What returns are you underwriting?
At an UMM buyout strategy where base cases are about 2.7x-3x MoM on five year holds or 22%-25% IRR. It ain’t easy.
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Based on the most helpful WSO content, underwriting returns in an UMM buyout strategy typically aim for base cases of 2.7x-3x MoM (Multiple on Money) over a five-year hold period, translating to an IRR (Internal Rate of Return) of 22%-25%. However, achieving these returns is challenging and requires careful execution and value creation strategies.
Sources: Is it dumb to exit to LMM PE rather than starting in bigger (MF/UMM) opportunities first?, Value Buy-out vs Growth Buy-out Discussion from Associate Perspective, URGENT: Take offer at Insight or UMM fund?, Consider ultra-LMM, Q&A: Non-target UG to MM IB to $8bn+ UMM Buyout Fund
LMM buyout. Similarly targeting base case of 3x MOIC, 25% IRR.
Genuine question from the sell side - how is it possible that people are purportedly underwriting to 2x, even 2.5-3x+ and 20%+, yet this is actually a comparatively rare outcome for a buyout fund nowadays? I assume that’s gross, but even still, lot of funds well south of that on a net equivalent basis. Is the underwriting just optical at a certain point? Tell your committee you’re underwriting a top quartile return but make rosy enough assumptions on the fundamentals and terms that it comes out in the wash in the end?
Not trying to instigate, trying to understand.
Because the incentives in the industry have turned the process into this fake clown charade.
1. IC enforces rules like “must be 3x” etc.
2. Deal team captains/mid levels must bring in deals to keep their job and are promoted/paid based on the deals they can bring in, giving extreme incentive/pressure to get deals done
3. If deal team captains above bring in a deal that happens to be sub 3x in reality, no one will know for years, by which point they will have been promoted upwards and shielded or out of the firm anyways. However, if they don’t bring in a deal, their bonus/career progression will certainly suffer now. Chance of a risk in years vs. immediate real risk now
4. Given the above, deal originators will say whatever is needed or finesse numbers however they need to be to meet IC requirements, even if intellectually dishonest
5. ICs become clown show trials where every deal magically is a 3x, even if the investment is objectively questionable
Bingo, a lot of cognitive dissonance and outdated thinking not grounded in reality & what is occurring in the market.
A lot (L15Y) was underwritten in ZIRP. That’s no longer true so exit valuations compress and then the returns automatically compress
This is also true, but plenty of funds that liquidated or substantially harvested before rates came up that had the same story, so imho it’s not the full picture.
Like from a basic statistics standpoint, if four guys are all telling their respective ICs their deal is going to be top quartile, three of them are wrong at scale.
It actually makes sense if you take a step back. At my firm we typically underwrite to 2.5-2.7x / 20-22% IRR in the base case. Actual returns for the portfolio will Likely be c. 15%.
The reason is that (especially in UMM/MF) risk skews to the downside. In terms of unknown unknowns (uncertainty) will almost exclusively screw you.
Example:
- Dirsuption: Definitionally, in UMM you are buying companies that are already scaled. Thus you can be disrupted (e.g. AI-pocalypse) and it is rare that you will be the beneficiary of disruption (the disruptor will be VC/GE backed or MM-PE).
When you price 10 deals at 2.5 in your base case (I.e. what you “think” will happen) and 2 get screwed because the multiples turn against you (AI, Rates) or revenue growth slows (Regulatory changes, tariffs, key customer loss (see Cinven Amadys)) or cost structure (wage inflation with TICC, metals/energy inputs for industrials with Russia Ukraine)then you end up at 15% for the portfolio.
Sometimes things go as you think they will and sometimes things go better (e.g. exit to a strategic who is paying for synergies).
Bottom line, when you are wrong, it is less likely to be an upside.
At a private MF right now (latest fund >$20bn) and echo the above. Everything we take to IC must be 3x MoM or above but that’s questionable more often than not when you actually dig under the hood.
However, we’ve anecdotally heard that this mandate has become much softer at publicly listed funds given lower cost of capital (eg. BX, TPG, Apollo, etc. all having greater flexibility to underwrite closer to a 2x, especially if it’s a large TEV deal where the absolute carry dollars will still be monstrous).
We underwrite to 20% which is 15% on net basis. I think other than our latest fund we’ve hit 15% the latest fund will be like 10% net so we missed but people generally believe the hype that they’re getting 20% deals
large fund flexible strategy investing across the cap structure (500-1bn tickets typically)
Tipically underwrite 2x / 18% or so. Deliver that pretty consistently due to structured nature of instruments and downside protection
sixth street?
Question for people in this thread, with all honesty - are you guys looking at growthier sectors or just not haircutting management plans much? I just don’t really see how many deals pencil out to these returns in your traditional industrial/consumer verticals where you’re lucky to get mid-single digit organic EBITDA growth. And it begs the question when the music stops on the classic multiple arb roll-ups (look at where public insurance brokers are trading).
I think in many ways this is indicative of why there hasn’t been any liquidity in this industry. Underwriting a 20%+ IRRs with 4% SOFR is going to spit out single digit multiples in the vast majority of cases under reasonable underwriting assumptions? Have to imagine that’s multiple points of exit compression compared to where these deals were done? Yet somehow people are getting comfortable paying big multiples for the better assets; everything feels super competitive.
Just random musings, but it goes to an idea that PE funds don’t have a god given right to 20% IRRs. Kind of strange to be in the seat and watch it play out knowing you’re putting capital in the ground at low-mid teens (realistically) and clipping a check along the way. Not a bad existence by any means, but it does make all of the performative IC bullshit pretty annoying in the UMM/large cap space…
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