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Multiple Expansion

Learn the Concept of Multiple Expansion in Private Equity LBOs

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Multiple Expansion

Key Takeaways
  • What is the definition of multiple expansion?
  • Why is multiple expansion relevant to private equity investing?
  • Is multiple expansion an important return driver in leveraged buyouts (LBOs)?
  • What are the standard purchase and exit multiple assumptions used in LBO modeling?

Multiple Expansion Definition

When it comes to leveraged buyouts (LBOs), pricing is arguably the most important consideration.

Simply put, the objective behind multiple expansion is to “buy low, sell high”.

Once a financial sponsor acquires a company, the firm seeks to gradually pursue growth opportunities while identifying operational inefficiencies where improvements could be made.

Some common examples of potential value-add opportunities are:

  • Reducing Employee Headcount
  • Closing Redundant Facilities
  • Eliminating Unnecessary Functions
  • Divesting Non-Core Assets
  • Negotiating Longer-Term Customer Contracts
  • Geographic Expansion

If the changes implemented are successful, the post-LBO company will have higher profit margins and higher-quality revenue (i.e. recurring, stable), which is essential in the context of leveraged buyouts (LBOs) due to the highly levered capital structure.

While not a guarantee by any means, the odds of exiting at a higher multiple improves if the private equity firm is able to implement strategic adjustments such as the ones mentioned above.

The inverse of multiple expansion is called multiple contraction, which means the investment was sold for a lower multiple than the original acquisition multiple. In such cases, the buyer likely overpaid and subsequently took a loss when selling the company.

However, for larger-sized LBOs, minor multiple contraction can be acceptable (and often be expected). This is because the number of potential buyers is reduced as fewer buyers can afford to purchase the asset.

Modeling Purchase and Exit Multiple Assumptions

In practice, the majority of LBO models use the conservative assumption of exiting at the same multiple as the entry multiple.

Given the amount of uncertainty regarding the market conditions and unforeseeable events that could have a significant impact on the exit multiple, the recommended industry best practice is to set the exit multiple assumption equal to the purchase multiple.

Even if the private equity firm expects to take actions during its ownership period that could increase the exit multiple (and returns), the most important takeaway is that the private equity firm’s thesis and expected returns should not be overly reliant on selling at a higher valuation.

Multiple expansion can often be caused by favorable secular trends and market timing (e.g. COVID-19 and telemedicine).

Bain EV/EBITDA Multiples

US Buyout Purchase Multiples Trend (Source: Bain Global PE Report)

Multiple Expansion Example

For instance, let’s say that a financial sponsor acquires a company for 7.0x EBITDA. If the target company’s last twelve months (LTM) EBITDA is $10mm as of the purchase date, then the purchase enterprise value is $70mm.

If the financial sponsor later sells the same company for 10.0x EBITDA, then the net positive difference between the 7.0x and 10.0x is the concept of multiple expansion.

Even if the company’s EBITDA remains unchanged at $10mm, if the sponsor exits the investment five years later but at a 10.0x exit multiple, $30mm of value would have been created – all else being equal.

  • (1) Exit Enterprise Value = 7.0x Exit Multiple × $10mm LTM EBITDA = $70mm
  • (2) Exit Enterprise Value = 10.0x Exit Multiple ×$10mm LTM EBITDA = $100mm

Excel Template Download

Now, let’s go through an illustrative example that shows the impact of multiple expansion on the returns of an LBO investment.

To get started, fill out the form below for access to the Excel file.

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Entry Assumptions

First, the entry assumptions we’ll be using are as follows:

  • LTM EBITDA: $25mm
  • Purchase Multiple: 10.0x

In our hypothetical transaction, the LBO target has generated $25mm in LTM EBITDA, which is the metric upon which the purchase multiple will be applied.

By multiplying our LTM EBITDA by the purchase multiple, we can calculate the purchase enterprise value – i.e. the total purchase price paid to acquire the company.

  • Purchase Enterprise Value = $25mm LTM EBITDA × 10.0x Purchase Multiple
  • Purchase Enterprise Value = $250mm

Next, we must figure out the initial investment contributed by the financial sponsor, or the private equity firm.

Here, we’re assuming that the total leverage ratio was 6.0x LTM EBITDA and there are no other providers of capital other than the single leverage provider (i.e. debt-holder) and the financial sponsor. Since the purchase multiple was 10.0x, we can deduce the sponsor equity contribution was 4.0x LTM EBITDA (i.e. four turns of EBITDA).

  • Sponsor Equity Contribution Multiple = Purchase Multiple – Total Leverage Multiple
  • Sponsor Equity Contribution Multiple = 10.0x – 6.0x = 4.0x

We can then multiply the LTM EBITDA by the sponsor equity contribution multiple to figure out how much the financial sponsor had to pay for the deal to close.

  • Sponsor Equity Investment = 4.0x × $25mm = $100mm

Sponsor Investment

Before we move onto the exit multiples section, there are two more assumptions for our exercise:

  1. Holding Period: 5 Years
  2. Cumulative Debt Paydown: 50%

In the five-year holding period during which the acquired LBO target belongs to the sponsor, half of its total debt financing is expected to be paid down.

  • Total Debt Paydown = Initial Debt Raised × Debt Paydown %
  • Total Debt Paydown = $150mm × 50% = $75mm

On the date of exit, there should be $75mm in debt remaining on the balance sheet of the company.

Exit Assumptions

Since our entry assumptions have all been set up, we’re ready to see the impact of the exit multiple on the returns of a LBO.

We’ll be comparing three scenarios with different exit multiples:

  1. 8.0x: Multiple Contraction of – 2.0x
  2. 10.0x: Purchase Multiple = Exit Multiple
  3. 12.0x: Multiple Expansion of 2.0x

To isolate the impact of the exit multiple as much as possible, the LTM EBITDA assumed at exit is going to be the same as the LTM EBITDA on the date of purchase – i.e. no EBITDA growth is assumed throughout the holding period.

Given the unchanged exit $25mm LTM EBITDA, we apply the corresponding exit multiple against this figure.

  • Scenario 1: Exit Enterprise Value = $25mm × 8.0x = $200mm
  • Scenario 2: Exit Enterprise Value = $25mm × 10.0x = $250mm
  • Scenario 3: Exit Enterprise Value = $25mm × 12.0x = $300mm

For each case, we must subtract the $75mm in debt. Note that for simplicity, we are assuming there is no cash remaining on the B/S at exit – thus net debt is equal to total debt.

  • Scenario 1: Exit Equity Value = $200mm – $75mm = $125mm
  • Scenario 2: Exit Equity Value = $250mm – $75mm = $175mm
  • Scenario 3: Exit Equity Value = $300mm – $75mm = $225mm

The difference in the range of outcomes across these three scenarios is $100mm.

Returns Calculation (IRR and MoM)

In our final step, we can compute the internal rate of return (IRR) and multiple of money (MoM) for each case.

  • Scenario 1: IRR = 4.6% and MoM = 1.3x
  • Scenario 2: IRR = 11.8% and MoM = 1.8x
  • Scenario 3: IRR = 17.6% and MoM = 2.3x

From the exercise we just completed, we can see the extent of how sensitive the returns on a LBO investment are to the purchase multiple and exit multiple.

Multiple Expansion Complete

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