Downside case
LBOThe deliberately unkind scenario run beside the base case, testing what the equity is worth if the business underperforms and the exit multiple compresses.
Also written: downside scenario, bear case
A downside case is not a slightly worse base case. It is a deliberately unkind set of assumptions run to answer one question: if this goes wrong in the ordinary way that deals go wrong, what does the equity get back? The usual ingredients are flat or falling EBITDA, an exit multiple below the entry multiple, and weaker cash generation, applied together rather than one at a time.
The reason it carries so much weight in a buyout, and much less in a straightforward corporate acquisition, is leverage. Debt has a fixed claim, so a modest fall in enterprise value produces a large fall in the equity beneath it. A business that ends up 20% smaller than planned can leave equity that is far more than 20% smaller.
The second effect is easy to miss and often the more damaging. Weaker cash flow means less is left after interest, so the debt repayment that was meant to produce much of the return slows down at exactly the moment it is needed. The structure that most needs to deleverage is the one least able to.
Interviewers use the downside case to separate two kinds of answer. One says leverage raises returns. The other says leverage widens the distribution of returns, names both tails, and points out that choosing a leverage level is really a statement about how certain the cash flow is.
Worked example
A buyout of a business earning 100 of EBITDA at 10.0x is funded with 700 of debt and 300 of sponsor equity.
In the base case EBITDA reaches 130, the exit clears at 10.0x for 1,300 of enterprise value, 544 of debt remains, and the equity is worth about 756, or 2.5 times the cheque.
In the downside EBITDA is flat, the exit clears at 8.5x for 850, and only about 46 of debt has been repaid because interest consumed the cash. The equity is worth about 196, or 0.65 times. One capital structure produced both numbers.