Why do we not assume any exit multiple expansion in most LBO models?

It is more common for PE firms to increase returns by growing EBITDA, using more debt, or paying back debt. Typically, the exit multiple is assumed to be the same or lower than the entry multiple in order to be conservative. In order to justify increasing the relative valuation of a company, the PE firm would have to fundamentally and permanently improve the prospects of that company. This could include improving the long-term cost structure of the company and its margins, pivoting the company to a more attractive strategy and increasing the long-term revenue growth rate, or executing a turnaround on a struggling or distressed company.

However, most PE firms prefer to buy companies with stable and recurring cash flows in defensible markets while making small to moderate improvements in the company’s operations rather than relying on the necessity of executing large improvements. These small to moderate improvements, all things being equal, might justify a slight increase in the exit multiple, but this lift is often offset by increased market saturation as there is less white space to expand into as the company grows its market share. In fact, it is more common for PE firms to assume a contraction rather than an expansion in exit multiple relative to the entry multiple, especially for growth equity targets where declining growth rates are a feature of the transition from rapid growth to maturity.