LBO Returns - Increasing Leverage Doesn't Increase Returns?
I've heard a lot of people say that increasing leverage will generally increase your returns in a LBO scenario as long as the cost of debt is cheaper than the cost of equity.
That makes sense, but what I don't understand is what the cost of equity is in a LBO. Is it the levered IRR (so your return on equity will increase as long as it is higher than the cost of debt)? Having some trouble wrapping my head around this, any insight much appreciated
Leverage amplifies the magnitude returns. Meaning your gains will be larger but your losses as well. At a certain point (like in WACC) your debt level will become so high that bankruptcy will be a real concern and returns will decrease and WACC would begin to decrease as the cost of debt would become greater than equity.
Key is to not confuse return on equity (aka IRR) with COST of equity. Cost of equity is not something you normally think about much when modeling an LBO, but to answer this question, think about what cost of equity would represent in a private equity LBO.
Think about it like this. You can use debt and pay the cost of debt (interest/principal payments), or you can use equity. Where is the equity coming from? The PE fund. And where does the PE fund get the capital to make these equity investments? The LPs. So in this instance, the cost of equity that you are comparing the IRR to would be the return that the LPs demand, which is nearly always higher than the cost of debt.
As you take on more debt, the business becomes riskier as you have less cash flows to service the debt and increase your risk of bankruptcy. Therefore, your LPs would expect a higher return to compensate for the increased risk. At a certain threshold, that expected return could exceed the cost of debt.
To bring it closer to the way you're currently thinking about it, think about a non-LBO situation. If a company wants to finance a project, they can raise debt or issue equity. The cost of equity per CAPM represents the return that investors expect when they buy that equity. If you take on a ton of debt, your cost of equity is going to increase because investors aren't going to buy your issued equity if you suddenly raise your risk from debt that much. To tie this back to the paragraph above, in an LBO, who is going to buy the issued equity? Answer is another private investor, AKA another PE fund with its LPs.
This makes sense, thank you!
In LBO modelling specifically, would you ever care about comparing the return on equity to the return on debt to help make decisions?
Of all the investment memos that I have helped to draft and vet through, I have never seen ROE used in both the FOF or the PE directs space. More often than not, we look at IRR as the indicator for good/bad returns (because a PE fund usually has a hurdle rate). That said, I do believe that ROE is a pretty close proxy to MOIC, where the latter means how much you are getting back from the divestiture over your invested amount.
PS: I don't see how cost of debt can ever exceed cost of equity in the first place, both theoretically and realistically. Perhaps someone can help enlighten this?
Do appreciate the thoughtfulness of this response and a few below - private equity funds certainly have return thresholds to ensure they are meeting LP's investment objectives / continue to get LP commitments in a competitive marketplace.
However, let me gently disagree - in an LBO model, the cost of equity is equal to the IRR, which is equal to the rate of return an equity investment generates. The PE firm may determine that the IRR / cost of equity for an individual investment does not meet its return objectives (partially because as Yasuo points out, LPs evaluate the cost of equity of investing in a given PE fund vs. other capital allocation decisions).
To answer the original question - when cost of debt > cost of equity (IRR), interest payments grow faster than equity returns, so the more debt you put on at close (more leverage), the lower your equity returns become. Conversely, when cost of equity > cost of debt, equity grows faster than interest, so when TEV grows, more $'s go to equity vs. debt, and with lower initial equity, % growth on that equity goes up.
That actually is a way cleaner explanation. May have been trying too hard to analogize. OP, listen to the PE VP, not a 2nd year IB scrub :P
Super helpful and makes a ton of sense - thanks very much!
When a sponsor uses less capital (lower cash outlay), you are receiving the same cash flow stream and/or enterprise value of an asset.
Not the best, but a decent job by CFA: https://corporatefinanceinstitute.com/resources/knowledge/finance/lever…
Typical PE target IRRs used to be 20-30%, but previously dropped to 15-20% (maybe even lower for larger, stable/recurring revenue and margin businesses) pre-COVID. Cost of debt is always going to be lower than that.
What do the UMM PE funds typically expect the candidate to use as the equity IRR in the case study? Would it be a sensitivity of 15-25%?
Your model IRR should reflect your case study write up. So if your case study concludes its an interesting investment for the fund, don't land at sub 18% IRRs. If your case study concludes that the fund should invest but not push it on valuation, don't model 30%+ IRRs. If you are concluding it is a good opportunity, 20-30% is a fine range.
Harum facilis quis assumenda perspiciatis autem. Ut molestiae voluptatem nihil soluta aliquam.
Voluptatem enim minus quo hic exercitationem. Aut expedita magnam laudantium culpa ratione harum. Et autem et nihil. Eum libero id qui vel. Voluptatem voluptatem cupiditate in necessitatibus incidunt.
Laboriosam pariatur aut nam aspernatur quo aliquid nobis. Provident quibusdam qui ea. Voluptas tempore eaque maiores sapiente voluptatibus magnam dolores.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...