Key Rule 4

Question 1

Key rule 4:
- how to calculate returns
- IRR

Answer 1

• equity PE put down is a negative
• cash or dividends issued to PE firm throughout period are positive, usually 0 as PE uses to repay debt though
• sale proceeds minus debt standing is what PE gets.
  IRR is If we invested this initially amount of money and got this specific interest rate, compounded each year, we’d end up with the total amount of money shown in the final year at the end of the period.

Question 2

IRR put simply

Answer 2

The effective interest rate on this investment
- if PE firm receives cash or dividends from this company, would increase IRR as it would boost total funds received by firms

Question 3

Determining the exit assumption
- how do you determine how much the company can be sold for?

Answer 3

In an LBO model, assume an exit EBITDA multiple for the company, close to or below the purchase EBITDA multiple. Use range of values to valuation it, and then calculate enterprise value, then work backwards to calculate EV.

Question 4

Mental math and rules of thumb

Answer 4

• 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

Question 5

IRR approx example:

• A PE firm buys a company with no existing cash or debt for $1 billion, at an EV / EBITDA multiple of 10x.
• They use 50% debt and 50% equity.
• At the end of a 5-year period, they sell the company for the same 10x EBITDA multiple, but its EBITDA has grown to $150 million.
• It has also paid off $100 million worth of debt

Answer 5

Enterprise value roughly = EV
- so PE firm puts down 500mil cash, 500 mil debt
- sell for 1.5 billion
- needs to repay 400 million
- so 1.1 billion left
More than doubled money over a 5 year period, so estimate IRR as just over 15% -> 16-18% IRR

Question 6

What Affects the IRR in an LBO?

Answer 6

Greatest impact variables on IRR in LBO
- purchase price
- % debt and % equity used
- exit price
Anything which affects cash flow on the financial statements as well

Question 7

Changes That Increase IRR

Answer 7

Lower Purchase Price, Less Equity, Higher Revenue Growth, Higher EBITDA Margins, Lower Interest Rates, Lower CapEx

Question 8

Changes That Reduce IRR:

Answer 8

Higher Purchase Price, More Equity, Lower Revenue Growth, Lower EBITDA Margins, Higher Interest Rates, Higher CapEx

Question 9

When in doubt, ask yourself:

Answer 9

Will this change BOOST cash flow?, if yes, then it will increase returns, otherwise will decrease returns.