I don’t understand the 3 components of returns on a LBO investment:
1)return of pref shares
2)increase in price multiple on exit
- reduction in debt claims
**I guess my real question is on #3- I understand my return is made up of income and appreciation (like with a normal stock)…so I’m guessing ‘return of pref shares’ is the income piece and #2 is the appreciation piece…but what is #3? Why does a reduction in debt claims help return? What is meant by ‘reduction in debt claims’?
separate topic but I really don’t understand the significance of he pre-money valuation versus the post-money valuation? Why do we need to consider both?
For your second question, you need the pre money calculation to find the number of shares issued by the firm for the VC to purchase at the same share price.
Its because the private equity firm receives a portion of the residual value of the firm during an exit. Here is a simplified example:
PE Profit as a Percentage of Exit Value = PE
Exit Value = EV
Remaining Debt = RD
The payoff to the PE Firm would be: PE(EV-RD)
Since Remaining Debt (RD) is calculated as (Initial Debt Investment - Reduction in Claims), the remaining debt (RD) would be lower if there were a higher reduction in claims. This means that the RD would reduce the exit value by less, therefore increasing the PE firms profit.
Long story short: A reduction in debt claims means that when the firm is liquidated, less money would need to be paid out to the debt providers, leaving a higher residual exit value.
Hope that helped? It was a simplified example that didn’t factor in Preference Shares or anything else…
Even more simply: when you pay off part of a loan from your operating cash flow there’s a lower loan balance to pay off when you sell the business, so you end up with more leftover cash at the time of the sale.
wow- super clear now…thanks a bunch!