LBO Value Creation Analysis

1. Introduction

Which factors are driving most of the sponsor returns?

It can be tricky disentangling the different value drivers contributing to your rosy 25% IRR. It’s important to do so, however, for many reasons:

  • Is debt paydown or EBITDA growth contributing most of the returns?
  • Are these growth assumptions defensible?
  • Uh oh, we’re assuming 90% of the value creation comes from debt paydown and multiple expansion…

You get the idea.

This can be useful on both the buyside (before presenting your model to a superior) and the sellside (making sure that sellside case is somewhat defensible).

This tutorial is going to build off the prior two articles, and you’ll learn how to put together a value creation bridge - showing where the sponsor returns are really coming from.

Here is what the completed analysis looks like:

You can reference the completed excel file.

2. Fundamentals

Sponsors grow the equity value of their investments using two levers:

  1. Increasing the Total Enterprise Value (TEV)
  2. Debt Paydown - thereby increasing the portion of Total Enterprise Value allocated to equityholders.

Value creation from the sponsor’s perspective is:

Value Creation = Exit Equity Value - Equity Invested

This can be expanded to separate the impact of debt paydown from the change in Enterprise Value. These are the two levers from above:

Value Creation = Change in Enterprise Value + Debt Paydown

While debt paydown is simple to measure (that’s what the LBO model tracks), the change in enterprise value can be separated into different variables.

3. Decomposing Change in Enterprise Value

Enterprise Value, otherwise known as Transaction Value, is usually calculated:

Transaction Value = Adj. EBITDA x Transaction Multiple

Therefore, the change can be separated into these two buckets:

  1. Change in multiple (a.k.a. Multiple Expansion) and
  2. Change in EBITDA.

Change in EBITDA can be further decomposed into revenue growth and margin enhancement. For example, cost savings might not contribute any revenue growth, but would increase the EBITDA margin. We’re keeping the change in EBITDA in a single bucket here though, because in our dummy operating case we keep margins constant. Therefore, all of the EBITDA growth comes from revenue growth.

4. Takeaways

In our illustrative output above, you can see that ~50% of total value creation comes from EBITDA growth, and since margins are constant, we assume revenue is the primary driver.

On the buyside, it would be important to diligence the specific assumptions underlying that revenue growth. Especially for a larger company, you would probably have a detailed operating build for each of the different business segments. Maybe one segment in particular is driving most of the growth.

On the sellside, you know that sponsors will do this analysis, and they will focus on the key diligence points. You can help management prepare for the areas that will receive the most attention.

5. FAQ

Why are you adding fees to calculate the initial sponsor equity?

Because we’re calculating how much money the sponsor needs to invest, and they need to pay for fees. Therefore, bigger fees require a greater sponsor investment.

Why are you subtracting fees from the sponsor exit value?

Again, the sponsor needs to pay for fees. This value creation analysis is net of fees. Any money the sponsor receives comes after paying down debt and transaction fees.

For the entry calculations, why are you using total debt (600mm) vs. net debt (595mm)?

If you were wondering this, congrats - you’re being a careful reader.

The entry column must match the sources & uses. We assume 5mm minimum cash balance, so that cash isn’t available for the transaction. It’s the cash required to run the company and fund working capital. Therefore, we’re treating the 5mm of cash as an operating asset and ignoring it for the purposes of the transaction.

So why are you using net debt to calculate the exit value?

Good job picking up on this inconsistency - you may make an astute MD one day.

The entry column must match the sources & uses. That’s why we’re excluding the minimum cash balance there.

The exit column returns should match the returns included in the LBO. Therefore, we need to use the same net debt figure. In the LBO returns section, we try to keep it simple by calculating net debt as all debt minus all cash.

This leaves us with the aforementioned inconsistency in the treatment of operating cash. It’s important to recognize that this inconsistency stems from how we treat operating cash in the LBO. It is not a new assumption introduced in the value creation analysis.

If you spotted this inconsistency while exploring the value creation analysis, then I would argue that this exercise was successful. It led you to think critically about our assumptions and what really generated the modeled returns.

Hold up, why aren’t you subtracting fees in the LBO returns calculations?

Alright, you caught me. That’s another inconsistency. Generally, for high-level LBOs like this one, you don’t subtract future transaction fees in the returns calculations.

We’re including the fees in the value creation analysis, because it felt inconsistent to include the impact of the fees at entry and not at exit (especially when they’re side-by-side).

If you set the exit fees to 0, the calculated exit equity value and MoIC will match the values calculated in the LBO.

6. Next Steps

Try the rest of our private equity modeling tutorials:

  1. Easy LBO
  2. Intermediate LBO Guide
  3. Advanced LBO Guide
  4. Ability-To-Pay Analysis
  5. Dividend Recap Guide
  6. Private Equity Modeling Guide