Fees raise the equity cheque on day one and shrink the proceeds at exit. The shorter the hold, the more of the IRR they take.
Transaction costs cut an LBO's IRR twice: entry fees raise the equity cheque, and exit costs shrink the proceeds. On an illustrative 400.0 buyout at 10.0x EBITDA with 18.0 of entry costs (4.50 per cent of enterprise value) and 1.5 per cent of exit costs, a five-year deal that makes 15.7 per cent before costs makes 13.3 per cent after them, 2.4 points less, and 1.87x instead of 2.08x. Hold it two years and the same costs take 6.4 points.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most first-pass LBO models compute equity as enterprise value minus debt and stop. That equity does not exist: the sponsor also pays the M&A advisers, the banks' arrangement fees, lawyers, diligence providers and insurers, and every one of those is funded with equity at day one and earns nothing.
| Input | Value |
|---|---|
| Entry EBITDA | 40.0 |
| Entry and exit multiple | 10.0x |
| Enterprise value | 400.0 |
| Debt at 5.0x EBITDA | 200.0 |
| EBITDA growth a year | 6% |
| Debt repaid a year from free cash flow | 16.0 |
| M&A and deal fees, % of EV | 2.0% |
| Financing fees, % of debt | 3.0% |
| Legal, diligence and insurance | 4.0 |
| Exit costs, % of exit EV | 1.5% |
Interest and tax are inside the free cash flow that repays 16.0 of debt a year. The tax deduction on amortised financing fees is ignored, which makes the after-cost figures slightly conservative.
Entry costs = 2.0% × 400.0 + 3.0% × 200.0 + 4.0 = 8.0 + 6.0 + 4.0 = 18.0
Equity = EV + entry costs − debt = 400.0 + 18.0 − 200.0 = 218.0
This is the balancing line of the sources and uses table. The costs are 4.50 per cent of enterprise value, which sounds small, and 9.0 per cent of the equity, which is what the returns are measured on.
EBITDA grows to 53.53 in year 5 and sells at 10.0x for 535.3. Debt has fallen to 120.0. Exit costs at 1.5 per cent are 8.03, leaving 407.3 for the equity, against 415.3 without them.
MOIC = exit equity ÷ entry equity; IRR = MOIC1/years − 1
Before costs: 415.3 ÷ 200.0 = 2.08x, 15.7 per cent. After costs: 407.3 ÷ 218.0 = 1.87x, 13.3 per cent. In Excel, with entry equity in B2, exit equity in B3 and the hold in B4: =(B3/B2)^(1/B4)-1.
| Costs included | Entry equity | Exit equity | MOIC | IRR | IRR lost |
|---|---|---|---|---|---|
| None | 200.0 | 415.3 | 2.08x | 15.7% | |
| + deal fees, 8.0 | 208.0 | 415.3 | 2.00x | 14.8% | 0.9 |
| + financing fees, 6.0 | 214.0 | 415.3 | 1.94x | 14.2% | 0.7 |
| + legal, diligence, insurance, 4.0 | 218.0 | 415.3 | 1.91x | 13.8% | 0.4 |
| + exit costs, 8.03 | 218.0 | 407.3 | 1.87x | 13.3% | 0.4 |
The entry costs do most of the damage, 2.0 of the 2.4 points, because they are paid on day one and compound against the equity for the whole hold. To earn the clean 15.7 per cent after paying them, EBITDA would have to grow 7.77 per cent a year instead of 6.
| Hold | MOIC before costs | IRR before costs | MOIC after costs | IRR after costs | IRR lost |
|---|---|---|---|---|---|
| 2 years | 1.41x | 18.6% | 1.26x | 12.3% | 6.4 |
| 3 years | 1.62x | 17.5% | 1.46x | 13.3% | 4.2 |
| 5 years | 2.08x | 15.7% | 1.87x | 13.3% | 2.4 |
| 7 years | 2.57x | 14.4% | 2.31x | 12.7% | 1.7 |
A round trip of costs is a fixed charge, so the shorter the hold, the more of the annual return it takes. Before costs the two-year sale looks like the best IRR in the table; after costs it is the worst. Quick flips are where a model without fees misleads most, and the same arithmetic applies to when a buyout fund should sell.
These are deal-level costs paid to third parties. Fees a sponsor charges its own portfolio company or co-investors, such as transaction or monitoring fees, come on top and are a separate calculation.
Measuring returns on enterprise value minus debt. On this deal that is 200.0 of equity and a 15.7 per cent IRR, a figure no investor will receive: the sponsor wrote a cheque for 218.0. The second error is to leave exit costs out because they are "the buyer's problem". The seller pays its own advisers, and 1.5 per cent of a 535.3 exit is 8.03 off the proceeds.
Put every entry cost into the equity cheque and every exit cost against the proceeds: 2.4 points of IRR and 0.21x of multiple on a five-year deal, and 6.4 points if it is sold in two. The Buyout Investor follows one deal from the seller's adjusted EBITDA through sources and uses, the debt, the exit and the fund's fees down to what the subscriber earns, and the free LBO workbook for the book's case starts from a sources and uses with the fees in the equity cheque.
At entry: M&A advisory and deal fees, the banks' arrangement fees on the debt, and legal, diligence and insurance costs. At exit: the seller's advisory and legal costs. In the illustrative case entry costs are 8.0, 6.0 and 4.0, totalling 18.0 or 4.50 per cent of enterprise value, and exit costs are 1.5 per cent, 8.03.
In a sources and uses table the fees are a use of funds and equity is the balancing item, so with debt sized on EBITDA the fees are funded entirely by equity. Here they lift the cheque from 200.0 to 218.0, 9.0 per cent more equity that earns nothing.
Because they are a fixed charge spread over fewer years. The illustrative deal loses 2.4 points of IRR over five years, 4.2 points over three and 6.4 points over two, turning the best-looking IRR before costs, 18.6 per cent at two years, into the worst after them, 12.3 per cent.
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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