Just wondering, when modelling LBOs is it market practice to assume you:
a) amortise debt & forsake dividends over the holding period in favour of lower interest expense & a higher equity value at exit,
or
b) pay dividends & forsake debt repayment over the holding period in favour of a (slightly) higher IRR over the life of the investment
I assume it's a) because that slight bump in IRR from taking option b) is not worth the risk in the event the chit hits the fan and your cash flow drops for whatever reason and you struggle to meet your mandatory debt service. Can someone confirm/deny, or even modify my options?
Would especially appreciate insight of people who work in PE.
Depends on your credit agreements
Depends on your credit agreements and also GPs are incentivized to achieve as high of an IRR as possible
So if the aim is to bump up the IRR, then I assume GPs would want to take much cash as they can out of the business subject to:
1) Firstly of course satisfying any cash needs of the business from an operational standpoint.
2) not breaching covenants (ie. dividend lockup covenants, so for example if one year your achieved DSCR is on track to be 2.5x and your lockup is at 2.0x, you might plan to pay yourself the diference, 0.5x, in dividends )
3) plus any optional debt repayments that you feel it may be prudent to make to minimise future interest costs (and thus as I mentioned before, to minimise the risk of financial stress in an event where cash flow drops)
Back to your original question, it is market practice to assume debt repayment and no dividends for the most part
You may be making this way too complicated as most LBO deals won't have tons of excess cash to worry about
Yeah but sometimes lenders are stricter than just satisfying your covenants.
In addition to above, if company is performing heroically like doubling your EBITDA in 2 years, you may consider doing a dividend recap. If this is for a case study / practice, fair to say you can assume zero dividend / zero recap and just paydown debt as quickly as possible. If your debt is fully paid off in say, year 3 (pretty unlikely for a traditional company), then by all means build in the dividend.
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