New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: LBO Case Study: Modeling a Buyout Under Rising Interest Rates. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
12.1 Why Synthesis Matters at Practitioner Level
A closer look
Volume I closed by tracing one iPhone’s journey through every layer of the system it had built, because in the real economy nothing happens in isolation: understanding shows up only when separate chapters are forced to work together on a single problem. This Part does the same for Volume II at execution level. A live deal, scandal or crisis demands three or four Parts of this Volume at once, under time pressure and with incomplete information, and it ends in a document someone must sign.
12.2 Case One — Modeling an LBO Under a Rising-Rate Regime
The idea in plain words
This case reruns the buyout from Section 2.6 in a world where interest rates rise. Rates jump by two percentage points from Year 3 on the 60% of the debt that is floating. The return barely moves, falling from 20.0% to 19.7%, because by then the loan has been paid down, and because the extra interest is tax-deductible, so a quarter of it comes back as tax saved. The bigger danger is the exit: with the same rates and a 7.0x exit multiple, the return falls to 15.6%.
Key points
■Extra interest of $13.2 million less $3.3 million of tax saved costs $9.9 million of exit equity.
■Covenant cushion never falls below 29.9% in the shocked base case and 15.6% with downside EBITDA.
■Each 1.0x of exit multiple is $160 million of equity, sixteen times the rate shock.
A closer look
The situation: A private equity sponsor is underwriting the LBO of Section 2.6: The LBO Model — Sources & Uses, a stable, cash-generative manufacturer, and must decide what happens if, two years into the hold, the central bank starts a hiking cycle like the Fed’s 525 basis points of 2022–23 (Volume I’s Part 2).
A worked example
Professional Output — Investment Committee Memo (Case One)
Recommendation: approve at no more than 8.0x LTM EBITDA ($920 million), on the conditions below. Returns: base 2.49x and 20.0%; SOFR +200 bp from Year 3, 2.46x and 19.7%. Key risk: the exit multiple. Below 6.88x the IRR misses the 15% hurdle; weak EBITDA at 7.0x returns only 1.02x, though the covenant cushion never falls below 15.6%. Conditions: swap at least half the expected loan balance to fixed for three years; underwrite the exit at 7.0x, not 8.0x.
Under the hood
Under the Hood: Why 200 Basis Points Cost Only $9.9 Million
With a full cash sweep, lost equity equals extra interest after tax: 13.2 − 3.3 = $9.9 million. It is small because only the floating 60% reprices and the shock arrives after two years of sweeping, when the loan is down to $254.9 million (Year 3 costs 254.9 × 2% = $5.1 million). Year-3 interest of $42.9 million exceeds the 0.30 × 140 = $42.0 million deduction cap, but the carryforward is used by Year 5; on the downside EBITDA path it reaches $50.5 million, leaving extra interest unsheltered.
Decision rule
Run every leveraged deal with +200 basis points on the floating debt and an exit 1.0x below entry, together. Approve if that case clears the hurdle (15%; here 15.6%) and the downside keeps a 15% covenant cushion every year. Failing only the rate test calls for a hedge; failing the multiple test calls for a lower price. These are working heuristics; skip the rate test when over 75% of the debt is fixed for the hold.
The costliest mistake
Calling a deal safe because the rate shock barely moves the IRR: here +200 basis points costs $9.9 million (19.7% instead of 20.0%). The regime that raises rates usually lowers exit multiples: 1.0x lower costs $160 million and cuts the IRR to 15.6%; with weak EBITDA, 0.4%. Stress both together and price off the combination.
Where Experts Disagree: Do Buyout Returns Come From Cheap Credit or Better Companies?
Axelson, Jenkinson, Strömberg and Weisbach (1,157 deals, 1980 to 2008; Journal of Finance 2013) found that the economy-wide cost of borrowing drives buyout leverage, that cheap credit raises prices paid beyond public-market valuations, and that high leverage lowers fund returns. Guo, Hotchkiss and Song (192 buyouts, 1990 to 2006; Journal of Finance 2011) found operating gains, rising industry multiples and leverage tax benefits about equally important in explaining returns.
Recap
Rerunning the Section 2.6 LBO with SOFR 200 basis points higher from Year 3 cuts exit equity by only $9.9 million (IRR 20.0% to 19.7%), because only the swept-down floating loan reprices and the extra interest is deductible, so a quarter of it comes back as tax saved.
What the full article covers
In the full article I take you through these sections:
■12.1 Why Synthesis Matters at Practitioner Level
■12.2 Case One — Modeling an LBO Under a Rising-Rate Regime
It includes worked examples, a look under the hood at the mechanics, 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 Case Study: Modeling a Buyout Under Rising Interest Rates, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance