A sponsor buys a business for 10 times EBITDA of $100m with $500m of debt, exits after five years at 9 times an EBITDA of $140m, and pays down $150m of debt over the hold. What is the internal rate of return on the equity, and where did the return come from?

A sponsor buys a business for 10 times EBITDA of $100m with $500m of debt, exits after five years at 9 times an EBITDA of $140m, and pays down $150m of debt over the hold. What is the internal rate of return on the equity, and where did the return come from?

Approach: Build entry and exit equity values as enterprise value less net debt, take the fifth root of the multiple of money, then attribute the gain to earnings growth, the change in multiple and debt paydown.

12.7%. Entry enterprise value is 10 * 100, or $1,000m, against $500m of debt, so equity in is $500m. Exit enterprise value is 9 * 140, or $1,260m, against $350m of debt, so equity out is $910m. The multiple of money is 910/500, which is 1.82, and the internal rate of return is 1.82^(1/5) - 1, or 12.7%. The attribution is that EBITDA growth of $40m at the entry multiple adds $400m, multiple contraction from 10 to 9 removes 1 * 140, or $140m, and deleveraging adds $150m, which sums to the $410m of equity gain. Almost all of the return came from earnings growth and debt paydown, and one turn of multiple contraction cost more than a third of the operational gain.

Follow-up: The exit slips by two years with EBITDA flat at $140m and no further debt paydown. What does the internal rate of return become?

Key concepts: multiple of money, internal rate of return, deleveraging, multiple contraction.