LBO Urgent advice - why subtract dividends from sponsor equity

Intern in IB-M&A

Hi working on an LBO would appreciate advice within next 24 hours

During the LBO the company does a dividend recap resulting in a dividends payment of $100m

The sponsor initially invested $400m into the company and gave management 10% options at exit

should the 10% options be based on 1) the $400m initial equity invested or 2) $300m? (the $400m-$100m dividends)

I was told it should be 2) but I don't understand why? Apparently I should subtract the $100m dividends from the equity value and calculate what the 10% options in shares would be from that? I.e cash received from exercising the options would be 10%*(400-100) instead of 10% * 400 ?

Thanks

Comments (7)

Feb 19, 2020

If the PE shop sells the company after the div recap for 400, an additional 100 of value was created (apart from debt repayment from cash flow during holding period). Management therefore should be rewarded based on the remaining invested equity in the company, so after subtracting dividends.

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Feb 19, 2020

Not exactly. First, it is 10% options in the *increase *in equity value, not 10% of the Company itself. So if the equity is $400 at close and $500 at exit, management would earn 10% x ($500-$400) = $10.

A dividend is part of the increase in equity value. So instead of subtracting it from the initial equity value, you add it to the exit equity value. So if equity at close is $400, equity at exit is $500, and dividend is $100, management options would be 10% x ($500 + $100 - $400) = $20

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Feb 19, 2020

Wouldn't it depend on the specifics of the contract with management? You can be pretty creative and get away with a lot in the right situation.

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Feb 20, 2020

@notyourbuddypa In full buyouts, which is most of PE, this is what is traditionally done. Think about it this way: if you buy a company for $400M and sell it for $400M, meaning you made no money, why would you reward management with $40M (ie 10%)? Management options are always at a strike price and almost always the strike price is equity value at close. This means they get % of the increase in equity value. This is the standard/market.

As for @Rover-S , I didn't totally follow what you're saying but yes if the answer is the same you can use different methodologies. My methodology is what I use and gives the correct answer. My point is that a dividend in practice and in modeling does not reduce what you actually put in at close (ie doesn't change history) but is part of the increase in value of the equity that factors into the returns

I can't believe I got an MS and no SB. What I am saying is correct and is what I have done in 8+ deals over multiple firms.

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Feb 21, 2020

Don't understand the MS either. Your response is correct and helpful.

Feb 20, 2020

Explain me the difference between 500-300=200 --> 20 for management - and 400-200=200 --> 20 for management.... Both capture exactly the same: the absolute increase in equity value in the holding period.

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  • VP in PE - LBOs
Feb 20, 2020
Comment
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