In an LBO model, which variable typically has the greatest impact on projected returns?

In an LBO model, which variable typically has the greatest impact on projected returns?

• A. Leverage (debt)
• B. Revenue growth
• C. Purchase and exit multiples
• D. EBITDA margins

Answer: (C)

In an LBO, the main driver of returns is the price at which you buy and later sell the business—the enterprise value multiples. That’s because returns are largely determined by how much equity ends up being worth at exit, and exit value is basically EBITDA at exit times the exit multiple, minus the debt you’ve paid down and any remaining net debt. Because multiplying EBITDA by the exit multiple can swing the sale price dramatically, even small changes in the multiples can produce large jumps (or drops) in equity value and thus in IRR. The purchase multiple sets how much you pay upfront; paying more up front leaves less upside to work with, so it directly limits potential upside. Put together, the combination of entry and exit multiples tends to dominate the sensitivity of projected returns, more than shifts in revenue growth or EBITDA margins, which affect cash flow but usually to a smaller multiplicative extent. Leverage can amplify returns, but its effect is constrained by debt capacity and risk, so the most impactful factor among these is the purchase and exit multiples.

In an LBO, the main driver of returns is the price at which you buy and later sell the business—the enterprise value multiples. That’s because returns are largely determined by how much equity ends up being worth at exit, and exit value is basically EBITDA at exit times the exit multiple, minus the debt you’ve paid down and any remaining net debt. Because multiplying EBITDA by the exit multiple can swing the sale price dramatically, even small changes in the multiples can produce large jumps (or drops) in equity value and thus in IRR. The purchase multiple sets how much you pay upfront; paying more up front leaves less upside to work with, so it directly limits potential upside. Put together, the combination of entry and exit multiples tends to dominate the sensitivity of projected returns, more than shifts in revenue growth or EBITDA margins, which affect cash flow but usually to a smaller multiplicative extent. Leverage can amplify returns, but its effect is constrained by debt capacity and risk, so the most impactful factor among these is the purchase and exit multiples.