attribution analysis This is a topic that many people are looking for. newyorkcityvoices.org is a channel providing useful information about learning, life, digital marketing and online courses …. it will help you have an overview and solid multi-faceted knowledge . Today, newyorkcityvoices.org would like to introduce to you LBO – Returns Attribution Analysis. Following along are instructions in the video below:
“And welcome to another free tutorial video this summer app. We re going to be be going over a concept known as the returns attribution analysis in a leveraged buyout lvo model this is something that is actually not that complex but something that you may not have seen before and the idea is to figure out what is really driving the return. The irr. The internal rate of return or the money on money or mo m.
Multiple when you have a leveraged buyout scenario like this where you buy a company and then sell the company at some point in the future. Now. The reason that this came up is because we ve got a really good question. The other day.
I pasted it in a screenshot here. But you probably can t see it that well essentially. It s from one of our students on the site. Who got this interview.
Question about how financial sponsors make money so in other words how do private equity firms actually make money the interviewer didn t want him to walk through an lbo model. Because he assumed that this student already knew all the steps he wanted him to explain why it actually worked and what allowed the private equity firm to earn a return on their investment or earn a return above what they could earn elsewhere by buying and selling this company part of the question was if you buy a company at a certain multiple of ebit. Ah. And then you sell it at that same multiple can the deal actually work.
So can you get an irr that s above 20 percent or in money on multi. Multiple that s above 3x or 25. X. Can you actually make it work.
Now. When this came up interview. Our students said to do a dividend recap. Which essentially means making the company take on more debt midway through to issue a dividend to the private equity firm.
But the interviewer said in response that this wasn t necessarily wrong that could be one way to make an impact and to still get a return in the scenario. But there are other ways to do it such as having the company take on more debt and possibly doing other things so that s our question in this tutorial are there other ways to boost the returns and get an acceptable irr. Even if the purchase multiple and the eggs. Multiple are the same or let s go beyond just that what if you sell the company for the same price that you bond at forget about the multiples.
What if the price itself is the same can you get a return in that scenario. And the answer as you probably guessed by now is yes. But let s go through why. It s yes in a few slides.
First and then let s come back to excel and fill this out and i m going to show you exactly how to calculate this so we have this concept of the returns attribution analysis. Which tells us how reliable our model is and then how certain we can be of the returns because the truth is that in a leveraged buyout. There are really three ways that you can get returns the business itself can grow so in other words. It s ebay da can be higher in year three or year five or whenever you go to sell it then it was when you purchase the company or you can have multiple expansion.
So you buy it for a tech c beta. But you sell it for 10x ebay. Da. It s sort of like if you buy a house for eight hundred dollars per square foot or 800.
Whatever currency per square meter. And then you sell it for a thousand per square foot or a thousand per square meter. Or you can have the company pay off more debt and possibly generate additional cash above and beyond. What they need to operate in the mean time which means that your proceeds.
When you go to sell the company are going to be higher. So this analysis lets us trace. Which source of returns. We have and what makes the model work or not work now ideally most of the returns in an lbo should be from business growth so from the ebay da getting bigger and then from the company s debt repayment and cash generation ability the issue.
If you bet on multiple expansion. Buying low and selling high is that it s very very difficult to predict this in advance you can barely tell what s going to happen next year in the market. Let alone three years or five years in the future. So this one comes very close to gambling.
Whereas. The other two are more about making hedged bets. Where you ve done some analysis and you re trying to cover yourself. It s a type of thing where if it comes along great.
But you don t want to bet the entire deal on something like this happening now the implication of all these is that yes you can sell the company for the same multiple or the same price and still earn an acceptable irr. If the business grows enough or if they pay down enough debt or generate enough cash in the meantime now to actually analyze this we break it out into the separate components and first we look at the contribution from ebay da. Growth to do this we look at how much ebay da has actually grown and then we multiply it by the ebit da purchased multiple so if i bitar has grown by a hundred our final year ebay da is a hundred higher and our purchase multiple was 10x then we have a hundred times ten or a thousand that comes from ebay da. Growth now the intuition there is that you pay a certain amount a certain multiple kind of like that dollar per square foot or dollar per square meter metric for a house but then by the end if the company s ebit da has grown you ve now gotten more for your money you ve paid something and you ve gotten more from your money.
Then you initially paid and that is why you calculate it like this with multiple expansion. As you might have guessed you take the eggs and multiple you subtract the purchase multiple and then you multiply by the final year ebay da. So if the final your ebay da is 100 and the exit multiple is 12x the purchase multiple is 10x then you have 200 in returns that are coming from multiple expansion. Here because 12 minus.
10. Is 2 and 2 times 100 is 200. The intuition is you re trying to see how much more value does that final year kiba dot contribute when you get a higher value a higher multiple for it and then lastly sources. The debt paid out in cash generation.
You typically don t calculate this with a formula you back into it by subtracting these other two above so you see what the total proceeds are subtract. However much you put in and then you subtract both of these to get the amount that comes from debt pay down and cash generation now the same analysis can work in much more complex models here s a model in one of our courses based on seven days in a hotel company in mainland. China. And you can see we do basically the same thing there we look at ebay da.
Growth multiple expansion debt paid down and cash generation and we figure out that about two thirds is coming from ebay. Job growth and about one third from debt pay down and cash generation. And there is no multiple expansion in that case. So the same analysis works.
No matter. The complexity of the model. Let s take a look at it in a simple scenario. Now and fill out an lbo model.
And then look at what the numbers tell us at the end so here s our model on screen. We buy the company for 10x ebay da. We use 50 debt 50 equity. So we have a purchase price of a thousand.
We sell the company for 11x c. Beta. And then we have revenue growing at 10. A forty percent annual aberdale margin.
And then a few other stats on the cash flow items. Depreciation. Amortization capital expenditures. The change in working capital and a few items on the interest rate of 10 on the debt.
The tax rate and that initial cash balance of 20. So let s fill out our simple lbo model. Here and then look at the exit. Calculations and the returns attribution at the end for revenue.
Let s start there we have 250 initially and we re going to make it grow by 10 per year. So let s copy that across now the ebit on margin is going to be 40 percent each year. So we ll take our revenue and multiply by the 40 and copy that across then we need to subtract our depreciation and amortization and interest. We cannot actually calculate our interest yet so we re going to leave that out for now.
But for depreciation and amortization. We can take our revenue put a negative sign in front and then multiply by dna as a percent of revenue. The three percent we re going to anchor that and copy that across when we have our ebit saw and we subtract our depreciation and amortization that gets us the e bit. Then we subtract our interest and that gets us to our pre tax income.
So we can take our ebit saw subtract our depreciation amortization and our interest both these are going to be negative. So we can just use addition signs copy this across and then we have to tax the company so pre tax income times our tax rate of 40. We put a negative sign in front of this one as well and we ll copy this across and we can get to our net income at the bottom pre tax income minus our taxes so we have that now we need to see how much cash flow. The company generates and how much debt it repays and how much cash it actually accumulates over time so for the net income.
We can link to our mini income statement and have right there depreciation and amortization. We re going to link to our number on the income statement. And just flip the sign copy that across this is a non cash add back it saves us on taxes. But we re not paying this in cash in these periods.
These correspond to prior capital expenditures. So we add them back on the cash flow. Statement and then the change in working capital for this one. This is a percent of the change in revenue.
It s 15 here so it means basically if our revenue goes up by a hundred we need to spend fifteen on working capital to get there in the first place so for this one. I m going to take our year. One revenue and subtract our year zero revenue. And then multiplied by this fifteen percent right here anchor.
That and copy this across and then for capex let s take our revenue up here and multiply by capex as a of. Revenue the 45 will anchor that and copy that across now our free cash flow just going to be our net income. Plus. Our depreciation and amortization the change in working capital and capex.
So we have this the amount we use for debt repayment is very simple we take the minimum between our free cash flow and then our beginning debt balance in this year. So 553 in this case. So if we only have ten of debt left at the stage. We re just going to repay that ten.
But if we have 553 of cash flow. We re going to repay 53 with our available cash flow. We ve that let s copy this across and then our debt balance. We re just going to subtract.
However. Which we use for debt repayment each year copy that across and then for our cash balance. We re going to take our old number and then we re going to take our free cash. Flow and subtract.
The cash used for debt repayment and copy this across so to show you how this works. Let s say that we changed our percent debt used only 10 well in this case. We repay that debt very quickly our debt balance goes to zero. And then we start accumulating a huge cash balance after that so this just handles the case where that actually happens and we don t have much debt or we repay it very quickly and then everything simply accumulates on our balance sheet to this cash balance.
We don t need nearly this much cash to run the company so much of this will be considered excess cash by the end. I m going to change this back to 50 for now just we have it in our model. Now the other thing that we need to do is with the debt and cash numbers in place. We need to go back up and fill in our interest to keep things simple here.
I m just going to use our beginning debt balance. So in other words the ending debt balance from the year before and multiply. This by our interest rate of 10 and now you can see the real impact of the leveraged buyout. Our net income goes way down our pre tax income goes way down because we have quite a bit in interest expense.
That s owed here and you can see that we don t repay nearly as much debt by the end. We still keep the same cash balance. So now our exit enterprise value we re going to take our final year. A pizza and multiply by the 11x multiple up here and then we re going to work backwards and go from enterprise value to equity value at the end.
When you go from equity value to enterprise value you add debt and subtract cash. So when you re doing the opposite. You re going from enterprise value to equity value. You also do the opposite and you subtract debt and add cash instead so we re assuming that it s going to be our responsibility to repay this 307 of debt and that we get back this 20 of cash at the end so our equity proceeds.
Here are 1484 now for the money on money multiple. It s just going to be this 1484 divided by our initial equity contribution of 500. So 3x. Multiple and then the internal rate of return the easiest way to calculate it here is to take our equity proceeds divided by the initial contribution raise it to the power of 1 over 5 because 5 years have passed in this model.
You re one through five and then subtract one at the end so we get to an irr of 24 percent and a multiple of 3x. Which are acceptable by pretty much any standard. Any private equity firm would say that these numbers look good now for the returns attribution. So what s responsible for these numbers is it all coming from multiple expansion is it coming from a bita growth is coming from debt pay down and cash generation to answer that for the ebay growth.
Let s take our final year ebay da 161 and subtract our initial ebay da that we purchase the company out of 100 and then let s multiply by that purchase multiple of 10x remember going back to our slides. You want to see how much more you get for your money. And that s why you re multiplying by the purchase multiple now for multiple expansion. You want to take the exit.
Multiple and then subtract the purchase multiple up here and then multiply by the final year. A beta of sixty one and then debt paid out in cash generation. You have to back into this so for the total return to equity investors. We take our equity proceeds.
1484 and then we subtract our contribution of five hundred right in the beginning have that and then let s take this number subtract our ebay dog growth and then our multiple expansion. The returns from those anyway. And that s how we get to our final answer yet so what does this tell us in this case. The moral of the story is that almost two thirds the returns are coming from ebay dog growth.
If you look at the percentage here 62. Percent relatively little is coming from multiple expansion and also relatively little is coming from debt pay down and cash generation looking at these numbers. Our recommendation on this deal would be that we re somewhat positive. But we think right now a little bit too much is coming from multiple expansion right here.
And we think it might be better if more we re coming from debt pay down and cash generation. So one thing we might do is go back in and say let s change the multiple to tedx and you can see here. The irr falls to 21 or 22 percent. But still acceptable and that s helpful for letting us see what happens if there is no multiple expansion if everything is coming from ebay da.
Growth and debt pay down and cash generation instead we also might go in and look. At scenarios. Where the company s revenue isn t. Growing quite as.
Quickly. So let s say. Maybe. 75.
Percent. Growth instead and now you can see that ebay dog growth contributes far less and the irr also falls. But then that s to compensate maybe we could use more like 60 or 70 percent debt. So i ll say 65 debt.
Here. And now you can see that our irr goes back up and debt paid down and cash generation. Overall are contributing more to the returns in this case. So that s what this type of analysis can tell us what s really driving the analysis.
And the model. How we can make it better how we could reduce risk. And where the biggest risk sources are because if most of the returns are coming from ebay dog growth. That also means that the is a risk factor.
Maybe the company won t grow as quickly maybe. It s margins will fall if most returns are coming from debt pay down that s a risk factor. Maybe their cash flows will become unstable. Maybe.
They only need a lot of cash for something else so. It s a very very important analysis. And it speaks directly to that question we went through in the beginning. Which is how do financial sponsors make money and now you know the answer that they make money through ebay are growth multiple expansion sometimes and then debt pay down and cash generation.
If you buy a company at a multiple and sell out the same multiple. Yes you can make money on the deal. It s just that your money will have to come from the business. Growing or from you paying down more debt and generating more cash in the meantime.
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