IRR is one of the defining metrics by which an LBO deal can be deemed to be successful or a failure IRR stands for your internal rate of return and there are a number of factors which contribute to this annualized return Let's have a look at this example and see where these factors come from First of all, we can look at a company with EBITDA at entry (when we require it) of 36.3 We're going to assume that we exit fours years later and in that time the EBITDA has gone up to 62.7, fantastic! An increase in your EBITDA, that is going to contribute to more returns to your equity shareholders A second factor that can help us is EBITDA multiple On entry the EBITDA multiple is 6 times, but on exit (four years later) it's gone up to 7 times Again, another factor that is going to help us We'll see these contributing in just a second So these calculate our enterprise value, at entry you take EBITDA times the multiple, gets to 217.8 On exit it's gone up dramatically to 438.9, great! Now we come onto the third factor debt! At entry, the amount of debt that we're able to put into this deal is 108.9 And then over the next four years, we use its cash flows to try and pay down the debt And that is one of the defining things about LBOs, we try and pay debt down as quickly as possible Debt has gone down to 65.3 So reduction in debt is going to contribution to an increase in equity And here we have the equity values At entry, we can calculate the equity as the enterprise value (217.8) minus the debt of 108.9 Which gets us to equity of 108.9 So that's how much we have to put in at the beginning, what will shareholders get out at the end? Well on exit, the enterprise value is 438.9. Subtract the debt, 65.3 So at exit your equity holders are going to get 373.6, wow what a dramatic increase Remember that's over four years, so if we find the annualized return (that's your IRR), that comes to 36.1% That's a fantastic level of return In an LBO, we're typically aiming for a return of 20 to 25% or more. This ones very good In terms of the total value created in terms of currency, we can see that equity (we've been in 108.9) and we came out with 373.6 That gets you your value created of 264.7 The question now is, how did each of those factors contribute? We'll debt repayment, if we look at the debt on entry and exit. That went down by 43.6 and that has contributed 43.6 towards that value created What about the EBITDA improvements? Well in order to calculate this, we take the exit EBITDA (62.7) Subtract the entry EBITDA (36.3) and then you multiply that up by the entry multiple And that contributes 158.4 to the equity value created, wow that's a really good contribution Lastly, we have the multiple expansion So we take the difference between our exit and entry multiple which was one and times that by the exit EBITDA Which gives us 62.7 Add up those three factors, the debt repayment, the EBITDA improvement and the multiple expansion gets us to the value created 264.7 So where is this useful? Well if I'm looking to make an LBO purchase and I'm wondering what kind of returns it's going make I can try and analyse what factors might contribute towards returns And how I might be able to change them when I buy the company