## What is **Ability to Pay Analysis?**

**Ability-to-Pay Analysis (ATP)** is a method used by private equity investors to guide pricing and determine the affordability of a potential LBO acquisition.

Often referred as a “reverse LBO”, an ATP model allows a financial sponsor undertaking a leveraged buyout (LBO) to offer a more logical purchase price bid that meets (or exceeds) the fund’s minimum required return hurdles.

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## How Does Ability-to-Pay Analysis Work

Before we discuss how to perform an ability-to-pay analysis, we must first shed light on what a private equity firm is attempting to estimate by creating a leveraged buyout (LBO) model.

The essential question that the PE firm strives to answer is, *“How much can our firm afford to approximately pay to acquire this target opportunity, while still meeting our minimum return hurdles?”*

**Therefore, the ability to pay analysis (ATP) feature in an LBO model is a form of estimating the affordability of a potential private equity investment.**

When building an LBO model, one of the initial steps is to set up a basic schedule of assumptions (e.g. debt pricing, initial total debt / EBITDA ratio to fund the transaction, sponsor equity contribution).

Afterward, you can designate a range of targeted returns, or IRRs, and back into an implied purchase price (or multiple) – which is the premise of an ability-to-pay analysis (ATP).

Once the necessary assumptions are entered, the range of purchase multiples that result in enterprise valuations that yield the target internal rate of return (IRRs) and multiple-of-money (MoM) figures per set of assumptions can be determined.

## How to Perform ATP Analysis in an LBO Model

A common term used in private equity is the “hurdle rate”, which refers to the minimum rate of return that financial sponsors must meet before moving forward with an LBO transaction.

Each firm will have a different hurdle rate (i.e. minimum threshold) for what is considered an “attractive” investment to actively pursue. However, the standard hurdle rate tends to range between 20% to 25%.

At the end of the day, the projected fund returns drive investment decisions, regardless of how compelling the fundamentals of the company (and industry) are or how well the target company aligns with the fund’s portfolio strategy.

**The LBO model can be used to quantify the maximum purchase price that could be paid at entry, while still realizing the minimum 20% to 25% IRR (“hurdle rate”).**

Therefore, an LBO model provides a so-called “floor valuation” of a potential LBO transaction, since it is used to determine what a financial sponsor could afford to pay for the target under consideration.

Given the risk profile associated with significant debt financing and the relatively short investment horizons (~3 to 8 years), the hurdle rate to invest (i.e. the cost of equity) will be higher than if an identical business had no exposure to those same LBO-related risks.

Said differently, the implied present value (or target enterprise value) will decline due to the higher hurdle rates of financial sponsors than valuations conducted under the traditional discounted cash flow (DCF) or relative valuation approaches — all else being equal.

Hi BB, 2 quick questions

1) At exit, are you assuming that no ebitda expansion between entry and exit? as I can see 25m was used to calculate exit EV

2) At exit, are you assuming that 25m of cash will be generated, hence 125 net debt?

Thanks

Hi, Ulster,

That is correct for #1, they are assuming no growth in EBITDA. As for #2, it could be 25 of cash generated or it could be assuming that 25 of debt was paid down.

BB

If you already have an LBO set up, is it not simpler to use sensitivity tables to work out purchase multiples at different IRRs and exit multiples?

Hi, Syed, Data tables can certainly be used to calculate implied purchase multiples at different IRRs. However, if one sets the exit multiples equal to the purchase multiples, then it will create a circularity and require an iterative calculation to solve for the implied purchase multiple. A data table can… Read more »

If a sponsor only purchases 80% of the company with Management rolling over the remaining 20%, would line 21 in your excel file include the initial equity contributions from both the sponsor and management? Or should line 21 only reflect the sponsor’s equity contribution?

Hi, Jon,

You are correct, that line would represent total of sponsor and management equity, because line 16 is the total equity available to both at the end.

BB

Do we also have to take Cash to B/S or min. cash requirements into account as an (-) expense after the financing fees line?

Hi, Felix, Indeed, the company may need an injection of cash (or some of its existing cash set aside as a minimum balance), but rather than being accounted for as an expense on the I/S, it would be accounted for in the sources and uses schedule, under uses of funds,… Read more »

Thank your for the answer. Just to be precise. If the investor inject cash in the company at closing or the company has a required minimum balance of $ 10, this must be added as (-) below financing fees (line 24 and 34) and would reduce the Enterprise Value @… Read more »

Hi, Felix,

Yes, that is correct!

BB

Hi, many thanks for this. Two quick questions please: How do you get to $38 for that Sponsor Equity Contribution? I tried the formula you wrote above but it does not give me this value. Can you please clarify? Why are we removing Initial Debt Raised to get to EV… Read more »

Hi, Rony, If we take $94, the amount the sponsor gets at the end, and divide it by (1 + 20%) ^ 5, where 20% is the required rate of return and 5 is the number of years, we get $38, and so forth. We are adding initial debt raised… Read more »