How do you think about LBOs and entry debt as % of total sources vs equity investment in the often highly-valued SaaS space (the question also applies to other highly valued industries)? If a business is valued at 25x EBITDA, than the LBO debt at entry will be very low as a % of total sources as you realistically will not be able to lever more than 6-7x at entry?

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Comments (38)

  • Analyst 2 in HF - EquityHedge
Aug 1, 2020 - 8:37am

Few ways to make this work... you can be creative with the debt structure and do PIK notes, you might need a longer holding period to get to a higher ebitda level, or you may see an opportunity off the bat to cut marketing / G&A expenses but slow down growth to bring the multiple to a more normal level... therefore your 25x ebitda multiple suddenly becomes a 12x or something depending on how much cash expenses you can take out

  • Analyst 2 in HF - EquityHedge
Aug 1, 2020 - 8:38am

Also to answer question more directly, once you take our expenses or reach a normalized level, you can recapitalize the biz and get your equity back

Aug 1, 2020 - 8:44am

nah I dont agree with your answer. PIK notes would not mean that lenders would be ok with levering more than 6-7x, you wont see that in the market at all. In terms of increasing EBITDA, lenders would likely base their leverage on closing year EBITDA or sometimes closing year + 1 EBITDA, and it is unlikely that EBITDA would increase dramatically so quickly. EBITDA cuts may also not be an alternative if the value creation is mostly in growth.

So my question is still how you think about LBO debt as % of sources when the valuation is significantly higher than EBITDA AND provided that a LTV -based leverage is not really applicable?

Most Helpful
Aug 1, 2020 - 2:22pm

Not different from other industries, sponsors pay large multiples for SaaS companies with high growth, cash flow, and margin opportunity. It sounds like you already work in investment banking so I'll give you a real life example to help illustrate.

Say a company has $100mm of revenue, 100% net customer retention and CAC of $1, currently growing at 15% with a 80% gross and 20% EBITDA margin. The company operates in a niche end market and is the clear market leader with a sticky product. This is a high quality business and a sponsor may pay 20x EBITDA for it. That would mean TEV of $400mm.

Under the above parameters, the company would spend 15% of its sales on Sales and marketing ($15mm of revenue growth costing $15mm = $1 CAC, 100% net retention so no leakage from last year's revenue). The remaining 45% of cash operating expenses is in R&D and SG&A. Given its market position, the sponsor may think that they can reduce R&D and SG&A to 25% of sales. Those expenses are largely headcount and can be realized in year 1. The sponsor will identify the headcount and go to lenders to receive credit for some of the anticipated cost cuts. Sponsor will claim year 1 EBITDA is $40mm, lenders may cap cost savings to $10mm and settle on EBITDA of $30mm; total leverage of $200mm.

In the above scenario, the sponsor will put in $200mm of equity and anticipate Year 1 EBITDA is $40mm. They'll hope to grow the asset for three years and then sell it with $50mm EBITDA at 15x or $750mm. They probably generated $100mm of cash flow and exit equity would be $650mm off of a $200mm check, or 3.2x MoM / ~50% IRR in 3 years.

Alternatively, maybe the sponsor underwrites the elevated R&D and SG&A to new product development and accelerated growth. The sponsor accepts that at $20mm of EBITDA, the most leverage they'll receive is $120mm, and put the remaining $280mm of equity themselves. The core product continues grow at 15% a year and doubles to $200mm of revenue in 5 years. The R&D leads to a new product that generates $100mm of incremental revenue. Year 5 revenue is $300mm, revenue CAGR was 25%, and EBITDA margins remain constant at 20%. The company sells for 20x EBITDA or $1.2bn and paid off its debt along the way. The sponsor returns 4.3x MoM / ~35% IRR in 5 years.

Either outcome would be a home run, and IRR's would be even higher after dividend recaps. It's not surprising, either. The sponsor originally paid 4x revenue for a high retention, growth, quality and margin SaaS business. That's incredibly cheap!

The lender community knows high quality SaaS deals (particularly if done by the best sponsors) almost never lose money and are very willing to finance them.

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Aug 1, 2020 - 9:35pm

God damn you know your shit. Anyone have any good resources to learn about tech business models/the PE investment process?

Aug 1, 2020 - 2:28pm

Thanks, but not really the answer to my question. Lets say we have a company valued at 3.2bn USD EV. Let's say our EBITDA is USD 100m. At best, we can lever this company 6x EBITDA, which results in LBO debt of 600m. If we assume no roll-over etc and ignore fees, our sponsor equity in our S&U would be 20% which is very high. My question is therefore - would a PE firm avoid this transaction or try to lever up the company over the course of the holding period based on the thesis that EBITDA will go up?

  • Associate 1 in IB-M&A
Aug 1, 2020 - 3:37pm

Isn't the whole point simply that the return is derived from growth rather than leverage? So yes, you'd make more money if you could lever the thing up further, but regardless of leverage its a great deal?

  • Associate 1 in IB-M&A
Aug 1, 2020 - 3:50pm

Got it, and that's because cash yield as % of TEV is inherently lower in high multiple deals? So changes in cash yield are per definition a lower % of total return for high multiple assets

Do you think the higher multiple environment is why Growth Equity is increasingly more attractive to funds, and funds that can successfully play on growth will do better in coming years (vs. classic LBO cost take out)? Regardless whether its "growth equity" in the original sense, or simply high growth assets being LBO'ed

Aug 2, 2020 - 1:42pm

Well as multiples go up (TEV as a multiple of your cash streams, e.g. EBITDA) and assuming reasonable debt structures, of course the cash flow yield is inherently lower (fcff as % of market cap) as you paid more for the equity as a multiple of your cash. Especially in high growth/high multiple cases, your cash flow at the beginning will not be sufficient to get you to 20% IRRs.

Aug 1, 2020 - 3:30pm

SaaS sponsors have gotten very comfortable with equity buyouts (look at H&F/Ultimate for the classic example). Say you are buying a company for 25x EBITDA. It's obviously a great business so you can take on 7x debt. 18x to go. You as the sponsor put in 10x. You get two pension buddies or big LPs to coinvest 3-4x each. Mgmt rollover picks up the last 1-2x. So you end up having majority control of the business with slightly more than 50% equity stake.

Here's what that looks like at $100M in EBITDA (and therefore $2.5bn in EV given the 25x multiple):


Debt: $700M

Sponsor Equity: $1,000M

LP Co-investor 1: $400M

Pension Investor: $400M

Mgmt Rollover: $150M

Total: $2,650 (that extra $150mm could be transaction expenses, cash to BS, etc.)

This is simplified but gets the point across. The sponsor now has a 51% controlling equity stake but their equity in at purchase is only 40% of TEV.

You'll see this a lot with the $5bn+ take privates and carveouts of high quality software businesses. Blackstone will do this exact deal, cut $50mm in costs. Grow it another $100M in EBITDA (M&A/organic) in 5 years and turn around and exit for $4.5bn (7x multiple contraction) to someone else.

Assuming debt gets paid down to $200m, you've got $4300 in equity, Blackstone's take is $2,150 fully diluted and they get a nice 2.15x/16.5% IRR to keep the fund running.

  • Associate 1 in IB-M&A
Aug 1, 2020 - 3:36pm

Just for my understanding, why would you want to give away all that equity to co-investors if you find a great deal? Or is this purely driven by concentration of the bet because your can't get enough debt, so you take your loss on the "diluted" return just to be able to do the deal?

Aug 1, 2020 - 4:30pm

Typically driven by concentration limits. If I'm a $10bn+ fund, I have concentration limits written into my docs, so unless you are H&F, who are explicitly investing in a more concentrated manner with LPs who are on board with that, you cannot throw 15-20% into one deal. Co-investors solve that problem and can offer a variety of other benefits related to running your broader business outside of this single investment. "Diluting" your equity stake can be worthwhile for those reasons. They will often have no control or board seats, so it's usually not a challenge to deal with them. Just a bit annoying.

Aug 1, 2020 - 6:04pm

I work at a direct lending shop and provide the debt for many SaaS LBOs. In many cases we will lend to software businesses that are EBITDA negative or very low EBITDA margins if the company is growing rapidly (think ~20%+ per year) and has other positive metrics like a sticky solution with high customer retention and a high % of recurring revenue.

In these cases we may underwrite a loan off of revenue. We'll probably shake out around the ~2x revenue range, going up and down based on how much we like the business. As an additional requirement we may require the sponsor to have a minimum % equity contribution, e.g. 65% of purchase price to make sure there is an appropriate LTV cushion.

If we underwrite a loan on a revenue basis then we'll also likely include some mechanism to convert to an EBITDA-based loan 1.5-3 years down the road once the company has had a chance to grow EBITDA.

Aug 1, 2020 - 6:23pm

Our actual multiples vary based on all the credit factors you would expect to matter for a software business (retention, switching costs for the end user, revenue growth, LTV, competitive dynamics, customer concentration, who the sponsor is / their experience investing in software, liquidity needs, years to CF breakeven (if they're negative), and our analysis of a second way out being a few of the common ones we look at). I just said ~2x revenue because we often end up in that range and in the case of a lender turnover we usually assume you can fairly easily sell a distressed software business for ~2x revenue based on comps we've seen. In actuality we may be higher or lower depending on all the factors above. The actual leverage multiple may be on recurring revenue, LQA recurring revenue, or ARR depending on how sponsor friendly we are in that deal.

Aug 1, 2020 - 10:26pm

A lot of software LBOs also have significantly higher leverage than you would see in most cases. This S&P report is on the older side, but still useful. 6x is not the upper bound on leverage:…. Even if you look at more growth like buyouts, like Ultimate Software which had a 70% equity contrib., there's still significant leverage, which in that case was 11x. Here's another good article outlining more what you're talking about with primarily equity funded SaaS buyouts:….

Aug 5, 2020 - 11:08pm

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  • Analyst 1 in IB - Gen
Sep 1, 2021 - 11:38pm

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