Chapter 2 of 6 · 12 min

The value creation bridge

Split the equity gain into EBITDA growth, multiple change and debt paydown, to the dollar.

By the end of this chapter you can

Calculate the three pieces of the equity gain
Check that they add up to exit equity minus entry equity
Work back from a multiple of money to the exit multiple achieved
Explain why committees care where the return came from

The intuition

You bought a flat with a mortgage and sold it years later at a profit. Where did the profit come from? Partly you made the flat worth more by renting it for more. Partly the whole street became fashionable, so buyers paid more for every dollar of rent. And partly you paid down the mortgage, so more of the sale price was yours.

Those are the three pieces of every buyout gain. The first and third you can plan for. The second is luck with the market, and investors want to know how much of a return depended on it.

The key idea

Equity gain = growth (extra EBITDA × entry multiple) + multiple change (exit EBITDA × change in multiple) + paydown (debt repaid). The three add up exactly.

Why it works

Entry equity = EBITDA × entry multiple − entry debt. Exit equity = exit EBITDA × exit multiple − the debt still owed.
Growth is valued at the entry multiple: the extra EBITDA the business earned, priced at what the sponsor paid for EBITDA.
Multiple change is applied to the whole exit EBITDA: what the market did to the price of every dollar of earnings.
Paydown = entry debt − exit debt. Every dollar repaid is a dollar of the exit price that goes to the equity instead of the lenders.
Why that split adds up. Growth plus multiple change equals exit enterprise value minus entry enterprise value. Add the fall in debt and you have the change in equity. Valuing growth at the exit multiple while still applying the multiple change to exit EBITDA would count the overlap twice.
Why committees care. Growth and paydown are the sponsor's work and can be repeated. Multiple expansion is the market, so LPs discount a track record built on it.

EBITDA $100M bought at 10x with 5.0x of debt; five years later EBITDA $150M, exit at 11x, debt down to $300M

Entry equity: 1,000 − 500	500
Exit equity: 150 × 11 − 300	1,350 (gain 850, MOIC 2.7x)
Growth: (150 − 100) × 10	500
Multiple change: 150 × (11 − 10)	150
Paydown: 500 − 300	200
Check: 500 + 150 + 200	850
At a flat 10x: (150 × 10 − 300) ÷ 500	2.4x

Growth is 500 ÷ 850 = 58.8% of the gain; the multiple adds 0.3x of MOIC.

The formulas

From growth = (EBITDAₙ − EBITDA₀) × entry multiple

Extra earnings at the price paid for earnings.

From multiple = EBITDAₙ × (exit multiple − entry multiple)

The market's re-rating, on all of exit EBITDA.

From paydown = entry debt − exit debt

Debt repaid leaves more of the exit price to equity.

Growth + multiple + paydown = exit equity − entry equity

The three pieces add up to the gain, exactly.

Exit multiple = (MOIC × entry equity + exit debt) ÷ EBITDAₙ

Rebuild the exit price from the return, then divide.

Worked example

Entry equity and exit equity first, then the three pieces, then check they add to the gain.

Drawing the numbers…

See it move

Same deal. Change the price, the leverage, the growth, the exit multiple, the paydown and the hold.

Drawing the numbers…

Try this

Set the multiple change to zero. The multiple bar disappears and the two MOIC bars match.
Raise growth. The growth bar rises, and a multiple bar that is not zero grows in size too, because the change in multiple is applied to a bigger exit EBITDA.
Raise the share of debt repaid. Only the paydown bar moves, and exit equity rises by exactly the same amount.
Add leverage. Entry equity shrinks and the paydown bar grows, while the growth and multiple bars do not move.

Run it backwards

Same deal, reversed: you know the price, the growth, the paydown and the multiple of money. What multiple did the sponsor sell at?

Drawing the numbers…

MOIC × entry equity rebuilds exit equity. The lenders were repaid first, so add back the debt still owed to get exit enterprise value. Divide by exit EBITDA.

This is how you read a fund's reported deal: from a headline multiple of money, work out whether the exit multiple rose, and so how much of the result was the market.

Traps

Valuing growth at the exit multiple.

The convention prices growth at the entry multiple and puts the whole re-rating in the multiple line. Mix them and the overlap is counted twice.

Applying the multiple change to entry EBITDA.

The market re-rates the business you sell, so the change applies to exit EBITDA.

Leaving out paydown.

Growth and multiple explain the change in enterprise value. The equity gain also includes the debt repaid.

Calling leverage a fourth driver.

Leverage creates no value. It shrinks the check, so the same gain is a bigger multiple, and lets cash flow repay debt, which is the paydown line.

Presenting multiple expansion as the plan.

It is the one driver no one controls. A sound case works with the multiple flat or lower.

Say it in the interview

The interviewer asks

“How would you break down where the return on a buyout came from?”

Say yours out loud first, then compare.

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.

0 of 4

Drawing your questions…

Remember

Growth = ΔEBITDA × entry multiple.
Multiple = exit EBITDA × Δmultiple.
Paydown = entry debt − exit debt.
The three add to the equity gain; the multiple is the part nobody controls.