New on FinoLib · Volume II: Capital Markets
My latest article is now live on FinoLib, the free finance library I write: LBO Returns: Debt Paydown, IRR and MOIC Explained, from Volume II: Capital Markets. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
The idea in plain words
An LBO model follows the cash. Each year, the company’s free cash flow goes into repaying debt, and at the end the business is sold and the debt is subtracted to find what the owners keep. Two numbers measure success: MOIC, how many times the money came back, and IRR, the yearly rate of return. In this example $400 million becomes $994.1 million in five years, which is 2.49 times the money and a 20.0% yearly return, with no help from a higher sale multiple.
Key points
■Free cash flow = EBITDA − interest − taxes − capex − working capital; it repays $264.1 million of debt over five years.
■The gain bridges exactly: $360.0 million from EBITDA growth, $264.1 million from paydown, $0 from multiple, minus $30 million of fees.
■Scenarios range from 1.06x (1.2% IRR) in a recession to 3.11x (25.5%) in a strong exit.
■The base case needs an 8.01x exit for 20%; the downside returns capital at 6.79x.
A closer look
Once the deal closes, the model projects the target’s cash flow forward for the sponsor’s expected holding period (typically 5 years), using each year’s free cash flow to pay down the debt raised at entry. At the end of the holding period, the model assumes an exit — usually a sale to a strategic buyer or another PE firm, or an IPO — at an exit multiple applied to the target’s EBITDA in that final year. Two figures then measure the sponsor’s return:
A worked example
Worked Example — Compare the Scenarios: Recession, Plan, Strong Exit
Same structure and $400 million of equity; only the EBITDA path and the exit multiple change. US dollars in millions. Scenario EBITDA, Years 1–5 Exit multiple Exit EV Net debt at exit Exit equity MOIC IRR Downside 108, 105, 110, 115, 120 7.0x 840.0 415.1 424.9 1.06x 1.2% Base 123, 131, 140, 150, 160 8.0x 1,280.0 285.9 994.1 2.49x 20.0% Upside 126, 139, 152, 165, 175 8.5x 1,487.5 242.8 1,244.7 3.11x 25.5% Flip points. In the base case the sponsor needs an exit multiple of 8.01x for a 20% IRR, so the plan has no margin for a lower exit; at 6.82x the IRR drops to 15%, and only below 4.29x would the sponsor lose money.
Decision rule
Underwrite with the exit multiple at or below the true entry multiple. Accept the deal only if the base case meets the fund’s target IRR without multiple expansion and the downside case still returns at least 1.0x with covenants intact. In the return bridge, if more than about a third of the value created comes from multiple expansion, reprice or walk away: that lever belongs to the market at exit, not to you. Treat the one-third threshold as a heuristic.
The costliest mistake
Ignoring time. The same 2.49x MOIC earned over five years is a 20.0% IRR; if the exit slips to Year 7 at the same equity value, the IRR is 2.485^1/7 − 1 = 13.9%, below a 15% hurdle. Exits slip exactly when markets are weak, so a model that assumes a Year-5 exit in every scenario overstates returns in the scenarios that matter most. Run the base case at five and seven years.
Career Insight
Three levers drive every LBO return: debt paydown (deleveraging), EBITDA growth (operational improvement), and multiple expansion (exiting at a higher multiple than entry — the least controllable of the three, since it depends on market conditions at exit). PE professionals are trained to decompose a projected return across exactly these three levers, because a return driven mainly by hoped-for multiple expansion is a far riskier bet than one driven by debt paydown and operational improvement the sponsor can actually control.
Recap
The debt schedule converts five years of free cash flow into $264.1 million of debt repayment, and an exit at the entry multiple of 8.0x leaves $994.1 million of equity: 2.49x and a 20.0% IRR on $400 million. The return bridges exactly to EBITDA growth and paydown less fees, and the scenarios show how quickly leverage moves the result between 1.2% and 25.5%.
What the full article covers
The full article includes worked examples, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, LBO Returns: Debt Paydown, IRR and MOIC Explained, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
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