LBO returns: MOIC, IRR and the three drivers
Where the sponsor's return comes from: EBITDA growth, the exit multiple and paying down debt.
- Calculate entry equity, exit equity, MOIC and IRR
- Split the equity gain into growth, multiple change and debt paydown
- Work out the exit multiple needed for a target MOIC
- Explain what leverage does, and does not do, to returns
The intuition
You buy a $500,000 house with a $100,000 deposit and a $400,000 mortgage. Five years later you sell it for $600,000, having paid the mortgage down to $350,000. You walk away with $250,000.
The house rose 20%, but your $100,000 became $250,000: 2.5 times your money. Part came from the price rising and part from the mortgage you paid off. The borrowing did not make the house worth more; it concentrated the gain onto a small deposit.
Exit equity = exit enterprise value − the debt still owed. MOIC = exit equity ÷ entry equity. The gain comes from three places: EBITDA growth, a change in the multiple, and debt paid down.
Why it works
- At entry, enterprise value = EBITDA × entry multiple, debt = turns × EBITDA, and equity is the difference.
- At exit, enterprise value = exit EBITDA × exit multiple, the remaining debt is repaid first, and the sponsor keeps the rest.
- MOIC (multiple of invested capital) = exit equity ÷ entry equity. IRR = MOIC^(1 ÷ years) − 1: the same gain as a yearly rate.
- The three drivers. Growth: the rise in EBITDA × the entry multiple. Multiple change: exit EBITDA × (exit multiple − entry multiple). Paydown: the debt repaid. Together they equal the equity gain.
- Multiple expansion is the least reliable driver, because it depends on the market at exit. Sponsors rarely underwrite it.
- Leverage magnifies whatever the business does, in both directions, and adds interest cost and covenant risk.
| Entry equity: 1,000 − 600 | 400 |
| Exit equity: 150 × 10 − 300 | 1,200 |
| MOIC: 1,200 ÷ 400 | 3.0x |
| IRR: 3.0^(1/5) − 1 | 24.6% |
| Growth: (150 − 100) × 10 | 500 |
| Multiple change: 150 × (10 − 10) | 0 |
| Paydown: 600 − 300 | 300 (gain 500 + 0 + 300 = 800) |
The formulas
The sponsor's check.
Growth compounded over the hold.
What is left after the lenders are repaid.
How many times the money.
The same result as a yearly rate.
Worked example
Entry equity, exit equity, then turn the multiple of money into a yearly rate.
See it move
Same deal. Change the price, the leverage, the growth, the exit multiple, the paydown and the length of the hold.
- Raise EBITDA growth. Exit enterprise value and exit equity rise, so MOIC and IRR rise.
- Lower the exit multiple. Exit equity falls by the whole drop in exit enterprise value, because the lenders are still repaid in full.
- Raise the share of debt repaid. Exit equity rises by exactly the extra debt repaid.
- Lengthen the hold. MOIC rises because EBITDA keeps growing, but watch the IRR: the gain is spread over more years.
Run it backwards
Same deal, reversed: the investment committee needs a set MOIC. What exit multiple do you have to believe in?
The equity needed at exit is the target MOIC × entry equity. The lenders must be repaid too, so the exit enterprise value has to cover both. Divide that by exit EBITDA to get the multiple.
Compare it with the entry multiple. If it is higher, the deal depends on multiple expansion, which few committees will accept. You would need more growth, more paydown or a lower price.
Traps
Say it in the interview
“What drives returns in an LBO?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Exit equity = exit EV − debt remaining.
- MOIC = exit equity ÷ entry equity; IRR = MOIC^(1/n) − 1.
- Returns come from growth, multiple change and paydown.
- Leverage magnifies returns both ways; it does not create value.