Hey,
How do you think about LBOs and entry debt as % of total sources vs equity investment in the often highly-valued SaaS space (the question also applies to other highly valued industries)? If a business is valued at 25x EBITDA, than the LBO debt at entry will be very low as a % of total sources as you realistically will not be able to lever more than 6-7x at entry?
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Not different from other industries, sponsors pay large multiples for SaaS companies with high growth, cash flow, and margin opportunity. It sounds like you already work in investment banking so I’ll give you a real life example to help illustrate.
Say a company has $100mm of revenue, 100% net customer retention and CAC of $1, currently growing at 15% with a 80% gross and 20% EBITDA margin. The company operates in a niche end market and is the clear market leader with a sticky product. This is a high quality business and a sponsor may pay 20x EBITDA for it. That would mean TEV of $400mm.
Under the above parameters, the company would spend 15% of its sales on Sales and marketing ($15mm of revenue growth costing $15mm = $1 CAC, 100% net retention so no leakage from last year’s revenue). The remaining 45% of cash operating expenses is in R&D and SG&A. Given its market position, the sponsor may think that they can reduce R&D and SG&A to 25% of sales. Those expenses are largely headcount and can be realized in year 1. The sponsor will identify the headcount and go to lenders to receive credit for some of the anticipated cost cuts. Sponsor will claim year 1 EBITDA is $40mm, lenders may cap cost savings to $10mm and settle on EBITDA of $30mm; total leverage of $200mm.
In the above scenario, the sponsor will put in $200mm of equity and anticipate Year 1 EBITDA is $40mm. They’ll hope to grow the asset for three years and then sell it with $50mm EBITDA at 15x or $750mm. They probably generated $100mm of cash flow and exit equity would be $650mm off of a $200mm check, or 3.2x MoM / ~50% IRR in 3 years.
Alternatively, maybe the sponsor underwrites the elevated R&D and SG&A to new product development and accelerated growth. The sponsor accepts that at $20mm of EBITDA, the most leverage they’ll receive is $120mm, and put the remaining $280mm of equity themselves. The core product continues grow at 15% a year and doubles to $200mm of revenue in 5 years. The R&D leads to a new product that generates $100mm of incremental revenue. Year 5 revenue is $300mm, revenue CAGR was 25%, and EBITDA margins remain constant at 20%. The company sells for 20x EBITDA or $1.2bn and paid off its debt along the way. The sponsor returns 4.3x MoM / ~35% IRR in 5 years.
Either outcome would be a home run, and IRR’s would be even higher after dividend recaps. It’s not surprising, either. The sponsor originally paid 4x revenue for a high retention, growth, quality and margin SaaS business. That’s incredibly cheap!
The lender community knows high quality SaaS deals (particularly if done by the best sponsors) almost never lose money and are very willing to finance them.
SaaS sponsors have gotten very comfortable with equity buyouts (look at H&F/Ultimate for the classic example). Say you are buying a company for 25x EBITDA. It's obviously a great business so you can take on 7x debt. 18x to go. You as the sponsor put in 10x. You get two pension buddies or big LPs to coinvest 3-4x each. Mgmt rollover picks up the last 1-2x. So you end up having majority control of the business with slightly more than 50% equity stake.
Here's what that looks like at $100M in EBITDA (and therefore $2.5bn in EV given the 25x multiple):
Sources:
Debt: $700M
Sponsor Equity: $1,000M
LP Co-investor 1: $400M
Pension Investor: $400M
Mgmt Rollover: $150M
Total: $2,650 (that extra $150mm could be transaction expenses, cash to BS, etc.)
This is simplified but gets the point across. The sponsor now has a 51% controlling equity stake but their equity in at purchase is only 40% of TEV.
You'll see this a lot with the $5bn+ take privates and carveouts of high quality software businesses. Blackstone will do this exact deal, cut $50mm in costs. Grow it another $100M in EBITDA (M&A/organic) in 5 years and turn around and exit for $4.5bn (7x multiple contraction) to someone else.
Assuming debt gets paid down to $200m, you've got $4300 in equity, Blackstone's take is $2,150 fully diluted and they get a nice 2.15x/16.5% IRR to keep the fund running.
I work at a direct lending shop and provide the debt for many SaaS LBOs. In many cases we will lend to software businesses that are EBITDA negative or very low EBITDA margins if the company is growing rapidly (think ~20%+ per year) and has other positive metrics like a sticky solution with high customer retention and a high % of recurring revenue.
In these cases we may underwrite a loan off of revenue. We'll probably shake out around the ~2x revenue range, going up and down based on how much we like the business. As an additional requirement we may require the sponsor to have a minimum % equity contribution, e.g. 65% of purchase price to make sure there is an appropriate LTV cushion.
If we underwrite a loan on a revenue basis then we'll also likely include some mechanism to convert to an EBITDA-based loan 1.5-3 years down the road once the company has had a chance to grow EBITDA.