Article | Leverage in the Private Equity Value Bridge

Traditional value creation or value bridge models tend to mischaracterize the impact of leverage in private equity deals. These articles offer simple, but effective, solutions.

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Introduction

In the context of private equity, the value creation analysis or “value bridge” represents a way to explain historical investment returns. The “value creation” part is simply a change in shareholder equity. Because these values ultimately tie to wire transfers between the bank accounts of buyers, sellers, and lenders, value creation is objectively true (especially for exited deals). In contrast, value creation “analysis” is a subjective interpretation of why such changes in equity value happen.

Value bridges describe returns through underlying movements in company capital structures and P&Ls, and sometimes sector or market forces. For example, consider AlphaCo, which grows enterprise valuation from $100 to $180. Its EBITDA increases from $20 at Entry to $30 at Exit, so its valuation multiple expands from 5.0x to 6.0x. The transaction is funded with $20 of net debt that is paid down to $0 at Exit, so shareholder equity grows from $80 to $180, resulting in $100 of equity value creation, a 2.25x Gross multiple of invested capital (MOIC), and a 22.5% Gross internal rate of return (IRR) over the 4.0-year hold.

Figure 1. Value bridge for AlphaCo

The value bridge above interprets the $100 of AlphaCo equity value creation as $55 of EBITDA Growth, $25 of Multiple Expansion, and $20 of Debt Paydown. Each value driver is positive and makes intuitive sense because equity value should be enhanced by increasing EBITDA, expanding multiples, and paying down debt. However, in the case of AlphaCo, this popular value creation model overstates both EBITDA Growth and Multiple Expansion (by about 11% in this case) and its Debt Paydown formula fails to address how debt can amplify equity gains (and losses).

This series of articles shows that fixing the leverage calculation is easier than most imagine, and that doing so solves many other problems, by:

• Ensuring that the models work over the widest range of investment types, company capital structures, and market conditions.
• Reducing volatility and sensitivity to underlying input variables.
• Making the analysis work with practical and accessible metrics that analysts are likely to find in fund reporting and marketing materials.
• Defining mathematically rigorous relationships among value drivers so they can be reliably converted back and forth between the various models and measures with no loss of integrity.  

The Conventional Model of Value Creation

The model behind Figure 1’s value bridge requires Entry (t1) and Exit (t2) measurements for total enterprise valuation (TEV), total equity value (TEqV), net debt (ND), EBITDA (E), and valuation multiple (M), which is defined as TEV/E. Equity value creation is expressed as the change in total equity value, where:

Described as the Conventional Model of value creation in Private Equity Value Creation Analysis, this is the form most likely to be encountered in the field. EBITDA Growth (VEG), Multiple Expansion (VME), and Debt Paydown (VDP) are driven by various capital structure and P&L changes, where ∆X=X2-X1, and averages, where X=(X1+X2 )/2.

In the Conventional Model, the sum of VEG and VME is the Unlevered Return because ∆E⋅M+∆M⋅E can be simplified to ∆TEV. However, the following example illustrates that there must be more to leverage than just -∆ND. Consider two companies with the same enterprise valuation and P&L characteristics as AlphaCo, but throughout the holding period BravoCo maintains net debt of $0 and CharlieCo maintains net debt of $50.

Table 1. Conventional Model Value Creation

Enterprise valuation growth (∆TEV), and therefore Unlevered Return, is $80 for all three companies in Table 1. Because -∆ND for both BravoCo and CharlieCo is $0, total equity value creation (∆TEqV) for these companies is also $80. This suggests that the unlevered components drive 100% of value creation and, therefore, leverage has no impact on either company’s equity return. Clearly, this cannot be the whole story because the debt on CharlieCo’s balance sheet drives its Gross MOIC from 1.80x to 2.60x and its Gross IRR from 15.8% to 27.0%

The Conventional Model fails to address “gearing”, which makes equity grow faster than the enterprise when things go well and shrink faster than the enterprise when they do not. Various attempts from academic and industry literature to correct the leverage calculation are described in the next article. The Derivative Model of value creation, which successfully measures total leverage impact using numbers already available on Table 1, is introduced in the following article.

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