Multiple expansion
LBOSelling a business at a higher multiple than was paid for it, the least controllable source of buyout return.
If a sponsor buys at 9.0x and sells at 11.0x, the extra two turns of EBITDA is multiple expansion. It can come from genuine repositioning, growing the business into a category that commands a higher rating, or simply from a friendlier market at exit.
It is the driver a sponsor controls least, which is why respectable underwriting assumes the exit multiple equals the entry multiple, or lower. A model that requires expansion to clear the hurdle is really a bet on market conditions in five years.
It cuts both ways, and multiple contraction is the main reason deals underwritten in benign conditions disappoint. Holding everything else constant, an exit at 8.5x instead of 10.0x can take a 2.4x return down below 1.9x.
Where it can be argued for, the case has to be structural: a shift from a cyclical to a recurring revenue mix, from a single customer to a diversified base, or from a regional to an international footprint.
Worked example
Entry at 9.0x on 100 of EBITDA, so 900 of enterprise value, funded with 550 of debt and 350 of equity.
Exit five years later on 130 of EBITDA with 300 of debt remaining. At a flat 9.0x, enterprise value is 1,170 and equity is 870, a 2.5x return.
At 11.0x, equity is 1,130 and the return is 3.2x. At 7.5x it is 675 and the return falls to 1.9x. Nothing operational differs across the three, which is why respectable underwriting assumes a flat or lower exit multiple.