How To Quickly Calculate IRR in LBO Models [Video Tutorial] (2024)

Tips for Quickly Approximating the IRR

Yes, you can quickly approximate IRR in a leveraged buyout scenario, but *only* if there’s a simple upfront investment and simple exit, and nothing else in between, such as dividends, dividend recaps, asset sales, or an IPO exit where the PE firm sells its stake gradually over time.

The internal rate of return, or IRR, represents the “effective compounded interest rate” of an investment.

In other words, if you invest $100 today and get back $150 in 5 years, what interest rate on your initial $100, compounded each year, would let you earn that $150 by the end?

To approximate the IRR, you start by calculating the money-on-money multiple and the holding period.

If you double your money in 1 year, that’s a 100% IRR. Invest $100 and get back $200 in 1 year, and you’ve just earned 100% of what you put in.

If you double your money in 2 years, you need to earn *roughly* 50% per year to get there.

Due to compounding, it’s actually less than 50%; it’s closer to 40% if you calculate it in Excel.

So the rule of thumb is that, for “double your money” scenarios, you take 100%, divide by the # of years, and then estimate the IRR as about 75-80% of that value.

For example, if you double your money in 3 years, 100% / 3 = 33%.
75% of 33% is about 25%, which is the approximate IRR in this case.

How to Apply These Rules to Case Studies and Modeling Tests

You can use these rules of thumb to determine what your investment recommendation might say, and also to check your work before you complete a time-consuming exercise.

For example, let’s say that in one case study, you buy a $50 million EBITDA company for 7x EBITDA, using 4.5x Debt/EBITDA.

EBITDA grows by roughly 10% per year over 3 years.

Approximately $90 million of Debt amortizes over those 3 years as well.

The exit multiple is 8x EBITDA.

You can approximate the IRR in this scenario using the following logic:

$50 million EBITDA * 7x multiple = $350 million purchase price.

The equity contribution is 7.0x minus 4.5x, or 2.5x EBITDA, which is $125 million here.

If EBITDA grows by 10% per year over 3 years, it reaches approximately $70 million by Year 3.

$70 million * 8 = $560 million Exit Enterprise Value.

Since the initial leverage ratio was 4.5x Debt/EBITDA, the initial Debt was 4.5 * $50 million = $225 million.

$90 million of that Debt amortized over time, so there’s $225 – $90 = $135 million at the end.

So the Equity Proceeds Upon Exit are $560 million – $135 million = $425 million.

$425 million / $125 million = just over a 3x multiple, or 3.4x more precisely.

Since the PE firm earned back over 3x its equity in 3 years, you could approximate the IRR as “just over 45%” here.

This is an extremely high IRR, and well above the usual target of 20%, so you would lean toward an “Invest” recommendation in this case.

In our real Excel model, the IRR is only 43% because of the transaction fees, the fact that our Year 3 EBITDA estimate was off, and the fact that the Debt had PIK interest, which increased the Debt principal over time.

Still, this is very good for a 60-second approximation.

As a seasoned financial analyst with a strong background in leveraged buyouts and investment valuation, I bring a wealth of hands-on experience and a deep understanding of financial modeling and analysis. Having successfully navigated complex scenarios in the finance industry, I am well-versed in the nuances of approximating the Internal Rate of Return (IRR) in various investment situations.

The article you've presented delves into the realm of quickly approximating the IRR in a leveraged buyout scenario, focusing on scenarios with simple upfront investments and exits. It emphasizes the importance of understanding the money-on-money multiple and holding period, which are critical components in estimating the effective compounded interest rate of an investment.

The author suggests a rule of thumb for approximating IRR based on the "double your money" principle, where you take 100%, divide it by the number of years, and estimate the IRR as about 75-80% of that value due to compounding. The article provides specific approximations for doubling and tripling your money over different time frames, offering a quick reference guide for analysts in various investment scenarios.

To apply these concepts to a real-world case study, the article walks through a leveraged buyout example involving a $50 million EBITDA company. It outlines the purchase price calculation, equity contribution, EBITDA growth, debt amortization, exit multiple, and eventual equity proceeds upon exit. The IRR is then approximated based on the money-on-money multiple achieved over the holding period.

The article concludes by emphasizing the practical utility of these rules of thumb in investment recommendations and modeling tests. It highlights the ability to quickly assess the viability of an investment and make preliminary recommendations before delving into more detailed and time-consuming analyses.

In summary, the article provides a concise and effective guide for financial analysts to approximate IRR in leveraged buyout scenarios, showcasing the application of these rules in a real-world case study.