In an LBO model, which of the following would increase the IRR for the sponsor without improving the company’s performance?

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BlackTom AI · Accepted Answer

Question restatement: In an LBO model, which of the following would increase the IRR for the sponsor without improving the company’s performance?

Option 1: Improving EBITDA margin through cost-cutting.
This option improves the company’s operating performance by increasing EBITDA, which in turn raises cash flow and profitability. Since the criterion specifies not improving the company’s performance, this choice does not meet the condition. It would raise IRR by improving the business, rather than by financing structure or exit timing.

Option 2: Reducing working capital investment.
By managing working capital more efficiently, the company could free up cash, boosting free cash flow without altering underlying operations. However, this still reflects a tactical cash management improvement within the business model, which arguably changes the company’s performance profile (cash generation) rather than purely altering financing terms. Depending on interpretation, this may count as a performance change, so it’s arguable whether it truly satisfies “without improving performance.” In most LBO analyses, tighter working capital is considered a performance-driven improvement of operating efficiency.

Option 3: Increasing leverage at entry.
Using more debt at the time of the LBO increases the sponsor’s equity returns when the exit occurs, due to a higher debt burden magnifying equity cash-on-cash. This levered structure can raise IRR because equity is smaller relative to enterprise value at exit, and interest tax shields also contribute to higher cash flow to equity. Critically, this enhancement comes from financing choices rather than an improvement in the company’s operating performance, so it aligns with the goal of increasing IRR without changing operating performance.

Option 4: Move entities to different countries to reduce tax.
Shifting jurisdictions to lower taxes can reduce cash taxes and improve after-tax cash flow, potentially boosting IRR. However, such moves involve legal, regulatory, and transfer-pricing considerations and may not be feasible or permitted in all contexts. Even when possible, this is a strategic tax optimization rather than a direct operational improvement, and it can blur ethical and legal boundaries. Depending on the model, it could still count as altering after-tax cash flow without improving operating performance, but it introduces significant legal risk and complexity that many sponsors would flag as problematic or outside standard practice.

Summary: Among the options, increasing leverage at entry is the most direct way to raise IRR for the sponsor without changing the company’s operating performance, since it leverages financing structure rather than operational improvements. The other options either change the company’s performance or rely on tax/regulatory strategies with considerations beyond simple performance improvements, and in some interpretations may still involve performance-related cash effects or legal risk.

In an LBO model, which of the following would increase the IRR for the sponsor without improving the company’s performance?

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