LBO Returns Analysis

Hey guys, I'm doing an LBO for a PE Case Study and am trying to evaluate the returns / if this is actually a good investment.

The IRR I'm getting for my Base Case is approx. 16% which isn't too bad (Downside Case IRR is approx. 12%), but I know 20%+ is usually a good target to go for. However, one key assumption that they told us in the case study is that "Your cost of equity for a publicly traded asset with this level of risk is 9%".

By definition, Cost of Equity is the return a company requires to decide if an investment meets capital return requirements. So since the ~16% IRR I'm getting is greater than the 9% Cost of Equity, doesn't that make this a good investment or am I understanding the concept of Cost of Equity incorrectly in this situation?

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Comments (6)

Feb 11, 2020 - 6:26pm

The cost of equity of listed peers is not relevant. A PE firm underwrites deals to its own cost of capital ie the required rate of return for its LPs. For MF that is mid to high teens IRRs net to LPs (ie post fees and carry) and mid market will be more like 20%+. this means deals should be targeting gross IRRs of high teens or ideally 20%+. don't forget about MOIC too, not just IRR.

Feb 11, 2020 - 6:43pm

Thanks - definitely makes sense. Only thing I am still confused about is the relevance of the 9% Cost of Equity in this case. They gave very few assumptions and that was one of them, so I am not entirely sure how to think about that in the context of the investment.

Feb 12, 2020 - 2:52am

Guy above is right - have never come across that CoE mention in a case before but potentially worth mentioning that it's a good metric to have as a benchmark however given the PE model it isn't as relevant to all stakeholders involved. Don't see it factoring into your LBO model other than the periphery analysis / IC memo if involved. Is this industry specific by any chance? Changes the narrative slightly if so but not really a ton

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Feb 11, 2020 - 8:37pm

Cost of equity for PE is ~15% - 25% (20% is the midpoint). Cost of equity is literally the return the equity provides needs / expects to make, which is 20% for PE.

Since they're giving you the public markets COE, do they want you to do a DCF as part of analysis?

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