LBO Waterfall Help
Hi Monkeys,
I got a LBO modelling test with the below waterfall structure:
- Term Loan @ 3x LTM EBITDA
- Mezzanine Structure @1.5x LTM EBITDA with 2% warrants on exit equity value
- Management incentive plan with a hurdle rate of 10%
Say we have an exit equity value of 500M. How would you structure the warrants and management incentive? Am I correct to think warrants get paid out first before management? And the 10% hurdle is post warrants pay off (i.e 490*10% vs 500*10%), so we get the below?
Total exit equity value = 500M
Mezzanine upside = 10M
Management sweet equity = (500M-10M)*10% = 49M
Sponsor equity = 490-49 = 441M
Appreciate any insights!
You may be missing a piece of information on the management incentive plan. Usually these things are expressed as X% over Y% IRR, i.e. an X% share of cashflows after the sponsor receives a minimum return of Y%. Typically Y would be called the 'hurdle rate', but you haven't said what X is.
To the other question, you generally want management to be as closely aligned as possible with the sponsor's cashflows. Therefore you would take out all financing cashflows before calculating the MIP entitlement. However, you do get situations where the sponsor will take out their own financing above the MIP, but it's less common (think management teams with high % ownership selling a minority that don't want PE-style leverage).
Hey, thanks for the quick response. Indeed it was missing the management upside after the hurdle. Assuming this is 5%, does the below look right?
Total exit equity value = 500M
Mezzanine upside = 10M
Sponsor Hurdle of 10% = (500M-10M)*10% = 49M
Management Sweet Equity = (500M-10M-49M)*10% = 44M
Sponsor equity = 500M-10M-49M-44M = 397M
I would think about the hurdle differently. The way you calculate it, that's a 1.1x MOIC hurdle. A 10% IRR hurdle would need to adjust for the number of years that have accrued. 10% would accrue to about 1.6x over 5 years.
Also I think the second 10% is a typo and should be 5%.
Thanks - really helpful.
So assuming an initial sponsor equity of 200M and a 5 year hold, the sponsor hurdle should be 122M (=200*(1+10%)^5 - 200). And the revised waterfall should look like the below?
+++
Total exit equity value = 500M
Mezzanine upside = 10M
Sponsor Hurdle of 10% = 200*(1+10%)^5 - 200 = 122M
Management Sweet Equity = (500M-10M-122M)*5% = 18M
Sponsor equity = 500M-10M-122M-18M = 350M
Total Sponsor Proceeds = 350M + 122M = 472M
I should have spotted this before - but it looks like you are adding back the sponsor equity. Management only get their share of the profit, not the original principal from the sponsor. Think of the sponsor equity as a debt tranche with a 10% coupon that has to be fully paid back.
Total exit equity value = 500M
Mezzanine upside = 10M
$490 net proceeds for sponsor and MIP
Sponsor puts in $200 with a 10% pref rate = $322
$168 mm proceeds after paying the sponsor's preferred return
Sponsor share = ($168)*95% = $159.6
Management share = ($168)*5% = $8.4
Total Sponsor Proceeds = $322 + $159.6 = $481.6
What you can see from this is that it's a very skinny MIP (3% of value creation). Usually I would model a MIP at about 5-7% of profit on a deal that size. The reason is that the hurdle rate is very high and the share is pretty low. I've seen these at more like 5-10% over 6-8% IRR (but depends on biz type and how important mgmt are obviously).
Super useful - thanks
I had just one question - is the 5% management options always applied on the remaining proceeds after the hurdle and not on the fully diluted company, post-transaction? i.e. 5%*490 = 24.5, provided hurdle rate is met)?
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