The interest bill is the smaller channel. The larger one is how much the lenders will still advance, and the equity that has to replace it.
Less than the headline suggests through the interest bill, and more through how much lenders will advance. On an illustrative 9.0x buyout with 275.0 of floating-rate debt, two points on the base rate cut the five-year IRR from 16.4 to 15.2 per cent if the debt stays at 5.5x EBITDA. If the lenders hold a 2.0x interest cover instead, the debt falls to 238.1, the equity rises to 236.9 and the IRR falls to 14.2 per cent.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Since base rates left the floor, every buyout committee has asked how much of the return is gone. The answer depends on which of two effects you model. The first is the extra interest on the same debt. The second, usually larger, is that a lender who wants the same cover at a higher rate lends less, and the sponsor writes a bigger cheque for the same company.
| Input | Value |
|---|---|
| EBITDA at closing | 50.0 |
| EBITDA growth a year | 6.0% |
| Entry and exit multiple | 9.0x |
| Fees and cash funded at closing | 25.0 |
| Debt at closing, x EBITDA (floating, one tranche) | 5.5x |
| Margin over the base rate | 4.5% |
| Base rate, flat: base case / higher case | 4.0% / 6.0% |
| Capex (equal to D&A), share of EBITDA | 20.0% |
| Working capital, share of EBITDA growth | 10.0% |
| Tax rate | 25.0% |
Every dollar of free cash flow repays debt at the year end, interest is charged on the opening balance, and the exit is at the same 9.0x, so the only thing that changes between the two cases is the rate. The operating cash funded at closing is conservatively left out of the exit equity in every case.
Free cash flow = EBITDA − capex − ΔNWC − tax − interest
Interest = opening debt × (base rate + margin); tax = 25% × (EBITDA − D&A − interest)
Exit equity = 9.0 × year-5 EBITDA − debt at exit
In Excel, the IRR of a single entry and exit: =(Exit_Equity/Equity)^(1/5)-1.
| Year | EBITDA | Interest at 8.5% | Debt at 8.5% | Interest at 10.5% | Debt at 10.5% |
|---|---|---|---|---|---|
| 1 | 53.0 | 23.4 | 261.0 | 28.9 | 265.2 |
| 2 | 56.2 | 22.2 | 244.3 | 27.8 | 252.6 |
| 3 | 59.6 | 20.8 | 224.5 | 26.5 | 237.1 |
| 4 | 63.1 | 19.1 | 201.3 | 24.9 | 218.3 |
| 5 | 66.9 | 17.1 | 174.3 | 22.9 | 195.7 |
| Exit equity / MOIC / IRR | 427.9 | 2.14x / 16.4% | 406.5 | 2.03x / 15.2% |
The enterprise value at exit is 602.2 in both columns. The difference is all in the debt: 174.3 against 195.7. Over five years the higher rate charges 28.6 more interest, saves 7.1 of tax, and leaves 21.4 less equity. The quick estimate, two points on 275.0 for five years after tax, gives 20.6; the other 0.8 is interest on the debt the business could no longer repay. The year-one free cash flow falls by 4.1, 29.5 per cent, which is where the pain is felt first, in the cash sweep and the covenants rather than in the IRR.
The same lender, asked to keep at least 2.0x of EBITDA over interest at closing, advances no more than 50.0 ÷ (2.0 × all-in rate). At 8.5 per cent that is above 275.0, so the 5.5x cap binds. At 10.5 per cent it is 238.1, or 4.76x, and the sponsor must find the missing 36.9.
| Base rate | All-in | IRR, debt 5.5x | Debt sized to cover | Equity | IRR, sized |
|---|---|---|---|---|---|
| 2.0% | 6.5% | 17.5% | 275.0 | 200.0 | 17.5% |
| 3.0% | 7.5% | 17.0% | 275.0 | 200.0 | 17.0% |
| 4.0% | 8.5% | 16.4% | 275.0 | 200.0 | 16.4% |
| 5.0% | 9.5% | 15.8% | 263.2 | 211.8 | 15.4% |
| 6.0% | 10.5% | 15.2% | 238.1 | 236.9 | 14.2% |
| 7.0% | 11.5% | 14.6% | 217.4 | 257.6 | 13.4% |
With the debt fixed, each 100 basis points costs about 0.6 points of IRR. Once the cover test binds, the loss nearly doubles: from 4 to 6 per cent the IRR drops 2.2 points, of which 1.2 come from the interest bill and the rest from replacing cheap debt with equity. The multiple falls from 2.14x to 1.94x. Bought with no debt at all, the same company returns 11.1 per cent, so leverage still adds more than two points even at a 7 per cent base rate.
Scale check: one turn of exit multiple is worth the year-5 EBITDA, 66.9 of equity, three times the 21.4 that two points of rates cost on fixed debt. If higher rates also compress exit multiples, that is the channel to model first.
The common mistake is to run the rate sensitivity on a model whose debt is a hard-coded 5.5x. It shows a modest, linear loss and reassures the committee. In a market where lenders size on cover or on a fixed charge ratio, the debt quantum is itself a function of the rate, and the honest table flexes both. The reverse error also appears: treating the extra interest as a pre-tax cost, which overstates the damage by a third, or ignoring the tax deduction limit that caps the shield at high leverage, covered in how the 30 per cent interest cap hits LBO returns.
Hedging addresses only the first channel. A swap fixed at closing protects the interest bill in Step 1 for its term; it does nothing for Step 2, because the debt quantum is set by the rate prevailing when the deal is financed.
Two points of base rate on unchanged debt cost this deal 1.2 points of IRR; the same two points through the lender's cover test cost 2.2. Model the debt quantum as a function of the rate, not as a constant. The book's own case runs a higher-rates scenario as a complete live case, alongside a full model with a sweep, a second lien and a revolver, in the free workbook for this case, and how much of the return leverage supplies in the first place is worked in how much of an LBO's return comes from leverage.
In this illustrative five-year case, with 5.5x of floating-rate debt at a 4.5 per cent margin and every dollar of free cash flow repaying debt, 100 basis points on the base rate costs about 0.6 points of IRR if the debt amount is unchanged. The cost nearly doubles when the lenders reduce the debt they will advance, because the equity cheque grows.
Interest is tax deductible and the extra cost is spread over a growing exit. Two points on 275.0 for five years is 27.5 of interest, 20.6 after a 25 per cent tax rate, plus 0.8 of interest on the debt not repaid: 21.4 off an exit equity of 427.9. That is 5 per cent of the proceeds, roughly 1.2 points of IRR on the same cheque.
They narrow the gap but do not close it here. Bought with no debt, the same company returns 11.1 per cent. At a 7 per cent base rate with the debt cut to 4.35x by the cover test, the levered deal still returns 13.4 per cent. Leverage adds less, but it still adds, as long as the all-in rate stays well below the return on the whole business.
This article is one calculation from The Buyout Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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