Any insights would be highly appreciated on the following question regarding a sponsors & management returns in an LBO.
At entry a total equity purchase price of $100
- Sponsor contributes $95
- Management rolls their existing equity for the remaining $5
- At entry management also receives time-vested & performance tiered options. From a fully diluted ownership perspective this would dilute sponsor ownership by 10% at exit assuming all options meet performance thresholds.
Year 3 exit w/ a gross equity sale price of $235
- Sponsor equity at exit: 235*95% - 10% dilution from management options (235-100)*10% = ~210mm
- Management equity at exit 235*5% + value of management options (235-100)*10% = ~25mm
Cash-on-Cash multiple:
- Sponsor = 210/95 = ~2.2x
- Management = 25/5 = ~5.0x
IRR:
- Sponsor = (210/95)^(1/3)-1 = ~30%
- Management = (25/5)^(1/3)-1 = ~71%
In sum, I'm really struggling with difference in returns between the sponsor & management. Is this methodology right with the assumption of basing mgmt. returns on the management options net dilution, i.e. (235-100)?
Or should I be accounting for a cash outflow for the management options, i.e., 100, and looking at the returns / multiple from a gross perspective? - - (gross equity at exit of 235 * mgmt ownership post dilution of 15%) (Entry equity of 5 + exercise of options cash flow of 10) = ~35/15 = 2.3x CoC multiple
Your analysis is fine (at a high level). When a company performs well and management options are valuable, the CoC and IRR for option holders will be massive compared to those of the sponsor.
Your second example depends significantly on how the options were priced and when they were exercised. Many sponsors structure the equity so that there is a massive chunk of preferred and an extremely inexpensive piece of common. That way the strike price of options are set at essentially nothing. Also, many times some of the options vest or are exercised at the time of the sale (based on different vesting schedules). As a result, management gets paid a "net" value of the shares versus the strike price. As such, there is no point in including the price paid to exercise the options when calculating management's CoC. Again, it depends on the structure....
Thanks for your input, very clear.
you're thinking about it the right way, both management and sponsor will have the same gross IRR / cash on cash multiple, and management would get paid on top of that for the incentive pool. Although I'm not sure the third bullet point in your question is clear. Typically management would get 10% of the gross gain in this scenario, but this language suggests sponsor is diluted an incremental 10% (85% pro forma sponsor equity) which would change your math. I put a little excel table together for you. does anyone know if i can upload that / how?
Also - in practice, these incentive waterfalls tend to be much more complicated and involve a number of thresholds to realization, i.e. post preferred, after sponsor gets the higher of a 2x return OR a 15% IRR, etc. etc.,
Wookie is correct that your math is slightly strange / incorrect. 10% options suggest 10% of the value of the gross equity, or 10% of the $235 in this case. Your structure has it set up so that management only gets 10% of the gain. This would be the case if the initial $100 equity purchase price consisted almost entirely of preferred (which isn't unusual) and had a 0% preferred rate.
Math errors aside, the general intuition behind your calculation of management CoC and IRR is correct.
Think I'm following. Does the cap table below clarify my horribly phrased last question? Tranches assume all common stock and all have the same par value, and every tier of performance options & time vested options vest.
Class A -Sponsor 95 shares 95% ownership (A only) -Management 5 shares 5% ownership (A only)
Class B -Sponsor 5 shares (A+B = 100) & A+B ownership of 95.2% -Management 0 shares (still 5 shares) & A+B ownership of 4.8%
Management options issued at entry with an option price / share of $1 and the exercise price being equal to entry value in a per share equivalent, thus a $1 / share. In sum, a buck to buy and a buck to exercise and what my term "net dilution" was referring to.
-13 shares
Fully diluted ownership (A+B+Mgmt options) -sponsor 100 shares - Ownership = 100/118 = ~85%
-Management 18 shares - ownership = ~15%
What is the difference between the Class A and the Class B shares? Voting rights?
By the way, I assume this is for an upcoming interview you have with a PE firm, correct? Or is this a Sell-side engagement?
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