Dealers. Welcome back everyone to our 10th session here on Felix Live.

This is going to be on private equity acquisition analysis, which we used to just kind of call LBO, but that kind of leaves out a lot of the other sort of types of transactions that are involved in that. But it's also called levered analysis too, which is another way to think about it because, it regardless of the of the nature of the entity, whether it's public or private, it's, it's an acquisition involving a lot of leverage. So we're gonna tackle that today. And it's a more, more on the advanced side of things, but given our two hour window, I'm going to try to build it up and then try to hit some of the, you know, hit some of the basics as well as for anyone who, has that curiosity, kind of touch upon some of the, the more complex aspects as well. I've got my assistant Yolanda Wadowski here as well.

And so what I'd like you to do, if you could, is if you could go to the course section just get that workout file ready to go. And that's going to be let me switch over there to that syllabus, the private equity analysis, November 29th, and just grab that, grab that empty file, and we'll, you know, we'll get to it kind of momentarily, and I'm gonna draw up some notes as I usually do.

So most people probably if you've gone through any kind of any kind of business school training or even undergraduate business training you've probably seen valuation or DCF. Out of curiosity, I'm just curious, has anybody, has anybody seen or worked on or seen a, a levered valuation, Something that involved a lot of leverage? Maybe, maybe it was called acquisition private equity acquisition, maybe it was called an LBO. Just curious if anybody has worked on that or if maybe works in an area such as leveraged finance where they, or sponsors, financial sponsors, perhaps, where they might where you might see this kind of kind of analysis.

Anyone? Anyone? Or is this new to most people? Just getting my windows straight here.

Okay. Well, that being the case I'll probably maybe go a little bit slower with it. It's very unusual analysis, right? Because it falls along that category of the intrinsic valuation.

But, I think one way that I like to, I like to think about the levered valuation is to go back again to the old house buying thing, which when you, I know your point in your career, you probably haven't started accumulating your, your trophy properties yet. That's coming. But, I call this the power of leverage because I think it just kind of puts in perspective what's happening here. I think that in reality the private equity business model, which is kind of like what we're gonna see in a nutshell, the business model of, of buying an asset with a lot of leverage controlling that asset for a number of years and then exiting or selling the asset for hopefully a profit. I think that that model came from real estate. I really do. And I think that's why real estate often fits in quite well with most private equity firms. Not all of them do real estate, but most of them do real estate. Some of them started as real estate, some of them are mostly real estate. They think about a firm like Starwood, for example, which is a real estate kind of private equity firm. And, and the reason why is because of, again, just the way real estate is typically purchased is with a small amount of equity and a large amount of leverage. So let's think about how that works in an actuality. So let's just say, for example, that we've got an asset here, and let's just say we're gonna buy a house. It's a million bucks. Now, that gets you, it gets you nothing here in la, but still is a nice, nice round number for us to go with. So we're gonna buy a house that's worth a million dollars, and we're gonna finance that house. Now, typically, if you were to go into the commercial to the residential mortgage market how much would we be able to get in, in terms of financing here? Does anybody know, anybody know what the rough percentage of debt financing available to a home buyer? Is anybody peaked into that? Perhaps saw an apartment come up flat, come up somewhere? It's a little bit different in the corporate world, but yeah, Jack, excellent. 80% let's see. Saw 50, 58%. Well, that's a nice, Shelby, that's a really that's a very specific number. 58%. Well, in the commercial real estate market, a 60% loan to value is actually probably right down the middle of leverage. So, Shelby, you're not too far off there. I'm gonna do the residential example, which is in fact, closer to 80% as Jack suggested, just because it's a little bit more extreme. It just shows, again I'm trying to highlight the power here of leverage, so the more leverage, the better.

But actually both answers could be technically correct. So I'm gonna put on this asset here. I call this today.

Let see, hang on one second. My wire connection to my, router is not on. Hang on one second. Where'd it go? Here it is.

Okay. I just, it's amazing how many, amazing how many things can be plugged into one, one computer at one time. But that should get us a little more stability, hopefully on the connection.

Okay, so today we buy a place for a million dollars, and we're gonna finance that with 80% debt. So that's gonna be 800,000, and then 20% of equity, and that'll be 200,000.

So let's just say, for example, in five years, we go to sell this place, and we've benefited from the hot real estate market that's kind of been been in many big cities for, for a number of years now. And the same building, the same home is now worth 5 million. So we'll call this year five.

And this isn't gonna be to scale here, but I'll do all the numbers out. So this now is now worth 5 million. Now, let's just say in this example that we have kind of what we would call a bullet loan. I'm gonna come back and define some of these terms today because I think that capital structure is important to talk about in when we're talking about LBO financing, and I wanna make sure we understand some capital structure terms. If we call this a bullet loan typically when you have a mortgage, you pay off a little bit of principle each, each month or each year, and that would be called an amortizing loan. But let's just say this is a bullet loan. So all we've been doing essentially is servicing the loan with interest. So we've been paying interest on the loan each year. So in, in year five, the loan is still at, let's say, 800,000, still worth, we have to pay the bank off 800,000. So that's gonna be this slice at the top, and that's the debt, right? So always have the debt on top of the capital stack because the debt has priority over the equity, right? So in case that wasn't clear to anybody, lemme just point that out. So now we still owe the bank 800,000. So the bank, obviously their, their share is fixed. It's called fixed income because the income received by the investor, from the borrower is fixed. But also, generally speaking, the amount of the loan is fixed, unless there's a couple of certain situations that are, that are changing it. But this is a loan that's not changing in value. So now what happens is, once we pay that loan off to sell the property, the rest of it goes to the residual stakeholder, which is the equity holder. So the equity holder is now sitting on top of, for 0.2 million in equity, 4.2 million in equity.

So what's happened here is because the property has appreciated in value, and the loan has remained the same, the equity stakeholder has profited significantly. Now, let's just kind of do the math to understand why this is so appealing to financiers. If we think about the multiple of if we think about the multiple of asset value, the multiple of asset value here is five times. So the asset value or the enterprise value increased by five x, the price went up five times, and we'll talk about entries and exits in this process, but, the enterprise value, the asset price went up by five times. But what did the equity increase by? What did the investors share increase by who can do that quick math in their head? What is my equity multiple here? Well, if I put in 200,000 and I got back 4.2 million, it went up like 21 times or something, right? 21 x. So effectively, by borrowing from the bank and letting the bank kind of carry the risk, putting in as little equity as possible, I've supercharged the return, even though the building is worth five times more, my equity investment goes up 21 times. And that's effectively the power of leverage, right? So you could see how applying that principle is, is quite, is quite attractive, to financiers to investors as they think about a way to do it. Now, what was possible here in terms of that, increase in value came about? Why? Why was I able to sell the building for four five times more? What did I, the investor or the buyer benefit from in this in this example, what did I benefit from? Yeah, Shelby says, appreciation. Yeah, the market going up. I benefited from the market going up here. So in this case, I was actually quite, quite lucky, right? Because, what happens if, you know, if the market goes down, right? What happens if the market goes down, down? Well, if the market goes down effectively, you've got a problem. Now, let me ask you this just because we're gonna talk about capital structure as well. Why would a lender, why would a bank or a, a private capital firm? Because a lot of these deals are being done not by banks, but by non-depository institutions, we call private debt or private credit. Why would a lender lend into this situation and allow an investor that kind of upside and carry that kind of risk? What does the lender get out of this? Any thoughts on that? Jack says protection. The lender gets protection. How is the lender protected? Jack, if I may ask for a follow up? I mean, there's a legal protection, right? When you take out a loan that says the law says, or the contract, there's a contract there that says that you have to pay it back. Kiri has something in higher claim, okay? So, so higher claim than the equity holder to the assets. That's a good follow-up answer to that, principle plus interest. So that is, that is the legal claim, correct? To my anonymous participant Kiri said there's a covenant in place. The covenant is, is definitely a protection on, on the loan. Those are, those are absolutely ways to protect, the loan. The covenants typically are they're kind of separate conversation, but the covenants will often restrict a borrower from borrowing more where they might, kind of monitor the performance, right? We'll call maintenance covenants, monitor the performance. I'm just gonna do a quick little slide here. If the default, the bank gets all the assets. Yeah, so exactly Max. And I think it was Jack also that came in on that, but I wanna just talk about this concept really quickly here, because particularly if you work in a traditional bank, this is something, we'll call these loan protection.

So, with loan protection, essentially what we've got here is for every loan that is made, you've got kind of two ways out, right? There are two ways out of every loan.

The first way out is the cashflow of the company, meaning that you're relying on the company or the borrower, if it's an individual, they have a job, they have a way of servicing the loan. So principle plus interest as one of our participants has pointed out two ways out of every loan. So there's cashflow, and that's generated by the asset or there's assets that are pledged as collateral.

So in order to get at the assets though, you basically have to sell the asset to, to kind of get at it, right? Because otherwise, the value of those assets are kind of locked up. So the last thing you'd ever wanna do is make a loan to somebody and then kind of say, okay, we're stuck. The cash flow ran dry, let's start selling off the assets, because that means you're effectively putting the company, you know, out of business, right? So this is sort of what's happening. And, you know, Max is also pointing out that there are upfront free fees, and there are definitely upfront fees on loans as well. And those sweeten the pot Max, the fees are gonna sweeten the pot of the deal, but you're not gonna cover you're not gonna cover the loan the loan value with the fees. They're just gonna kind of make it more, more profitable. So in terms of my original question, which is what is the bank get out of this? Yeah, the bank is gonna get, they're gonna get they're gonna get fees, they're going to get they're going to get protection of the assets. The assets are pledged as collateral.

And effectively what that means is, just to go back to my original example and I'll do that kind of down here.

Um, if I make this loan at 800, what I've basically built in is a 20% cushion in value.

So that means that if this, if this profit by, if this profit, if this building by year five actually goes down in value by 20% and is now worth only 800,000, I've still got protection because of that, because of that asset collateral that we talked about. And this is year five, right? Now, if on the other hand, the building goes down to 700,000, now I've, I've lost money, right? This is a loss, this 100,000, because I can only get back what the asset's worth. So in that sense Max I would be kind of happy. Well, I lost a hundred grand, a hundred grand on the loan, but hopefully I got some very rich fees upfront to do the loan. And so this is kind of what's happening in an LBO or in private equity analysis, which is to say that, we've got a bank that's willing to lend at a certain level and be protected a certain amount. Now, 80% is very high, right? 80% is very high. At 80%, you're gonna incur, you know, a lot of interest. And back to Kiri's point that would be very, very difficult from a covenant perspective to protect, because the, the margin for error is very, very small. When you're, when your interest expense is very high, every period, you've got a very small margin for error to meet that. So if your, or if your earnings dip and you don't make that covenant, that interest coverage covenant, you could, you could go into default, right? So that's kind of getting a little bit more into, into financing than maybe we need to go. But, but this just talks again about why that, you know, lender's gonna do that. So the lender does not care about the upside of the deal at all. The lender doesn't care about it. That's all for the equity to get. So the, the lender's gotta make sure that they can be covered. So going back to how, how I started this, I asked for kind of what what factor contributed to our profitability here, and Shelby answered correctly, which was that the market appreciated. So in order to understand, you know, what makes an an LBO work there's lots of different ways we can look at this. There's, we can talk about, you know, what kinds of companies and what are the circumstances. And I'll, I'll cover some of that at the end if I have time. I mean, quite honestly the LBO, but private equity market has become so vast and so voracious, the appetite is so voracious for assets to buy. I mean, almost anything makes an LBO these days. To be honest with you, now, we're in a tight market right now, but, but looking at the peak the last 10 years, there were very few examples of companies that didn't fit the the LBO profile, but I'll talk a little bit more about that at the end. But for, just to make sure we get in the correct kind of, you know, analysis that we need to get in for, for, for the basics, there's essentially, three ways to make money in an LBO. There's three ways that a buyer can buy in and, and profit from, from what we call the exit or the, the sale of the asset at the end of the holding period. So let me just kind of describe, what's happening here. So we have, we have a buyer who we often call, a financial sponsor. And a financial sponsor is a fancy way of saying a private equity firm. And the reason why they're called financial sponsors is because the, the transaction is really backed by, by financial engineering. It's not backed by the synergy of two companies coming together, which is what a traditional acquisition does. Like we looked at, you know, in the last few weeks, you know, that would be like, you know, one chemical company buying another chemical company or, or a manufacturer buying a supplier to integrate. Now, those are what we call strategic acquisitions, but, financial transactions, financial sponsor transactions are driven by, by engineering, by pure financial engineering. So a financial sponsor uses a small amount of equity. And that small amount has changed over the years, and we'll talk about that. But, small amount of equity to buy out. So there's where the buyout comes from, the previous ownership of a company.

The company is run in conjunction with the sponsor meeting. The sponsor has significant amount of input. Now, financial sponsors being, quite honestly, a bunch of finance people obviously don't know everything about every industry they buy into. Now, it's become a lot more specialized. So you've got healthcare buyout shops, you've got software buyout shops and whatnot, but for the most part, they're still finance people. They don't run companies, right? But they, but they oversee it, right? So the company is run in conjunction with the sponsor for a hold period, during which time the company is focused on increased profits or efficiency, increased profits or efficiency.

So at the end of the whole period, the company is sold.

This is called the exit.

The debt is paid down, and the profits that are left float to the equity holders.

So in this kind of blurb that I'm taking the time to write here are actually the keys to understanding how private equity makes money on the deal.

So I'm actually gonna go ahead and capitalize this, just, so this is also called the entry. Okay? See, they buy out the company, that's the entry. They hold the company, they improve it, and then they sell it at exit. So the three ways that a sponsor can actually make money on this deal.

R anyone wanna tell me while I get my, my numerical bullet points lined up? What are the three ways that a sponsor can make money increase or, or can drive a, a profit over what they invested versus what they get out? Jack comes in with dividends. That's certainly kind of the harder one. So Shelby has said increased co increased revenue, decreased costs, appreciation. So appreciation of value. Natasha's thrown definitely seen some deals, I think before, maybe study this, perhaps multiple expansion, and I'll explain that term. Operational improvement, dividend recap, and the name is cut off here, but Umay can't see the full name. It's IPO or sale to another company. Good. So that's an exit, that's an exit strategy for sure. And the question of course is can you get enough outta that strategy to actually make a profit? So that is in fact a negative. Let's talk about some of these. So clearly some, some folks have seen some of these upfront. So the first thing we talk about here is, and I'll use the term Natasha is thrown out, which is called multiple expansion. So multiple expansion is what we saw in my example on the house. So multiple expansion means that you buy a company at one multiple of ebitda, and that's how these deals are done as multiples of ebitda EV to ebitda. So we purchase at one level, one level of EV to ebitda. That's the multiple I, and then sell at a higher level.

So I buy a company at 10 times, I sell it at 12 times.

So in the case of the house, what did the homeowner do to actually benefit from to, to drive that profit, to benefit from them? Nothing. The homeowner didn't do anything, just sat back, took care of the house probably, but that's just kind of regular maintenance, didn't do anything.

The area got hot, then multiples expanded, and then boom, they actually benefited from that. Okay? The next thing that they can do is pointed out, I'm just using Natasha's clips snippet here because it's, it's pretty succinct. Operational improvement, and a few people other, some other, somebody else said, you know, drive revenues, drive, drive up revenues, drive up profits. Now let's think about that for a minute.

Increase profits improvements, right? Let's think about that for a minute. So you buy a company and you buy a company at, let's just say it's got a hundred million of ebitda. You buy a company at it's got a hundred million of ebitda and it's a 10 x multiple. So the EV is a thousand.

EV is a thousand. So let's say in five years, this is my multiple, let's say in five years, nothing has changed in the market. There's no, there's no more appetite for these assets. The, the multiple has stayed the same.

So we still have a 10 x multiple, but put year zero here.

But we've been able to, through operating efficiencies in five years, grow EBITDA to get to 150.

Now, what's my ev it's 1500.

So in the first example, or the first bullet point, we were relying on the market to effectively deliver our profit.

Now, that's adding an entire nother level of risk to this type of transaction. We've already, we've already put a lot of stress on this company by taking out a significant amount of debt, forcing it to pay very high levels of interest. That that really does parallel. It can't paralyze a company, right? When you have a fixed income charge, every quarter, or every semi-annual period, or every annual period, whatever the, however the loan is structured or the payments are structured, you're forcing a company to take a significant number of dollars away from running its business and put it into financing, and that can sink a company. So that's a significant amount of risk. High leverage is high risk.

So that's the inherent risk in all of these transactions. Now, if you tell me that you've pegged your return entirely to the market going up, meaning, you know, I don't know if I can afford this house, but in five years it's gonna be worth a ton and I'll get out of it and pay off my debt, no problem.

Well, okay, but what happens if it doesn't go up? What happens if the market stalls and we're at the same 10 times multiple? Well, in this situation, because the multiple is driven by the earnings EV to ebitda, if we drive the earnings up, we drive the value up.

And that's why this particular strategy is, is very important to understand, drive up the earnings, we drive value kind of on our own terms, that's under our control. Now, you can't just pull profits out of a hat, but at least it's something that with the right management team and the right focus you can achieve, the market achievement is up to the market. We just don't know. So that handles essentially the first kind of, two points. Now, the third point we saw some people talking about, including Natasha and I think Max and maybe maybe Shelby as well, some other folks we're talking about, about a dividend recap. Okay? So dividend recap is a kind of a fancy way of saying to refinance the debt and kind of pull out the profits. Now, that's a bit of an advanced strategy. And, one that for a long time was very much looked down upon. It's gotten very, very popular again. But effectively what's behind that is the concept of paying down the debt. Paying down the debt. So if we were to go back to this, example here that I talked about in the first scenario where we bought a building for a million had 800 and 200, and what I said was that it was a bullet loan and we weren't gonna pay anything down. Well, let's say for example that that wasn't our approach.

Let's say that our approach was like a lot of people do, is they say, look, I've got a, I've got a significant loan on this property. I'm gonna put all of my excess cash flow into paying down this loan so that when I, it comes time to sell it, I own more of the asset.

So let's just assume that over these five years, this owner decided to put every single nickel of excess cashflow into paying down the debt. And so at the end of five years, the asset had not appreciated, but the loan had depreciated through repayment, and as a result, they were actually able to grow the equity value by four times.

Now, in this situation, how much did the asset, how much did the EV appreciate? Zero x, right? Zero x.

But the equity appreciated by four times because all of that cash flow went to paying down debt.

Now, this is actually the old fashioned way of doing an LBO in the early days of LBO, which goes back to the, to the eighties, really. I think they might've even really kind of started in the late seventies, but, there was a significant innovation in the eighties that really kind of jumpstarted this process.

But that's the way it was done. You basically levered up a company and then paid down the debt over time, just the way you do with a real estate property. And then you sell the company at the end of five years. And in those days, we're talking again, a long time ago you did not see the kinds of increases in asset values that we've seen in the last 20 years.

So the chance that you could buy low and sell high with a company in the early eighties was not, there wasn't a great chance of that. You probably were not gonna get a lot more than you paid for it in terms of multiple. So we've been in a period of significant multiple expansion where a lot of people have gotten kind of very rich off of the fact that multiples that were, you know, 6, 8, 9, 10 times climbed up to 12, 11, 13 times. And so all you had to do was sit back on cruise control and you were gonna make money.

And that those days are kind of over, they've been over for a little while now. So, this way of doing it is not, is not so popular. You kind of have to think about what is the best way to use the company's capital, the company's, cashflow and generate returns.

So I wanna do a little exercise just to kind of break down these numbers in a little more concrete way in a spreadsheet, just so we can see sort of how this really plays out. And then we can actually start to understand why a sponsor has a particular strategy. And then I will come back and talk about this dividend recap again, since it seems to be on people's minds. But before I do, there's some very basic math of LBO and the dividend recap actually follows slightly different math. And that's why I wanted to kind of push that aside for the moment. But there's kind of two ways that we, we measure re returns in an LBO. Does anyone know what they are? What the two measures of return in an LBO are? When you talk, when you're talking you're hanging out with your private equity friends, they all got their vests on because you got, you gotta have a vest if you work in private equity, and you, you're hanging around, okay, excellent. So we've got money on money, cash on, right? Money, multiple, multiple of invested capital. That's all. Those are all correct terms. And IRR, so we've got MOM, which is the money multiple. Sometimes it's called cash on cash, sometimes it's called multiple of invested capital. Those are all, those are all correct terms, money on money.

And I did the money on money calc, right? In my real estate problem, what did I put in? And then what did I get out the multiple of those two things. So the multiple of what I, multiple of what I got out of the deal versus what I put in what was delivered and versus invested.

So, hopefully this is a nice high number, right? I won't get into kind of what makes a deal or what doesn't make a deal. It really depends on a lot of factors, but obviously anything greater than one is kind of required, right? In many cases it's probably much higher than that. In the real estate problem we put in, we put in 200,000, and then we got back, I think in that first example, like 4.2 million or something that's major, home run that you probably haven't seen the likes of very often. But that's a money multiple, right? Put in a million, we got back 5 million. There's a five x multiple right? Now, what does the money multiple not factor in? What does cash on cash or moic, what does that not factor in? That's very important for anybody. Yes, time. Anybody in finance that gives you a number without the concept of the time value of money is giving you kind of a very crude back of the envelope answer. Now, I don't really know why money, money, the money multiple became, I think it's just really easy to, you know, it's just really easy to do. UBut it seems kind of silly to me that such there's still a lot of emphasis placed on the money multiple, when in fact, who knows how long that money was out there for. So, you know, if somebody's bragging at the pub about, you know, a five x money multiple, and it turns out they've, they've had the assets since 1997, you know, that's not probably a great return. So what we need to do is we need a return that actually incorporates the time value of money, and that's gonna be the IRR and that's the internal rate of return.

And what the internal rate of return is going to do is it's going to measure the annualized return on the investment from the initial investing period, which is time zero measures the average annualized return from investment to sale.

And what that does is it shows you that for longer hold periods, that average return is gonna go down. And for shorter hold periods, obviously the returns are gonna be, you know, all things equal, much higher. So this is the one that ultimately is probably gonna get more, more of a look when it comes time to making an investment decision. So we need to understand these two. Now, the simple way to do this is what we're basically doing is we're solving for the yield, so to speak, or the, or the rate depending on the terminology you use. So, you know, if we think about our, our our present value formula, the, the one that I was stumbling over last week, um, we said that the present value is equal to the future value over one plus the rate raised to the number of periods, right? So here we're basically kind of solving for that r and usually it's a lowercase r actually, we're trying to solve for that r and what we're doing is we're, we we're saying, okay, I have a present value, that's what I invested, and I have a future value and I know what my hold period is because I, that's when I sold the company, that's my exit year. So what is that annualized return that got me from the present value to the future value? So that formula is just if you kinda rework it, algebraically the future value over the present value raised to the one over the number of periods.

And what that tells us is in percentage forms, how, how much did that investment grow? So if I had a 15% return and I invested a hundred, it means that number would would show as one 15. So one 15 future value over 100, that's a 115% growth, right? So what we have to do in this formula just to strip out the return of the original capital, is we have to back out the 100 or back out the 100%. So I'm gonna subtract one here, and that's all that does, is it just backs out the return of the original capital. So, you know, when someone says, you know, what's the return? You say 7%. Well they, that means they, obviously that's seven on top of what they invested. So that's the very basic internal rate of return formula. Now, um, that's kind of what we need. These two numbers are what we need to kind of do sort of the first problem. And let's do the first problem, and then I'm gonna come back to this and we'll talk, again about that dividend stuff in a moment. But let's just make sure we can kind of get this into our, into our registries and, and make sure we understand it. So, workout one has kind of a series of different cases where we can examine what went on in this, in these deals and help us break down how the private equity firm got their money back and how they generated their return or how they lost money perhaps.

So the entry case, and again, I'm gonna, I'm gonna complain about formatting here, but the entry case is kind of, you know, the basis of all of these and then the exits, how we got out of the deal are gonna show different strategies. Now, what I'd like to do here is I'd like to also add moving those over. Uh, I'd like to also add here underneath IRR, that that multiple of invested capital, just, just because you know, it is, it is part of the lingo, you know, here that we kind of need to be in control of. So I'm gonna insert a row al ir, shift control plus, uh, sh there's all kinds of different ways to do it. Um, um, and I'm gonna do multiple of invested capital. That's kind of the new more professional term. You don't hear as much of the more lingo e money multiple or cash on cash used, at least I, you know, I don't, but depends on the shop, I guess. So we're gonna calculate that as well. So what's happening here is we bought a company for an EV to EBITDA multiple, and that's what that means. An enterprise value multiple of seven x.

And in buying a company for seven x, that means that the enterprise value, the value of the company that we bought is seven times the LTM ebitda. And we're not specifying LTM EBITDA here, but just as an aside, 'cause I, you know, I can't cover everything in two hours, but generally levered analysis is a trailing multiple business, right? Strategic kind of traditional m and a is a forward multiple business. This is a trailing, now the debt amount that we were allowed here is one point, 5 million or 1500 or whatever this comes out to. And once you denominate it, but, again I'm a little bit partial to doing this a different way because I come from the lev fin world. You know, you, you typically build this number up by using a debt multiple, a leverage multiple. And that leverage multiple is works the same way as the ev the EV EBITDA multiple only. It's just measuring the debt component. It's not measuring the EV component, it's measuring the debt component. So here, if we were to back into that leverage multiple, it would be the 1500 divided by the ebitda, and that would tell us that the financing markets would allow us five times debt to ebitda. And that's the critical number. Quite honestly. That's really the number that's gonna make this deal either work or, or not work. So, we'll, we won't get to spend a lot of time on that, but I'll, I'll, I will probably try to break that number down a little bit more for us by the end so we can understand what that is. Now, the ev if we do the EV of 300 times, the seven at 2100 tells us what the entire asset is worth.

The 1500 is how we're gonna finance it with debt. And what that means is that what's left is required to be put in by the equity sponsor. This is sometimes called the equity check. Now we're buying a company enterprise value.

Does it matter? Therefore, what if the company's already got a ton of debt? What if we're buying a company that was lbo OED a couple of years ago and it's already got a ton of debt, what do we do? Does that, does that impede our transaction in any way? Does that mean we can only put a tiny bit more on what if we're buying a company that had four times debt to EBITDA when we bought it, does that mean that we can only put on a tiny bit more? What happens if we try to buy a company that's super levered, Shelby says, does not matter, we will refinance it all based on the potential cash flows.

Correct? So effectively what I'm saying here is that, again, you know, I did this I think at one of the earlier sessions, but somebody wants to buy my house, somebody wants to buy my neighbor Tim and Heather's house.

We have the same house on the same plot of land built in the same year, equally renovated.

That is called the ev, that's Chris's house. It's Chris and Elizabeth's house. This is Heather and Tim's house. Heather and Tim bought their house like 20 years ago, their kids in college, and they've paid down a significant amount of debt.

So their stakeholders in that, in that asset probably look something, you know, like that. Whereas we bought ours just a few years ago. So ours looks something like this.

Now you wanna buy this house, all you know is that you're gonna pay market value for the house, you're gonna pay the EV for the house. You are then gonna turn around and you are going to refinance this side however you want. Now, based on what we've talked about, it probably makes more sense to come in and refinance it more like I've got it done right now because I'm, you know, I'm, I'm newer in, you know, I'm, I'm new into the transaction, so I've got a levered, very levered house. But the ev what you pay for the house is just how the profits get split among the previous owners. You're the new owner, you're gonna size up the cash flows as, as Shelby said, and you're gonna figure out how you can leverage this house that's best for your strategy. So the EV is what matters here, and that's why we're using an EV multiple. We don't really care. And it doesn't matter if there was already a ton of debt. Now the house itself can only handle so much debt. And that's because as is pointed out again, correctly by Shelby, it's gonna depend on that ebitda, the ebitda, you know, that's gonna be what the banks decide is a reasonable amount to lend on. So this is what's happening here in this transaction. The equity piece is the 600, what was on the books before we're not dealing with here, but it doesn't matter anyway. It just doesn't matter. So there's nothing else to be done in this entry year because the rest of it involves how we get out of the deal. So let's look at exit case one. In exit case one, what happens? Well, remember we have those three rules those three strategies, right? We've got the multiple expansion, increased profits, paid down debt.

So what's happening here in exit case one, we are not paying down debt.

We do not have multiple expansion because the exit multiple, and this here is showing entry and exit in the same row.

The exit multiple of seven x is the same as the entry multiple. Okay? So the market didn't get hot for us, but how did we go to work? Well, we, we drove up ebitda, the EBITDA efficiencies. So when it comes time to sell this company, it doesn't matter that the multiple didn't go up, there was no multiple expansion because we've increased value by driving up ebitda. And we also chose not to pay down debt. We chose to put all that money into driving efficiency and that, and that is effectively what a lot of the strategy has kind of moved toward, which is to hold onto that cash and put it toward efficiency. And we'll see why as these cases kind of run out.

So gonna sell this company, we're in a three year hold, which is kind of tight for an LBO right now. It's obviously unheard of because because the exits are just harder to, harder to come by right now. But the, the debt to EBITDA multiple kind of going forward, I don't care about this. Nobody and nobody cares about this. So let's just kind of gray this out. I'm not gonna spend any time doing it. We only care about the entry debt to EBITDA unless we're gonna do a refi, but we're not here. So, the debts EBITDA we don't care about going forward. But what is the equity value at this point? Well, the equity value is the EV minus the debt that's still outstanding and that is gonna bring us an equity value of eight 80.

Now that right there is our profit in this first case put in 600, got back eight 80. So let's do the math of what this equates to in terms of a return. So I'm gonna go ahead and I'm gonna take my future value of eight 80, put it over the present value of 600. I'm gonna raise that to one over the number of years, which is three.

And just to show you again how the math works, what that's gonna do is, again, it's not formatted, that's gonna give you 114% and that includes the original capital. So if I just back out the one that tells you that you made 14% on the deal hardly, hardly kind of a hall of fame deal here, right? This is kind of thin and we can talk a little bit about, about what our expected returns are momentarily. But for right now, that's, um, that's what that is. So lemme just make sure I didn't I heard a Microsoft chime, like something popped out of my, outta one of my ports, but sound looks okay. Okay, now let's just, for the sake of doing this, calculate the multiple of money. It's gonna be the eight 80 over the 600, and that's gonna give me 1.5 times. I've got some glare on my screen I gotta kill here. Alt hj. If you hit Alt hj, that brings you into our style formats. Now you can put, put that fancy multiple there.

So we can see that we got one and a half times now how much value was created? That is the eight 80 minus the 600. And that means we created 280 of value. So now what I wanna do is I just wanna break down how this value was created and that'll just kind of help me tie it up in a bow at the end. Well, in terms of the debt that was, um, paid down, the value created here is zero because the debt was not repaid at all. So when you repay back, when you repay debt, you're basically taking a dollar from the bank and putting it into the equity holder's hand, right? Just like when I pay my my mortgage down, I'm, I'm basically just putting that value from, from one stakeholder, the bank to another me. And that's why people tell you we gotta buy something, don't pay rent. Because you pay rent, you just pay the property owner when, when you pay, when you pay your mortgage, you pay yourself, right? That's what that means. So here we didn't pay ourself, we got zero out of it. How much EBITDA improvement did EBITDA improvement contribute to the value here? Well, in this case, the EBITDA contributed everything. But let's show this mathematically. So effectively what we're gonna do here is we're gonna calculate the growth in EBITDA and the growth in, in ebitda. Is the, the 40 that we improved, right? The 40 that we improved upon. So that's how we improved this business. Now how do we value that? Well, what did we pay for ebitda? What did we pay for it on entry? We paid seven times for it. So any improvement that we make on EBITDA gets valued at what we paid for it, not what the next buyer paid for it, that's the exit multiple, but what we paid for it. So I'm gonna take the three 40 minus actually do it this way, the three 40 minus the 300, I'm putting in some formula locks here just so that I can copy this over.

And then I'm gonna multiply that by the entry multiple of seven x and that shows us that all of that two 80 came from the multiple expansion, I'm sorry, came from the EBITDA improvement as far as the multiple expansion goes. Well, we didn't expand at all. So we don't have anything to put in here. Now I'm gonna, I'm gonna hold off on building that formula until case two so that we can actually check the number a little bit better. We can, we can go back and fill in the formula here. It's obvious that we didn't create any value for multiple expansion. We don't have any value left to create. Um, and it's plain to see that the multiple didn't expand. So I'm gonna put this formula in in the next period just so we can see it and understand it a little bit better without a zero in there. Okay? So any questions on what I did there or how that works? Okay, so let's go ahead and just fill in some values here for case two. My ev um, is now if in this situation EBITDA stayed flat, there was no improvement but I did benefit from the multiple going up.

So I guess it's kind of debatable whether somebody would pay you more for a business that had flat EBITDA for three years, but there's always a sponsor coming along who thinks they can do it better, right? That they can get more efficiencies out of it. I just saw there's a west coast based, financial sponsor called Griffon. They're very smart, smart shop. They just sold an asset, a company that they've had for several years to KKR. So that's basically KKR saying, okay, Griffon, bunch of smart people. You ran this company for several years, you made it better, we're gonna pay you for that. But you know what, we think we can do it even better. So we're, we are now gonna take over. So sponsors, selling to other sponsors happens all the time. And that probably, you know, implies that there's still more, more growth or EBITDA improvement to come. So that's not uncommon. So my EV here is gonna go up now we're just, we're ignoring case one. Now we're just looking at case two to the entry. My ebitda actually stayed flat, but my value still went up my ev by 300.

So that's, that's kind of interesting, right? Actually more value than even was generated in case one.

Now let's fill out the rest of this. What's my equity value? Well, the equity value is the debt the enterprise value paying down the debt. Now what else did we do here? Well, it looks like rather than put the money into the company, we paid down debt with it. So we took cashflow, we didn't build out infrastructure and you know, whatever, we just paid down debt with it, kind of the old fashioned way. And the result of that is that we had to pay, less debt off at the end and then more transfer to the equity holders. Okay? So let's go ahead and build the formula here for this. So I didn't lock my cells here, but I think I can the exit year that can move across the future value is gonna move. That's in D13, but the C13 is gonna get anchored. So I'm gonna lock that one and if I copy that over, that should work and it looks like it does. And that gives me a 26% return. And now same thing with the multiple of capital. If I take my C13 and lock it, I can now copy this over and that's showing a money multiple of two x. And then as far as the value created, again, I can lock that C13 copy across and that gives me value created of 600. In this example, let's break it down. What is my debt repayment? My debt repayment. If I take the initial value of 1500, subtract the 12, I get 300 of value created just by paying down debt, just by paying down debt.

The EBITDA improvement in this case, there was no EBITDA improvement. So I assume we just had a question come in and say, can you explain EBITDA improvement a bit further and what that means? So again, we buy a company that's running at a certain rate of ebitda. Let's say it has a 15% EBITDA margin. So that 100 of ebitda, or I'll use the EBITDA in this example, 300, maybe that, let's just use 10% because it's an easier number. That means they had, you know, 3000 of sales and generated 300 of ebitda. Well, we take this company over and in case one, we drive up that 10% margin to be a little bit higher, we drive it up to whatever, three 40 over sales would be. Maybe we drive it up to 12%.

So now this company is running much more efficiently.

And if you're valuing a company on ebitda, EBITDA is the driver. So you're driving value by driving up ebitda.

And that's, that's, you know, what a lot of these deals are predicated on. So in this example, we didn't drive up ebitda. So if I take this 300 of existing ebitda, which means, not only did the margin stay flat, but it, it might've even gone down because sales might've gone up too, right? We don't have sales here. This isn't a very complicated model, but we're basically saying that EBITDA itself is at a certain level and it stayed the same.

So if we're valuing based on EBITDA and the multiple has also not changed, then you're in big trouble, right? You're in big trouble in this case, however, guess what, the multiple did actually change.

So we did not grow ebitda, but the market is paying more for EBITDA these days.

So what that means is that I can still take that EBITDA, exit EBITDA and create some value with it. But the way I create it is with the, the difference in the exit multiple versus the entry multiple. So that eight, do it in parentheses, that eight minus the seven, and I'll anchor the C9 times the entire ebitda because what I'm showing here is the increase in multiple, in other words, what the next buyer is paying for EBITDA times the entire ebitda. So I'm not double counting Because I'm just, I'm taking that increase in multiple only, and that's showing an additional 300 of value.

So again, if I add these three things up, three contributing factors up, I get to the total value created of 600. And that's exactly what we created in the deal. So I can copy this backwards now and it should work and show me a zero value, right? That I had zero multiple expansion times three 40 of ebitda. EBITDA went up great, but there was no multiple expansion. So I don't get any credit for the, the multiple expansion here 'cause it's zero multiplying by zero zero. So now we can sort of see, you know, in a better way how, how the value is starting to shape up. Now, I'll just quickly go through these last, because I don't wanna, I don't want to beat a dead, uh, horse with the, with the formulas. But in case three, we have EBITDA growing and we have debt being repaid.

Um, so the enterprise value looks the same as it does in a case one because we have the same EBITDA and the same exit. The exit multiple does not change though. So this is gonna be debt. This is debt and EBITDA in case three, right? Let's see what happens here. The equity value that's left over is higher than case one, because in addition to the EBITDA improvement, we've also got some debt repayment. So that means that this company must have been thrown off some pretty, pretty serious cash, or the co the buyers knew exactly what had to be done here to, to drive improvement in ebitda.

So if I go ahead and calculate my IRR for this situation, we see a massive, kind of much more, you know, home run looking IRR of 32%.

And the money multiple is also higher. 2.3 x and the value created is at, 780. I'm just gonna sh now that I've got these formulas kind of locked in with the correct, um, I'll show these off to the right.

Okay, now we'll come over and look at our pave contribution factors. I'm just gonna copy over. So again, just to save some time here. And we'll talk about them again. What we see here is, what's starting to shape up to me is you can, you can kind of put a, put a number on the, on the, the way the value is created. If I look at the debt repayment again, how much did my debt go down? My debt went down by 500 and that created 500 of value.

So debt repayment is, is valued at one one x factor, right? One time factor. Every dollar of debt that gets repaid translates into $1 of equity. That's nice. But when you look at EBITDA improvement, EBITDA improvement, for every dollar that EBITDA goes up over your starting point, your value goes up by a factor of seven or your entry multiple. Because that's, again, what you paid for it. So, if you're able to drive ebitda, if excessively up, even if you paid a lot on the entry, multiple 10, 11, 12 times, if you can drive up ebitda, you're increasing by that factor. So if I pay 12 x for a company, every dollar of EBITDA improve is going up by 12. So think about that. You're a sponsor, you're putting a tremendous amount of capital at stake. You've got investors, yourself, your LPs that have contributed to your fund, your limited partners, and you're, you're being tasked with finding deals that are gonna generate return.

You've got two choices.

You can either pay down debt and basically improve your return by a factor of one x dollar of debt, dollar of equity, $2 of debt, $2 of equity. Or you could put all of your emphasis on driving up ebitda, putting, putting internally generated cash flow into efficiencies, better systems, hiring better employees, building out distribution networks, hiring r and d teams, and getting EBITDA up.

So that's valued in this case at the entry, multiple seven times, eight times, nine times, whatever you paid for it.

Where are you gonna put your money in at the one times factor or the 7, 8, 9, 10 times factor? If you're gonna put it in, put the emphasis on the higher multiple factor. Now you might say, well, in this case it looks like EBITDA improvement really kind of generates the lowest amount of value, right? Well, that's just the way these numbers are. And I probably would've drawn this up, this problem up a little bit differently myself. 'cause I, you know, having worked in this area, you know, I saw a lot of different extreme examples. But, um, the reality is, is that particularly in a low interest environment, which is what we just came out of, why would you pay back debt? Why would you take cashflow and put it toward paying down debt? That's at 4 or 5%. It's like, kind of very low right now we're in a different interest rate environment. So the whole math of this changes met drastically. But the heyday, these last, you know, 10, 15 years, even going back before the GFC of 2008, you've got very low interest debt. Why pay that down? You know, it's tax deductible. Interest is tax deductible. It's at a very low cost. There's a low fixed charge to the company.

Why not take that cashflow and put it into the business and drive up ebitda? So question is, why is EBITDA improvement based on the entry multiple, if the equity holder are paid out in the exit? Now, it's still a good question. I mean, I understand it's a little bit, it's a little bit kind of, I think it can be a little bit confusing as to why am I, why am I valuing EBITDA in terms of value contributed to the deal at exit, at the entry multiple, right? That's kind of the confusion.

Well, let me, let me just explain it. I think in a little, in an even more kind of basic way, just, just from a math, pure mathematical perspective.

If I take the improvement in ebitda, which in this case is the three 40 over the 300, right? If I take that and I apply to it, the exit multiple, if the exit multiple changes, I'm confusing the value creation.

In other words, I'm taking my growth in EBITDA and I'm applying it, I'm applying to it in multiple that has expanded. So I muddied the waters. I can't, I now cannot tell where the value was created.

The exit multiple expansion is a separate factor. So I don't want to multiply my EBITDA improvement by the exit EBITDA because that's going to change the math. I wanna stay consistent. I wanna isolate the value at which EBITDA has contributed to this deal, and therefore I have to use the entry multiple. Because that didn't change. So in this case, I could do it wrong and I'd still be right 'cause the multiple didn't change. But what I'm saying here is, let's just say that this one went up to eight times, well, that eight times that I just changed this multiply, that's that I want that value to show up in the multiple expansion value. I don't want that to show up in my EBITDA improvement. Because the EBITDA improvement is priced at what I paid for it.

So if I had done the 40 times, the eight I, the math would be wrong, right? It would, it would show me a value creation higher than the actual value creation.

Does that hope that's clear? Does that, does that help? Does awesome. Okay, so let's just do the last one. Last one is the buzz kill, right? Uh, and this is kind of what's going on, you know, sort of now in a sense, uh, the exits aren't there. And, in this case, we're showing that a company got out regardless at a lower multiple, that despite their great efforts to drive up EBITDA and create 280 of value, the exit multiple, contraction killed the deal. So you might be saying, well, you know, it's obvious that the exit multiple, um, because you're multiplying by the entire chunk of ebitda, that's really where the, where the, you know, where the heat is, where the gas is in the deal. That's really, so why don't we focus more on the multiple at the exit? Because if you can just drive that multiple up, you got a home run and you know, that's the problem. We can't drive the multiple up. Now, you, you could say, well if we just create a killer business, would that not fetch a higher multiple? I guess in a way it could. The reality is, is that the way these markets kind of shape up is that first of all, you, you pay higher multiples for larger companies.

So the best way, if you want to grow a company, growing a company, both through EBITDA improvement and through acquisition to get to a larger sized company, that's really kind of the strategy that a lot of these firms have undertaken in the last 10 years, is to really grow the initial investment. Because you cannot tell the market to, to, to raise the multiple, Hey, we're ready to get out. How about, you know, 10 times instead of eight times, you, there's nothing you can do. But there, there is a factor at play, which is that larger companies are more secure because they're more established, they can't get knocked around in the wind. And so those companies fetch higher multiples by nature.

Just like larger companies by nature have more stable credit ratings can be rated, you know, more highly than a similar company that's smaller, right? It's the same concept, less kind of market volatility.

So other than that, there's nothing you can do to change the exit multiple. So if you're trying to raise an investment fund, I'm just gonna reach for my cup of water, which is way down there. I make a, I always make a joke when I teach on Friday. I always say that I'm, that I'm going snorkeling after class. And that usually, you know, it's a joke about like, you know, a martini glass and me going in, I was not snorkeling down there. This is just water, I promise. If you think about, the strategy here of, of, of where they're gonna put their their emphasis, you can't control the exit. You've gotta go for the EBITDA improvement. And, you know, that's, you know, effectively what, you know, what this problem, you know, here is, is showing that there's really, there's, there's really, um, only a co a couple of ways that you can control what's going on in these deals. And, um, you know, that's effectively you know what this is all about. Now, are there any questions on this? I wanna, I wanna do like maybe another problem and talk about some of the, I wanna get back to the dividend recap as well.

Any questions on that? Let's see if there's another point I wanted to make there. I don't think there is. So one, one of the other things that came up was this, this other way of making money, and that's the dividend recap. And the reason why I'm leaving that out of it is, I left it out of it is primarily because, it actually changes some of this math a little bit because effectively what happens in a dividend recap, which is the, maybe call it the fourth way to make money, is you are think about the timeline of investing.

This is time zero and this is entry, and then this is exit.

So if we enter the deal at EV of 10 x and EBITDA of 100 and debt to ebitda, maybe I'll just, you know what, I'm gonna do this in a, in my spreadsheet just so that I can do it more quickly, more neatly and not make a mistake on the math, okay? This is always the time and the, when my, so we've got year 0, 1, 2, 3, 4, 5, and my terms are effectively, you know, I've got an EV to EBITDA multiple instead of, um, 10 x and I've got debt to EBITDA of And I still wanna break these numbers down for you a little bit, and I've got EBITDA of a hundred.

So just like we did in the last problem, if I it means that my, my entry investment, let's just, let's do it here. How much what's my total ev what's my debt? And then what's my equity investment total? EV is the enterprise value times the ebitda, the debt is therefore the debt cap, how much debt I can layer onto this times the ebitda, and then my equity is the difference. Now, you might be saying, well, that's a lot, right? That's a lot of equity. Well, this is kind of the problem, which I'll talk about next, which is the need for equity investors to put more and more money into these deals. So my equity investment at time zero is now 500.

And now let's just say that my EBITDA grows by 10% each year.

So I'm just going to go ahead and calculate that across. And I'm gonna say that the EV to EBITDA is constant. Now, most, if anybody's ever worked on these, one of these deals or worked for a private equity company or worked in financial sponsors, one of the first principles of kind of modeling out these kind of deals is that you, you generally don't ever assume that there's going to be multiple expansion because it's beyond your control. You cannot justify that in a model or to an investment committee. When you have to pitch this, you have to pitch to very senior people how you're going to use the firm's capital.

And you're gonna say, and we're gonna sell this thing for 13 x. And they're gonna say, well, how do you get that? Well, it made the returns really great, so we just used 13 x. And, you know, it's like, well, yeah, but we just paid 10. How, how are we gonna get to 13? Right? You cannot, there's no way on earth you can justify that, unless maybe you could do the size thing and say, well, we're gonna layer on this or this but that's still a lot. So, now I'm also gonna keep the debt multiple the same.

Now, as I said in the last problem, I said, remember I said we're gonna, we're not gonna, we're not gonna worry about the debt multiple here, because in these, this deal, this type of deal, these three deals, four deals, we didn't really need it.

But in this deal, it is important. And the reason why is again, I'm gonna go back to the house situation. So I've been in my house, let's say 10 years, and let's just say, in the 10 years, maybe, maybe interest rates have gone down or or maybe are at least lower than when I took out my, now I, I have a ridiculously low interest rate. I have one of what they, they call these prison rates because I got funded right before kind of everything started going up. So mine's so low that essentially it means I can never sell my house because I'll never get another rate as good as everything would be gonna be more expensive just on paper, right? I mean, fortunately I like my house, but in any event 10 years, let's just say rates are low sunk costs. Yeah, exactly. What I could do is I could actually say, okay, well the value of my house has gone up based on everything I've seen in the market.

So my EV has gone up. So if I go back to the bank and I just say, look, just give me the same loan that I had based on the same cashflow or whatever, you're giving me the same loan, but with an EV that's like super high, that means that the equity value has in fact gone way up, right? So what's gonna happen here is if I, let's say in year three, I go back to the bank and I say, look, I wanna redo this. I wanna do over, will you still give me five x? And the bank's like, absolutely, we're still a five x market right now. You can have five x. Great. So I will take, five x if I could. And what that five x means is that the bank is now gonna give me, I'll do this down here. I'll do this down here. So you can see I'm gonna keep this debt constant. Let's just say we're in a bullet kind of, a bullet kind of loan situation here. So that this is gonna be 500 all the way till the end. So I go back to the bank and I'll do, put this in the refi line and I'll say, give me five times my ebitda. My EBITDA has now gone up by 33%. So the bank is gonna give me 665.5, and I'm gonna pay off a loan that was worth 500.

And that means that that 1 65 0.5 of the debt gap is now effectively equity that I can pull out of the company. So I can take the 6 65 and subtract the 500 and kind of take that out of the company, take that profit out. Now what that means is that when I, when I actually, this loan now changes because I now no longer have a 500 loan on the books, I've actually now got a 665 loan on the books. So when it comes time to sell the company in year five, I now have to pay back a little bit more than I did when I took out the 500, right? So my equity kind of gets stuffed under that 665, but my EBITDA's also kind of gone up here.

So let's say I sell this company at the end of year five. What does that look like? Will my EV is now gonna be what? It's gonna be the 10 x times, the 161.1.

So now the EV is 1610.5. Now I've gotta pay back my new loan that I refied two years ago, and that's 665.5. So now my equity value is 9 45 profit.

So if I were to take this and kind of put this on a, um, you know, kind of in a timeline above the 500 investment, that's negative because that's the 500 I put into the company. And then if I go to year three, I now get an additional cashflow of 165, and then I get the final cashflow of 945.

Now, the way that the IRR formula works in our math, we, we actually can't do this problem because we, we assume a starting point and an ending point. But now I can actually use the internal rate of return formula in Excel to calculate this. Now, the first thing I'm gonna do, just for comparisons purposes, is I'm gonna pretend, the first thing I guess I'll pretend is that, we do this deal without the refi. So let me just add a few rows here and we'll do same thing. Here's 1, 2, 3, 4, 5.

Now it's my model that's lacking decent formatting, but I'm doing it on the fly here. So, and same thing, this is the refi deal or recap, and then this is the normal LBO with no, with recap. So in the normal LBO, what would've happened here is I would've kept the 500 of debt. I wouldn't have 665 here, but I would have 1610 of profit. That wouldn't have changed. So what I'll do here is I'll just kind of fudge the math and I'll do, here's my 1610 of EV minus the original 500 of debt. Just kind of bear with me. It's not pretty. But, uh, it'll get us there.

So that shows me, 1110.5 of profit.

Um, in the recap scenario, as we discussed, my profit gets shrunk a little bit in year five because I have more debt to pay back. I did that refi, that increased the loan, but that enabled me to take out 1 65 in year three.

So from a time value of money perspective, what's happening here? Well, I'm getting money, dividends, cash, however you wanna look at it sooner, and that's actually gonna have a big impact on the return. So if I come up here and for Excel to work, I need to actually have some values in any year that I don't have, a cashflow.

If I were to calculate the return for both of these situations, the returns are gonna be very different. So let's come up here and do the IRR for the normal LBO. So I'm gonna do equals IRR, and then I'm gonna start with my present value, so to speak, go to my future value in Excel, knows how to count these periods. Now you can use XIRR too, but you have to have dates for XIRR, right? So here I'm gonna do just normal IRR, and that's showing a nice kind of, you know, 17%. This would be a very acceptable return in today's market.

Not great, but not borderline acceptable. So now I'm gonna come in, I'm gonna do the same calculation. I'll just put that formula over here.

I don't know what happened there. I'll put this formula out over here.

Mm-Hmm, tab thank you. And I'll put that formula down here for the refi. So the same thing, but what's happening here is it's picking up in addition to the 945 profit, at the end, it's picking up a dividend repayment. And the dividend immediately goes into the, you know, into the investor's hands, not in a fund. It will work a little bit differently, but, but in theory it, it goes back, to the investors right away. And therefore the sooner you get capital in an LBO, the better. So overall, what are the principles, right? Get out as soon as you can in an LBO, longer hold periods, make the return smaller and return the cash as quickly as possible. So in this case, that dividend, and that's what it's called, the dividend repayment. Now it's called the a dividend recap because we recapitalize the company. We just redid the balance sheet in year three, and that enabled us to boost the returns by a couple hundred basis points.

And that's effectively a big deal, you know, in, in certain situations, and you might, you might do it when there's a little bit maybe more on the table to take, but still if for example, for example if exit multiples were really creeping up and you knew that, you know, you could possibly even get more then you might do the, the recap for that reason, right? So in any event that's kind of brings all of the LBO value drivers kind of into play. Are there any, any questions on that? And I want to just wrap up with a couple of, couple of other things before before moving on.

Okay. Well, the last thing I guess I'll just talk about real, real quickly, and maybe it's just because, I am coming from the, from the financing side, which is really just how these deals kind of come together. So just call this the LBO capital structure, and if there's any other questions that you have that you want, you always wanted to ask about LBO, please just put them in in the chat now and I'll make sure we have time to get to them. But, basically I think you saw the math sort of coming together, right? As, as we were doing a few of these different problems. And the first thing is, is like, where do these numbers come from? Like, you know, how do you get the how do you get the multiples and the, well the asset multiples, the EV multiples are very kind of easy, I think are easier to understand because that's just what we're seeing in the market. So we now have, at this point in time, a lot of private equity firms, you know, just hundreds and hundreds of them competing for assets, and they're all looking for ways to drive return. So in, in kind of the old fashioned days, what happened was you had, you had just a few people doing this and there was still a lot of competition. I mean, just go back and read about the RJ Reynolds deal and the Barb famous barbarians at the gate deal, right? All these kind of famous LBOs, there were still intense competition, but there were just, it was just much different market. And basically what happened was the way these deals get financed primarily is through, I'll call it bank debt. Now that's even changed a little bit because there's a lot of private credit in here. But effectively what I would say is senior secured debt bank, which used to be kind of another name for bank debt, senior secured bank debt, and the bank that, lent into these gigantic banks that are now banks like Bank of America, JP Morgan, Morgan Stanley does these deals as well from the financing side. Goldman does them as well.

But primarily these kind of big commercial banks, at the time which were different names. Then they lent at the senior secured level traditional depository institutions, and they would only lend at five times maximum debt to ebitda. So the first thing the financiers did was they went to these banks and they said, how much will you give me? And the banks said, look, you know, this is a very risky deal because interest rates were much higher back then. And you know, what we're doing is we're basically looking at a company's ability to pay down debt and ebitda, which at that time was even more strongly considered a proxy for cashflow. We know better now, right? But back of the envelope, this is not everybody had a computer in their pocket, let alone on their, even on their desk at this time. You know, they just said, okay, well if I'm a company, if a company's got a hundred million of ebitda, and I assume that that company does not grow at all, very conservative, I want my loan paid back in five years. So I want this a hundred million dollars loan to amortize down to zero, right? So that's effectively where the five times debt EBITDA came from. You're basically saying that under very, very conservative situation, you can get your money back in, in five years. And that's is the, was the general expectation for all of these loans. So that was capped at five x. Now, as far as the EV to ebitda, what the financiers figured is that if they could buy a company for six to eight times debt to ebitda and they could finance it at five times debt to ebitda, that obviously meant that they were putting in the equity multiple. We don't really talk about equity multiples because they're not really used, but that means it's like one to three times. So effectively you're looking at like 20 to 30% equity capital, equity capital 20 to 30%. And so think about it, if you're putting in a pretty small amount of money, as we saw with the, the real estate stuff, and you know, you have, debt repayment, maybe a little bit of EBITDA paid, uh, improvement, it was very easy to make money in this business for a very long time. But what happened was more people started competing for the same assets.

And so now we get into the two thousands, 2010, 2015. And what happens is that debt to EBITDA has changed a tiny little bit. There's been a lot of improvements in the debt to ebitda, kind of there's been a lot of improvements in the debt capital structure. We see, we see different types of term loans that don't require amortization. We see different players coming in and, and investing in loans create more liquidity in the loan market. So this market has gone up a little bit. So if this was, you know, 1980 or 85 I should say, and this is 2000 and you know, I'll call it 15 just to pick a nice kind of fat year this has now gone up to six times. The problem is that there's so many private equity sponsors out there buying up assets that the EV to EBITDA multiple, the competition drove up the hou the housing prices, so to speak. And so now this is like, you know, 11 to 13 times.

And so what's happened, what's happened is that the equity multiple has now gone to five to seven times. And that's like, you know, anywhere from, you know, 40 to even greater than 50% is required of equity. Now, the more equity you put into these deals, obviously if we go back to that to this problem, what happens if instead of putting in 500, I have to put in 700, well, the return goes way down, right? The return goes way down. So if I put in 200 return goes way up. I mean, it's pretty simple math. So in today's market, it's just much more difficult to get these deals done because what's required is a significant amount of improvement in the course of of running this company, figuring out can I improve ebitda? Can I extract dividends from the company? How do I exit the deal? Can I still do IPOs like, I think it was somebody suggested earlier, or do you know, can I sell to other financial sponsors at high multiples? Can I sell to strategic buyers at, at high multiples? So those are kind of the exits, the exit scenarios that you're looking at. And right now a lot of these are sort of locked up, right? There just aren't a lot of there aren't a lot of possibilities for exits.

You could you could do a recap, you could sell to another sponsor, you could sell to a strategic buyer, you could do an IPO, which would be effectively selling to, you know, other buyers, but just in the public market, right? So those are kind of the ways to get out and you know, right now these are sort of, locked up.

So let me just again, pause there and see, you know, sort of what, what questions people might have on this. A lot of the reason why I only did really one of the workouts is that a lot of the, a lot of the workouts here involve kind of some, some debt modeling, which, I just don't feel is really kind of appropriate. And for what the time that we have. So I'm gonna, I'll make the problems sort of available. If there aren't any questions, I'll quickly work through workout number four because it just kind of builds on this capital structure stuff that I've talked about. But Yolanda, are you seeing anything? I don't see anything here on the q and a, so I'll just go ahead and quickly work through this, workout for this workout for, and then we'll use it as kind of a wrap up. So, you know, here we've got a private equity fund acquiring, equity of pumpkin, very seasonal business, I imagine LTM EBITDA is 1200. Total amount of net debt to be refinanced as a result of the acquisition is 35 60. So here we're gonna see what happens when you buy a company that has existing debt. The banks have agreed to provide 4.5 times ebitda, and that's just for the senior debt. And now we're gonna get some additional financing from a junior lender, and that's called mezzanine financing and they're gonna lend an additional one. So that's again, one of the innovations in lending that's happened over the years. So calculate the required equity financing to complete the transaction. So how much can the equity spon is the equity sponsor required to put in? So in terms of the equity purchase price, the equity purchase price here is the 10 thousand. Now notice we're not working here off of an EVD EBITDA multiple. We're going right into what, what does the equity, what is the equity value worth? What did, what was the previous ownership requiring to get bought out? Now it could have been a public company and they might've, might've been a public, share price that you had to pay a premium above like we did with the DCF stuff, right? So that's what they're gonna get. Now, unfortunately, not only do we have to pay out the equity holders, we also have to pay out the debt holders too. Now, in theory, the debt holders don't own anything, they're just, they just are financing. So we could roll that debt over and just keep it on the new company, but generally from a legal perspective, that's hard to do because the entity's gonna change from a legal perspective. So we're gonna have to kind of take that out. So I'm gonna take out the 35 60 here, and that's another amount that I've gotta bring to the table. So my total uses of funds is 13 560. So this is effectively the enterprise value, right? The 13 560. And in fact, I can, I can calculate my implied EV to EBITDA by taking that 13560 and multiplying it or dividing it, excuse me, by the 1200. And there is a fat 11.3 2015, 2018 style multiple.

Okay? And now what I'm gonna do is figure out how I'm going to pay for this, right? So my uses always come first, even though they call it the sources and uses it's uses and sources, really, my senior debt financing is gonna be this 4.5 times my ebitda and then the mezzanine is going to be, one times my ebitda.

And so that's all I can put on this. 5.5 x is the max and the rest is gonna have to come from the equity sponsor, and that's gonna be the 13,560 minus the two pieces of debt or two tranches of debt. And that's gonna get me to a total sources of cash that actually matches my uses of cash.

Now what would complicate this in real life is you'd have some fees on the deal, you'd have some fees sometimes on the equity raise, you'd have some fees, on the debt financing as well. So thoughts on pick interest and the impact it has on a sponsor's return, well pick interest is called paid in kind interest. This is a good question and definitely on the more advanced side. So if you're just new to LBO, what pick interest does, pay in kind is that it allows you actually to save some cash. So again, think about it, what are some things you use cash for? You use cash to pay down debt. Use cash to pay interest. Well, if you can avoid paying interest and pick interest is usually on the very risky kind of mezzanine stuff here. So if this interest rate is currently, let's say 8%, the pick interest rate is probably gonna be like 12%.

So that's a lot of interest. So you can save that cash by, accruing that amount, kind of tacking it on the bill, just like the person doesn't gonna pay their bar tab. I just put it on my tab, put it on my tab, put it on my tab, and then, you know, closing time comes at, you know, very early here in LA much later in New York. And all of a sudden you look at your bill and you're like, wow my pick grew. Essentially what you're saying is a 12% picking loan grows by 12% each year. So you're paying off, an amount that's compounding each year. It's a massive amount. So what does that do? Well, it gets you some cash up front and I guess if you are confident that you can utilize that cash, and put it to good use at a higher multiple, then that cash is more valuable. If of course you get stuck and you can't refi very cheaply. This mezzanine, this pick stuff comes out usually in years, you know, 3, 4, 5. If you can't get that, pick stuff out in years three, four, you're in big trouble. Because now you're carrying, you know, a very high burden. So pick interest, went out of favor a few years ago and now it's kind of coming back into favor again because interest rates are so high. And I guess we're just gonna have to see in terms of the analysis, how it plays out in some of these deals. I mean in general, most of these loans are not fully pick anyway. There's some cash and some pick and there's quite a bit of analysis that goes into whether or not it adds anything to the return. So I guess I'm gonna kind of ride the fence on that one a little bit.

Great question though. Anything else before we, we wrap up for the day? Great. Well I'll thank you again for joining and I'm gonna post all my stuff and all the answers and my notes and I'll see you back here next week. We're gonna jump into m and a analysis next week and if you have any questions in the meantime, again, feel free to pinging me and we'll take it from there.

Alright, everyone, thank you very much and have a good night. Thank you, Yolanda. You're welcome. No problem.