we could justify paying 14x, but assumptions at exit were in line with more mature companies which traded in 11-12x range.
If the growth prospects of the company 5 years down the road will be meaningfully lower than what they are upon entry, then that seems reasonable to me as well
I don’t understand the context of your model, but in a situation like this I would probably try to increase COGS and/or operating expenses first (or at least make sure they’re reasonable). As long as you have the reasoning to back it up.
This is the correct approach for a modeling test-- if you're generating "insane" IRR on a five year projection, your projections are probably too optimistic.
The post below is the actual correct approach (SB'd), but you may not have time to do that (or explain it) during a modeling test/debrief.
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