Calculating Returns Flashcards
How do you calculate the internal rate of return (IRR) in an LBO model and what does it mean?
Calculate IRR by making the amount of investor equity that a PE firm contributes in the beginning a negative, and then making cash flows or dividends to the PE firm, as well as net sale proceeds at end, positives.
Apply the IRR function in Excel to all the numbers.
Technical definition of IRR
Discount rate at which the NPV of cash flows from the investment = 0
What IRR do private equity firms usually aim for?
Depends on the economy and fundraising climate for PE firms, but an IRR in the 20-25% range or higher would be very good
How can you estimate the IRR in an LBO? Are there any rules of thumb?
Yes, you can use these rules of thumb to come up with a quick estimate:
• If a PE firm doubles its money in 5 years, that’s a 15% IRR.
• If a PE firm triples its money in 5 years, that’s a 25% IRR.
• If a PE firm doubles its money in 3 years, that’s a 26% IRR.
• If a PE firm triples its money in 3 years, that’s a 44% IRR.
So can the PE firm earn a solid return if it buys a company for $1 billion and sells it for $1 billion 5 years later?
Yes, as PE firm will use a % of debt to buy this company
What if the equity contributed (investor equity) in the beginning is the same as the net proceeds to the PE firm at the end, when it sells the company?
If nothing else happens, IRR is 0%
If company issues dividends to firm or PE firm does a dividend recap, then IRR obviously higher than 0%
How do dividends issued to the PE firm affect the IRR?
Any dividends issued, either in the normal course of business or as part of a dividend recap increase IRR, as they result in the PE firm receiving more cash back.
don’t you need to factor in interest payments and debt principal repayments somewhere in these IRR calculations? How can you just ignore them?
Ignore as company uses own cash flow to pay interest and debt principal, since PE firm not paying for these, neither affects its IRR.
Let’s say that a PE firm borrows $10 million of debt to buy out a company, and then sells the company in 5 years at the same EBITDA multiple it purchased it for. If the PE firm does not pay off any debt during those 5 years, what’s the IRR?
Trick - need more information
- if purchase price = exit price, IRR 0%
- but multiple has stayed the same, but EBITDA likely to have risen, so implies higher IRR.
Normally we care about the IRR for the equity investors in an LBO – the PE firm that buys the company – but how do we calculate the IRR for the debt investors?
Need to calculate the interest and principal payments they receive from the company each year
- then simply use the IRR function in excel and start with the negative amounts of the original debt for year 0, assume that the interest and principal payments each year are the cash flows, and assume remaining debt balance in final year is your exit value.
Most of the time, returns for debt investors will be lower than returns for the equity investors – but if the deal goes poorly or the PE firm can’t sell the company for a good price, the reverse could easily be true.
How would you model a “waterfall return” structure where different equity investors in an LBO receive different percentages of the returns, depending on the overall IRR?
For example, let’s say that Investor Group A receives 10% of the returns up to a 15% IRR (Investor Group B receives 90%), but then receives 15% of the returns (with Investor Group B receiving 85%) beyond a 15% IRR. How does that work?
- first check to see what the IRR is with the amount of net sale proceeds assumed. E.g. lets say you get back 500 mil at the end and calculate that 500 mil equates to an 18% IRR
- then determine what amount of those proceeds equals a 15% IRR, lets say 450 million
- you allocated 10% of this 450 million to investor group A and 90% to B
- allocate 15% of the remaining 50 million to A and 85% yo B
In an LBO model, is it possible for debt investors to earn a higher return than the PE firm? What does it tell us about the company we’re modeling?
Yes, high yield debt investors often get interest rates of 10-15% or more - effectively guarantees an IRR in that range for them
No matter what happens, they receive their interest payments
- or if EBITDA median multiple falls, or company shrinks, PE firm could get lower IRR than debt investors
Most of the time, increased leverage means an increased IRR. Explain how increasing the leverage could reduce the IRR.
Increased leverage, past certain points could easily reduce IRR:
- if interest payments and principal repayments exceed the company’s cash flow, the IRR will drop
- if there’s declining growth or margins, could also get a scenario where increasing debt past a certain point results in a lower IRR
The trick with an LBO is to find the “sweet spot” that maximizes the IRR for the PE firm but which also doesn’t make it difficult for the company to repay debt
How do different types of Debt and interest options affect the IRR?
For example, does it benefit the PE firm to use a higher percentage of Term Loans or a higher percentage of Senior or Subordinated Notes?
What about cash vs. PIK interest?
Almost always better to use debt with lower interest rates and debt that can be repaid early, otherwise company’s cash flows are being wasted because its generating cash but the PE firm is not using this cash in any way
- having term loans will boost IRR over PIK interest as debt principal doesn’t balloon over time
- sometimes PE firm will use HY debt or debt with PIK interest anyway if the company is having cash flow issues or if its too difficult to raise the funds via term loans
Let’s say that we have a stub period in an LBO, and that the PE firm initially acquires the company midway through the year (assume June 30th). How does that impact the returns calculation?
Use XIRR function in Excel rather than the IRR function and you enter the dates of all the cash flows in addition to the amounts
- impact on IRR depends on the length of the holding period, if stub period results in a longer holding period, IRR will decrease because a longer time period means a lower effective interest rate
- if this stub period results in a shorter holding period, IRR will increase because a shorter time period = a higher effective interest rate.
