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.
Sponsors grow the equity value of their investments using two levers:
- Increasing the Total Enterprise Value (TEV)
- 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.
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:
- Change in multiple (a.k.a. Multiple Expansion) and
- 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.
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.