So, how do you do it?
Three quick tips on how to increase IRR in LBOs are as follows:
- Optimise the capital structure
- Improve operational efficiency
- Exit at the right time
Let’s dive into some
advanced LBO modelling techniques to make it happen.
What is IRR in an LBO?
First things first, let’s break it down. The internal rate of return (IRR) is a key metric used to evaluate the profitability of an investment. In the context of
financial modelling and an LBO, it measures the annualised return on the equity invested over the holding period.
Increasing IRR can lead to higher profits and more successful investments. For corporate Finance professionals (especially those focused on private equity transactions), private equity LBO professionals and finance professionals within portfolio companies, mastering this skill can set you apart from the competition.
So, how can you achieve a higher IRR in your LBOs?
Three Effective IRR Strategies
1. Optimise the Capital Structure
One of the simplest ways of increasing IRR in LBOs is to optimise the capital structure of the deal. What this ultimately means is finding the right balance of debt and equity.
- Use More Debt: More debt can amplify returns because debt is generally cheaper than equity. However, be cautious of the risks associated with high leverage, such as increased interest expenses and potential bankruptcy.
- Lower Cost of Debt: Try to secure loans with lower interest rates. This reduces the cost of capital and increases the cash flow available to equity holders.
Example: Imagine Company A is being bought for £100 million. If you finance the purchase with £70 million in debt at a 5% interest rate and £30 million in equity, the lower cost of debt will boost the returns on the equity portion, thus increasing the IRR.
2. Improve Operational Efficiency
Another way to boost IRR is by improving the operational efficiency of the target company. This involves increasing revenues and reducing costs.
- Increase Revenues: Implement strategies to grow sales, such as expanding into new markets or launching new products.
- Reduce Costs: Streamline operations to cut unnecessary expenses. This can include negotiating better terms with suppliers or improving inventory management.
Example: Company B, acquired through an LBO, implements cost-cutting measures and increases its revenue by 20% over three years. These operational improvements lead to higher EBITDA, which increases the company's valuation and, subsequently, the IRR.
3. Exit at the Right Time
Timing your exit can significantly impact your IRR. Selling the company at a higher valuation than the purchase price maximises returns.
- Market Timing: Sell when market conditions are favourable, and valuations are high.
- Strategic Buyers: Look for strategic buyers who may be willing to pay a premium for the company due to synergies or strategic fit.
Example: An investment firm buys Company C for £50 million. After five years, they sold it for £100 million during a market boom. The favourable market conditions and strategic sales lead to a high IRR.
How to Master IRR in LBOs
Boosting IRR in LBOs involves a mix of financial savvy, strategic planning, and operational improvements. By optimising the capital structure, enhancing operational efficiency, and timing your exit right, you can significantly increase the profitability of your investments.
Ready to take your LBO skills to the next level? Join our
Advanced LBO Modelling course at Redcliffe Training.
Don't miss out on this opportunity to enhance your financial modelling skills and boost your career!
FAQ
What is the rule of thumb for IRR?
The rule of thumb for IRR (Internal Rate of Return) is that it should generally exceed the cost of capital to ensure profitability. For private equity and LBO (Leveraged Buyout) investments, a typical target IRR is around 20-30%, reflecting the higher risk and expected returns of such investments. This benchmark helps investors evaluate the attractiveness of potential deals and make informed decisions.