LBO Exit Strategies: M&A, IPOs, and Dividends / Recapitalizations

Exit Strategies in a Leveraged Buyout / LBO Model

There is typically VERY little thought given to the exit in a leveraged buyout (LBO) model – in 99% of models, people just assume a simple exit multiple based on EBITDA, implying that another company or another private equity firm buys the company.

But in real life, that doesn’t necessarily happen… sometimes, a portfolio company cannot be sold to another normal company or even to another private equity firm.

For example, it might be too big for another company to buy, or it might be in an unfavorable market where there’s little M&A activity.

Also, it tends to be harder to do M&A deals in emerging and frontier markets because potential buyers are also smaller and less willing to make big acquisitions.

As a result, you need to think about 2 alternative exit strategies: initial public offerings (IPOs) and recapitalizations (recaps), otherwise known as dividends / dividend recaps.

The Mechanics of an M&A Deal

A normal M&A deal is simple: you simply assume an exit multiple, calculate Enterprise Value based on that, and then back into Equity Value by subtracting Net Debt.

Then, you calculate the IRR and multiple to the private equity firm by looking at its initial investment and how much the firm receives back at the end upon exit.

There is some uncertainty around the timing of the exit and the multiple, but overall it is a very “clean” process because the firm sells 100% of its stake all at once, to another single firm.
Initial Public Offerings in an LBO

In an IPO scenario, the PE firm cannot sell its entire stake when the company goes public because it sends a big negative signal to everyone else in the market and new potential investors: if this company is so great, why are you selling your entire stake in it?

So instead, the firm has to sell off its holdings over a period of time… perhaps 20% in Year 1, 35% in Year 2, 30% in Year 3, and 15% in Year 4, as in our example.

If the share price stays the same, the MoM multiple is the same but the IRR is lower because it takes more time to get the same capital back.

But if the share price fluctuates a lot, it could work for the firm or against the firm: a higher share price over time obviously helps them, while a declining share price hurts them.

In general, though, the IRR tends to be lower in an IPO because it takes the PE firm more time to sell its holdings; the MoM multiple may be about the same, or it might be higher or lower depending on the share price movement.

Dividends / Recapitalizations in an LBO

This is not really an “exit strategy” at all: the private equity firm simply holds the company indefinitely and the firm keeps issuing dividends from its excess cash flow to the PE firm.

In some cases, the company may take on extra debt to issue these dividends (known as a “dividend recap”).

The problem here is that the company can only issue dividends with the cash flow it has available, which is typically far less than its EBITDA.

This strategy can work if the company grows very quickly and/or is a “cash cow” business with high margins and high FCF yield, but in general it is very tough to realize a high IRR solely with dividends, simply because it might take years and years just to recoup the initial investment.

The MoM multiple, over a long period, might be reasonable, but the IRR would end up being so low that many PE firms would not be interested at all.

Conclusion

The M&A sale is the preferred strategy in 99% of leveraged buyout scenarios because it tends to produce the highest IRRs and highest MoM multiples, with the least amount of uncertainty.

However, in many cases the PE firm will have to use strategies such as an IPO exit if, for example, the company is too big to be acquired; and if it really can’t figure out what to do, dividends / recapitalizations may be used.

They are especially common in emerging and frontier markets where the capital markets are smaller and less liquid and where it’s harder to find qualified buyers. Regulatory issues may also prevent these types of companies from going public in larger, developed markets.