I'm trying to work on ways to mentally estimate LBO IRRs quickly without building out the full model
Here, unlevered IRR can be estimated by:
EBITDA yield (inverse of entry multiple) + EBITDA growth rate
Example: An LBO @ 10x entry and exit EBITDA, with 5% revenue growth and constant EBITDA margin would yield around a 15% unlevered IRR.
Now, the trouble is trying to isolate the value created from leverage. Is there a way to quickly estimate Levered IRR (i.e. sponsor IRR)? Ideally with only cost of debt and debt multiples.
Hi TheOceanizer, the silence is deafening, sorry about that.... Any of the threads below helpful?
No promises, but thought I'd mention a few relevant users that work in the industry: karija Trull gnomechomsky
I hope those threads give you a bit more insight.
I'm new here, first post, and I don't know the answer, either. Awesome question!
Yes, use the Modigliani Miller proposition 2. It will allow you to estimate the return given the unlevered return, D/E, cost of debt, and tax rate. Probably need a calculator to do it but it's your best bet.
You're talking about rearranging the WACC equation to solve for cost of equity, right?
Cost of Equity = WACC + (D/E)*(WACC less Cost of Debt)
Which is the same thing as:
LIRR = UIRR + (D/E) * (UIRR - LIRR)
I tried that previously, but the problem is that this doesn't work in an LBO scenario with a non-static capital structure. If you're deleveraging over a 5-year hold, then what D/E ratio do you use? I played with this in Excel and it doesn't look like this works...
The example you give isn't exactly correct. What you're looking for is FCF yield, not EBITDA growth yield. For example, two different deals, with a 10x entry/exit EBITDA multiple, 5% revenue growth, and constant EBITDA margins will return vastly different IRR's if their capex profile is different. In other words, you can't use EBITDA as a proxy for cash flow because you're not taking into account capex, taxes, and changes in working capital. Unlevered returns converge on FCF yield assuming no multiple arbitrage.
There is no way to calculate levered IRR's because the type of debt you use is going to affect your returns differently. The higher your interest rate, the lower your return. The more aggressive your principal amort, the lower your return.
Yes I am aware the approach is not perfect, but I'm trying to find a good, consistently disclosed metric which is a proxy for FCF. That measure is widely considered to be EBITDA. Grab an IM near you and try - the EBITDA yield approach is a good approximation for a lot of industries out there. If you want, you can assume a fixed FCF conversion % from EBITDA and the approach will generally work too.
On the levered IRR point you would be correct. But still, there should be a way to approximate it, even if you have to make certain assumptions e.g. all the debt is a 5Y TLB with no amort etc.
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