What is Ability to Pay Analysis?
Ability to Pay Analysis (ATP) is a method used by private equity investors to guide valuation and determine the affordability of a potential acquisition.
Such an analysis, also known as a “reverse LBO”, 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.
Ability to Pay Analysis (ATP): Private Equity Training Tutorial
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?”
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 results in enterprise valuations that yield the targeted range of internal rate of returns (IRRs) and multiple-of-money (MoMs) can be determined.
IRR Hurdle Rates in Private Equity LBO Models
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%.
LBO Affordability Analysis (“Floor Valuation”)
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 using significant debt financing and the relatively short investment horizons (~3 to 8 years), the hurdle rate to invest (i.e. the cost of equity) is going to 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.
Ability to Pay Analysis Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. LBO Entry Assumptions
Suppose we’re provided with the following entry assumptions for a proposed leveraged buyout (LBO).
- LTM Entry EBITDA = $25mm
- Entry Leverage Multiple = 6.0x
From those two assumptions, we can calculate that the initial amount of debt raised to finance the deal was $150mm.
- Initial Debt Raised = $25mm LTM EBITDA × 6.0x Leverage Multiple = $150mm
Next, there are three more important transaction assumptions:
- LBO Holding Period = 5 Years
- Transaction Fees (% TEV) = 2.5%
- Financing Fees (% TEV) = 2.0%
Step 2. LBO Exit Assumptions
With those entry assumptions filled out, we can start working on the exit assumptions before reaching the ability-to-pay analysis.
For our range of potential exit multiples, the first input will be 9.0x – and using a step function of 0.5x – we’ll extend this to 11.0x.
As for remaining exit assumptions, we’ll assume the following:
- LTM Exit EBITDA = $25mm
- Net Debt at Exit = $125mm
To calculate the enterprise value on the date of exit, we’ll multiply the applicable exit multiple by the LTM exit EBITDA assumption.
For example, if we assume the investment will be exited at a multiple of 9.0x, the following formula is used:
- Enterprise Value @ Exit: 9.0x × $25mm = $225mm
Since we’re making our way down to the common equity value on the date of exit (i.e. at the end of Year 5), we must deduct the net debt and transaction expense (e.g. M&A advisory fees).
Note that the reason we deduct transaction expenses in this step, but not financing expenses, is that advisory fees are required again when selling the company, while financing fees are not.
Continuing off our 9.0x exit multiple example, the formula below calculates the residual common equity value, which we’ll recalculate for each exit multiple assumption.
- Common Equity Value @ Exit = $225mm – $125mm – $6mm = $94mm
Step 3. Ability to Pay Analysis Calculation Example (ATP)
In the next portion of our tutorial, we can now estimate the implied purchase price to achieve our targeted deal IRR.
Here, we’ll have two target IRRs:
- 20.0% Minimum IRR
- 25.0% Minimum IRR
One significant component of the IRR is the required sponsor equity contribution needed to complete the transaction.
We’ll first calculate the approximate sponsor equity contribution using the formula below:
- Sponsor Equity Contribution = Common Equity Value @ Exit / (1 + Minimum Deal IRR) ^ LBO Holding Period
Upon extrapolating this calculation for the entire range of exit multiples, we can link to our assumptions from earlier.
- (+) Initial Debt Raised: $150mm
- (–) Transaction Expenses: TEV × Transaction Fees %
- (–) Financing Fees: TEV × Financing Fees %
If you are wondering why transaction fees are accounted for twice, this is because M&A advisory services are required two times:
- Purchasing the Target (Buy-Side M&A)
- Exiting the Investment (Sell-Side M&A)
Once completed, we have the enterprise value as of the date of purchase. From the enterprise value at exit, we can divide that figure by the LTM entry multiple to get the implied purchase multiple that enables us to achieve the desired return.
- Implied Maximum Purchase Multiple = Enterprise Value @ Exit ÷ LTM Entry EBITDA
According to our model, assuming an exit multiple of 10.0x and required minimum IRR of 20.0x, the maximum purchase multiple we should be willing to pay should be around ~7.5x.
The same steps from our 20.0% hurdle rate section could subsequently be replicated for the 25.0% minimum deal IRR, as well as for higher required IRRs if needed.
Step 4. Ability to Pay Analysis Model Interpretation (ATP)
It is important to understand, however, that an ability-to-pay analysis (ATP) is only an approximation of the maximum purchase price (and multiple) and there remains room for error.
For example, for the sake of simplicity and also to avoid creating a circularity, the TEV on the date of exit was used, rather than the entry TEV when calculating the transaction fees.
While these minor discrepancies are unlikely to have a tangible impact on the pricing recommendation, these imperfections can cause slight mismatches in the return figures and are something to be aware of.
Hence, most complex LBO models with ATP tabs use the “ROUND” Excel function, as the implied multiples are meant to serve as a rough point of reference (i.e. an estimated ceiling), but NOT a precise purchase multiple.
To recap, an LBO model is often called a “floor valuation” as it can be used to determine the maximum purchase price the buyer can pay while still reaching the fund specific returns thresholds.
The purchase multiple is among the most important factors that determine the success (or failure) of an LBO — which an ability-to-pay analysis is intended to guide.
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?
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.
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 »
Yes, that is correct!
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 »