For a "paper" LBO, this is a typical simplifying assumption - you don't amortize the debt, you just accumulate the cash flow during the period and include it in the exit proceeds. In reality, a Term Loan A usually will have a small (1%) mandatory amortization, and some cash flow sweep / financial covenants attached. Bonds of course would not have any mandatory amortization.

I suspect the line is actually far more vertical. The current generation of LBO/PE investors have benefitted on the way in, money was easy, and on the way out, rates had often fallen, boosting cashflow during the period and increasing exit multiples.

Now flex the out comes when a) rates rise (and so running cashflow & exit multiples fall, b) real growth and/or margins fall due higher rates as competitors cut real prices desperate to keep up volumes to service their debt. (NB nominal doesnt matter because input costs will be rising).

The nice gentle downward slope of the last 20 years becomes a cliff.

Yes, levered private investing has greatly benefitted from the gradual decline in rates for the past 40 years, and has been able to pay ever higher multiples for businesses because of it. If rates remain on their uptrend, this will be a big challenge for the industry.

Can you tell me why you start an analysis with EBITDA? I am a bit of an outsider, and never got why analysts use that as opposed to say unlevered free cash flows? Also why not start directly from the cost of capital, as opposed to an exit multiple?

You can see that I'm influenced by some value investing schools, but I'd really like to know about how the industry does things.

EBITDA is a higher line item on the income/cashflow down to unlevered free cash flow. UFCF excludes capex, taxes and net working capital, which we take out after EBITDA in the modeling above. I don't have a theoretical answer as to *why* it's the convention only that practically speaking EBITDA is the ubiquitous metric within the industry. Perhaps its preferred by sellers because it is higher than UCFC (as it excludes capex) and so appears better?

On the exit - multiples are "easier" than a cost of capital approach, as you only need the cash flow at the end of the hold period to calculate it. To do a cost of capital approach, you need to project cash flows for the subsequent holder (and the subsequent holder and so on) and so its more cumbersome and the projections become ever less accurate as you go out. Multiples are also more easily compared vs. public comps and transaction comps. Plus, when assuming parity in the base case, you are inherently assuming the same cost of capital for the subsequent buyer (if cash flow projections continue on the same path), and so its a nice shortcut. The problem comes in scenario analysis where it can keep values arbitrarily anchored, and reduces the true variability of outcomes.

My hunch is that EBITDA may be better used in analyzing how fast can a company repay long term debt, with the assumption that a company can cut planned capex and won't have a tax burden if push comes to shove. In (equity) investing, it may be more used for convenience.

But this was one of those "so simple that I'm ashamed to ask" questions, so I really appreciate your input.

For the exit multiple, a possibly better default assumption may be a higher multiple, not just because of revenue growth, but also because of a tendency for a single operation to decline in risk as time passes.

Great writing Bear. Getting to Ben Hunt levels of reducing financial complexity to simplicity! Really encapsulates your skeptical take on markets. Also makes clear what happens when liquidity dries up and all the growth at all cost business models can't be supported by ad spending and then the cascade starts as in 2001.

If most PE investments are smaller than large public companies, their business variability is more similar to Russell 2000 than the S&P500, which means they will be sensitive economic environment. Rising rates hurts and reduced liquidity hurts sponsors ability to finance new transactions and will bring down new deal multiples. Will be an interesting period for the industry.

Clear explanation, thank you. So three variables should really be reduced to one critical independent variable and two minor orthogonal ones... and then the non-linearity becomes more obvious.

So why has the simplistic assumption of independent variables seen so much adoption? Maybe it's the reassuring answers...

The reassuring answers definitely help - any model can be “massaged” to tell the right story, and having a tighter range of return sensitivities presents as lower risk. There is also a less cynical answer which is that it is simpler just to make a bunch of independent variables rather than try to build in covariance between them, particularly when you are asked from above to model scenarios with specific assumptions.

I really enjoy these educational posts. Not coming from the investment world, they give me great background. I imagine that for those who are embedded in this world, it gives them pause to check their assumptions. Thanks for sharing your knowledge.

Thank you Bear! This is a great lesson!

Thanks Mr Dustan!

Thanks for throwing that one in. Appreciate a glimpse into the VC side of things!

TLBS is like a box of chocolates... you never know what you are going to get

Interest only debt? No principal pay down on the debt incurred in the LBO?

For a "paper" LBO, this is a typical simplifying assumption - you don't amortize the debt, you just accumulate the cash flow during the period and include it in the exit proceeds. In reality, a Term Loan A usually will have a small (1%) mandatory amortization, and some cash flow sweep / financial covenants attached. Bonds of course would not have any mandatory amortization.

I suspect the line is actually far more vertical. The current generation of LBO/PE investors have benefitted on the way in, money was easy, and on the way out, rates had often fallen, boosting cashflow during the period and increasing exit multiples.

Now flex the out comes when a) rates rise (and so running cashflow & exit multiples fall, b) real growth and/or margins fall due higher rates as competitors cut real prices desperate to keep up volumes to service their debt. (NB nominal doesnt matter because input costs will be rising).

The nice gentle downward slope of the last 20 years becomes a cliff.

Yes, levered private investing has greatly benefitted from the gradual decline in rates for the past 40 years, and has been able to pay ever higher multiples for businesses because of it. If rates remain on their uptrend, this will be a big challenge for the industry.

I have absolutely no idea what this is about, but l see how clear it is to you.

This writing makes me think of an Escher drawing,love the execution but l don’t always comprehend the underlying principles

Hope that comparison doesn’t disqualify my appreciation

Great work,thank you

Any and all appreciation is welcome. This one admittedly a very niche topic, but I'm glad you enjoyed nonetheless.

Great read I enjoyed it. So did he get the job?

This was just the first step in the process, but he probably got a second round!

I always enjoy reading your work.

Can you tell me why you start an analysis with EBITDA? I am a bit of an outsider, and never got why analysts use that as opposed to say unlevered free cash flows? Also why not start directly from the cost of capital, as opposed to an exit multiple?

You can see that I'm influenced by some value investing schools, but I'd really like to know about how the industry does things.

Thank you!

EBITDA is a higher line item on the income/cashflow down to unlevered free cash flow. UFCF excludes capex, taxes and net working capital, which we take out after EBITDA in the modeling above. I don't have a theoretical answer as to *why* it's the convention only that practically speaking EBITDA is the ubiquitous metric within the industry. Perhaps its preferred by sellers because it is higher than UCFC (as it excludes capex) and so appears better?

On the exit - multiples are "easier" than a cost of capital approach, as you only need the cash flow at the end of the hold period to calculate it. To do a cost of capital approach, you need to project cash flows for the subsequent holder (and the subsequent holder and so on) and so its more cumbersome and the projections become ever less accurate as you go out. Multiples are also more easily compared vs. public comps and transaction comps. Plus, when assuming parity in the base case, you are inherently assuming the same cost of capital for the subsequent buyer (if cash flow projections continue on the same path), and so its a nice shortcut. The problem comes in scenario analysis where it can keep values arbitrarily anchored, and reduces the true variability of outcomes.

Thanks again for reading!

edited Oct 10, 2022Thanks for the info!

My hunch is that EBITDA may be better used in analyzing how fast can a company repay long term debt, with the assumption that a company can cut planned capex and won't have a tax burden if push comes to shove. In (equity) investing, it may be more used for convenience.

But this was one of those "so simple that I'm ashamed to ask" questions, so I really appreciate your input.

For the exit multiple, a possibly better default assumption may be a higher multiple, not just because of revenue growth, but also because of a tendency for a single operation to decline in risk as time passes.

Great writing Bear. Getting to Ben Hunt levels of reducing financial complexity to simplicity! Really encapsulates your skeptical take on markets. Also makes clear what happens when liquidity dries up and all the growth at all cost business models can't be supported by ad spending and then the cascade starts as in 2001.

If most PE investments are smaller than large public companies, their business variability is more similar to Russell 2000 than the S&P500, which means they will be sensitive economic environment. Rising rates hurts and reduced liquidity hurts sponsors ability to finance new transactions and will bring down new deal multiples. Will be an interesting period for the industry.

Clear explanation, thank you. So three variables should really be reduced to one critical independent variable and two minor orthogonal ones... and then the non-linearity becomes more obvious.

So why has the simplistic assumption of independent variables seen so much adoption? Maybe it's the reassuring answers...

The reassuring answers definitely help - any model can be “massaged” to tell the right story, and having a tighter range of return sensitivities presents as lower risk. There is also a less cynical answer which is that it is simpler just to make a bunch of independent variables rather than try to build in covariance between them, particularly when you are asked from above to model scenarios with specific assumptions.

Really great article.

Thanks David!

Thank you! Very informational.

Thanks for reading!

I really enjoy these educational posts. Not coming from the investment world, they give me great background. I imagine that for those who are embedded in this world, it gives them pause to check their assumptions. Thanks for sharing your knowledge.

I’m trying to find the right mix and I’m glad you’ve enjoyed!