Private Equity Recruiting

EBT

(AKA EARNINGS BEFORE TAX): EBT is EBIT less Net Interest. EBT is important only insofar as corporate taxes are calculated based on a percentage of EBT.

EBIT

(AKA OPERATING INCOME OR OPERATING PROFIT): EBIT is EBITDA less D&A. Note that some companies include D&A as part of Opex. For such companies EBIT and EBITDA essentially switch places in the income statement. In order to get to EBITDA, D&A has to be added back to EBIT. Company valuations and debt levels are frequently calculated and quoted as a multiple of its EBIT, either instead of or in addition to EBITDA multiples.

IRR Calc

(Cash Returned / Cash Invested) ^ (1/# years) -1

FCF Calculation

=EBIT(1-Tax Rate)+D&A-Capex-Changes in NWC Note: for the purposes of FCF do not subtract interest expense from EBIT. FCF is calculated on an unlevered basis (i.e. disregarding any debt or interest expense the company has). Subtract capital expenditures because these are cash expenses that are not captured on the income statement. Subtract change in working capital (this can increase FCF if change in NWC is negative) because changes in working capital can be sources or uses of cash but don't get captured on the income statement. See the NWC section for more details.

Steps for a Basic LBO

1. Lay out Assumptions 2. Sources & Uses 3. Income Statement 4. Debt and Interest 5. Returns Analysis

MOIC to IRR Conversion Grid (5 years)

1.0x MOIC || 0.00% 1.5x MOIC || 8.4% 2.0x MOIC || 14.9% 2.5x MOIC || 20.1% 3.0x MOIC || 24.6% 3.5x MOIC || 28.5% 4.0x MOIC || 32.0%

MoM Calc

= (Sum of All Net Returns / Cash Invested)

IF YOU COULD CHOOSE TWO OF THE THREE FINANCIAL STATEMENTS IN ORDER TO EVALUATE A COMPANY WHICH WOULD YOU CHOOSE AND WHY?

Choose the income statement and the balance sheet because if you have them, you can actually build the CFS yourself. Remember that cash flow is basically equal to Net Income, plus/minus non-cash items on the income statement, plus rise in liabilities on the balance sheet, minus rise in assets on the balance sheet.

Pros / Cons of Market Valuation

Pros: Market value is always up-to-date and is instantly available for public companies Market value is determined by the individual decisions of many investors so it reflects the collective work and judgment of many people. Cons: The market can be wrong ... sometimes by a lot ... if it wasn't then hedge funds and other public market investors would almost never beat the market.

Annual Management Fee

A fee that Limited Partners pay to the General Partners. Typically 2% of the total assets under management

Sovereign Wealth Fund

A government entity that invests the savings of a nation. Since it is state-owned, its investment goals may be different from those of private equity funds.

WACC

A lot can be said about WACC. However, to keep things simple, the only thing you need to understand for PE interviews is that WACC is a measure of the riskiness of investing in a company. It is used as the discount rate in the denominators of the DCF equation. The TEV of every company is made up of some percentage equity and some percentage debt. Therefore, the WACC is the sum of the cost of equity and the cost of debt, each weighted by the percentage of TEV they constitute. The only wrinkle is that interest payments on debt are tax deductible (this is referred to as an Interest Tax Shield or ITS), so the cost of debt must be adjusted by multiplying it by one minus the tax rate. The simplest way to estimate the cost of equity is to apply the CAPM model (see the section on Cost of Equity). The simplest way to estimate the cost of debt is to use the yield on the company's debt (i.e. what % interest the company pays on its debt) See our guide to calculating WACC for more details on the subject, but the quick summary is that this represents the required rate of return investors expect from the company, and thus represents its opportunity cost. Present value of the projected free cash flows and terminal value

Deferred Taxes

A non-current liability on the B/S arising from timing differences between GAAP accounting and tax accounting Note: deferred taxes can sometimes be assets as well Deferred taxes are usually an asset on the balance sheet. Therefore, when they increase, cash decreases and must be subtracted from Net Income on the CFS. When deferred taxes decrease, cash increases and must be added back to Net Income on the CFS.

NET INCOME

AKA EARNING Net Income is EBT less taxes. Net Income is meant to be the most accurate measure of a company's real profitability and is the most common basis for measuring the equity value of a company. Note that Net Income accrues only to the equity holders of a company because debt holders have already taken their pound of flesh in the form of interest.

Current Liabilities

Accounts payable, Accrued Expenses, Current / Short-Term Debt Liabilities which are set to be paid within one year

Administrative overhead

Administrative overhead is those costs not involved in the development or production of goods or services. This is essentially all overhead that is not included in manufacturing overhead. Examples of administrative overhead costs are the costs of: Front office and sales salaries, wages, and commissions Office supplies Outside legal and audit fees Administration and sales office lease Administration and sales utilities Administration and sales telephones Administration and sales travel and entertainment

LBO Model Valuation

An LBO model may be used to value both public and private companies if you can project their ability to generate free cash flow

Control Premium Fun Fact

Another way to look at control premiums is from the perspective of the sellers. A public stock has a very fragmented ownership base. Thousands or more individuals or entities may be owners of a single stock, and the top ten largest owners frequently own less than 50% of outstanding shares. In order to consummate an LBO, the buyer has to convince at least a majority of shareholders to approve the transaction. Many of these owners own the stock precisely because they think it is undervalued by the market. Such owners would not be willing to sell the stock at its market price. There are of course zero (or nearly zero) owners who would sell the stock below its trading price. Therefore, by virtue of pure math, a new buyer will need to pay more than the trading price to acquire a majority of shares.

Why would you prefer a high MoM than IRR?

Assuming the hurdle rate has been exceeded, GPs are paid carry dollars based on MoM, not IRR. If a GP buys a company for $100 and sells it for $140 one year later, that translates to a terrific 40%IRR, but the GP would earn only ~20% * $40 = $8 in carried interest. On the other hand, if a GP buys a company for $100 and sells it for $250 after four years, the IRR falls to 25% but the carried interest earned is ~20% * $150 = $30. PE firms (and by proxy their LP investors) incur transaction costs when they buy and sell companies. If a PE firm sells portfolio companies too quickly in order to juice IRR, then it has to spend more money to find and close additional deals. In addition, once a PE firm fully invests its existing fund, it must raise another fund, which also has fundraising costs associated with it.

WALK ME THROUGH AN LBO MODEL AT A HIGH LEVEL

At a high level, there are 5 steps to an LBO: Calculate the total acquisition price, including acquisition of the target's equity, repayment of any outstanding debt, and any transaction fees (such as the fees paid to investment banks and deal lawyers, accountants, consultants, etc.). Determine how that total price will be paid including: equity from the PE sponsor, roll-over equity from existing owners or managers, debt, seller financing, etc. Project the target's operating performance over ~5 years and determine how much of the debt principal used to acquire the target can be paid down using the target's FCF over that time. Project how much the target could be sold for after ~5 years in light of its projected operating performance; Subtract any remaining net debt from this total to determine projected returns for equity holders. Calculate the projected IRR and MoM return on equity based on the amount of equity originally used to acquire the target and the projected equity returns upon exit

Beta

Beta is a measure of how levered a particular stock's returns are to the diversified Market Portfolio of equities. A Beta of exactly 1 signifies the stock is exactly as risky as the diversified Market Portfolio. A Beta between 0 and 1 signifies the stock is somewhat less risky than the Market Portfolio. A Beta above 1 signifies the stock is more risky than the Market Portfolio. Common examples of stocks with low Betas are utilities and consumer staples companies because such companies produce essential goods consumers need regardless of whether the economy is doing well. Common examples of high Beta stocks include semiconductors and durable assets (like cars) because demand for them soars when the economy is doing well but plummets during recessions.

CF from Investing Activities

CAPEX Other Investing Activities

CAPITAL EXPENDITURE (CAPEX)

Capex (aka payment for PP&E) is cash spent on the acquisition of assets (usually long-term noncurrent assets) that will benefit the company in future periods. Since capex expense does not support the company's generation of sales or profits in the current period, it is not included as an expense on the current period Income Statement. However, since capex is a real cash expense in the current period, it must be treated as a use of cash on the CFS IMPORTANT: Capex does not come out of the current period Income Statement

Current Assets

Cash and cash equivalents, accounts receivable, Inventory, prepaid expenses Assets which will be economically exploited within one year

Cash from Financing Activities

Cash from Debt Cash from Equity Shareholder Dividends

NET INTEREST

Companies pay interest on their debts to others and receive interest payments on their loans to others. Net interest is simply the sum of interest payments and receipts. Interest is not counted as an operating expense (and therefore isn't taken out of EBIT) because it typically depends on how a business is capitalized rather than how inherently profitable it is. Net interest can be positive or negative, but is almost always negative for companies which become highly levered via an LBO.

Precedent Transactions

Comparable multiples can be used with precedent transactions data just as effectively as with publicly traded stock data. Companies and investors are constantly making deals to purchase either entire companies or divisions of companies. During such transactions, buyers are paying some price for assets which have certain performance characteristics (revenue, EBITDA, EBIT, earnings, etc.). When the right data is available, comparable multiples may be based just as easily on precedent transactions as on public markets trading data.

CAPM

Cost of Equity Risk Free Rate + Beta (Equity Risk Premium) The Risk Free Rate is usually equal to the yield on safe government bonds (2-4% is a safe assumption in developed markets like the US).

Accrued Expenses

Current Liability on the B/S Expenses that have been incurred, but not yet invoiced (such as accrued wages, accrued taxes, and accrued rent)

HOW WOULD YOU ESTIMATE ROUGHLY HOW MUCH DEBT CAPACITY IS AVAILABLE FOR AN LBO?

Debt capacity for an LBO is typically constrained by three primary ratios, total leverage ratio, interest coverage ratio, and minimum equity ratio. Any one of these ratios could be the governing constraint for a particular deal. To estimate debt capacity for an LBO, you could estimate debt capacity under each of those ratios and take the lowest of the three. See the Debt coverage and Leverage Ratios section for further details. Total Leverage Ratio: The most common method for estimating this ratio is Total Debt / LTM EBITDA. During normal times, Maximum Debt = ~5.0x(LTM EBITDA). During hot debt markets this ratio can go up to ~6.0x, and during cold debt markets it can fall to ~4.0x. This ratio can also be higher or lower based on the nature of the target's business. Highly cyclical or risky businesses with few tangible assets are on the lower end of the range, while stable business with a lot of tangible assets (which can be liquidated to repay debt holders in the event of default) are on the higher end of the range. Interest Coverage Ratio: The most common method for estimating this ratio is LTM EBIT / Annual Interest Expense. The floor for this ratio is usually around 1.5x. Therefore, the maximum debt this ratio will allow is roughly:

IN WHAT WAY IS DEFERRED REVENUE DIFFERENT FROM ACCOUNTS RECEIVABLE?

Deferred revenue is a liability because the company has already collected money from customers for goods or services it has not yet fully delivered. Accounts receivable is an asset because the company has delivered goods or services for customers and has not yet been paid.

Income Statement and Balance Sheet Links

Depreciation reduces Net PP&E and amortization reduces non tangible assets. More of these assets on the balance sheet usually leads to more D&A on the income statement Current and long-term debt is what generates interest expense. More debt on the balance sheet usually leads to higher net interest on the Income Statement. Net Income from the income statement is added directly to Shareholder Equity

EBITDA

EBITDA is Gross profit less Opex plus Other Income. EBITDA is critically important in PE because it is frequently a quick proxy for a company's cash generating capability. The Total Enterprise Value (TEV) of a company is frequently calculated and quotes as a multiple of EBITDA. How much debt a company could take on as part of an LBO is also commonly calculated and quoted as a multiple of its EBITDA. Note that for the purposes of EBITDA Opex must not include depreciation and amortization.

Gauging profitability

Discover the historical profit margins of industry participants and then utilize the 5-forces framework to gauge whether industry-wide profit margins are likely to shrink, grow, or remain steady. The 5-forces framework is as follows: Bargaining power of suppliers: The relative level of consolidation between industry participants and the industry's suppliers frequently determines which side is likely to capture most of the profits. If industry participants are more consolidated than the industry's suppliers that is a good sign for future profitability. If not, the reverse may be true. Bargaining power of customer: Similar logic applies as Suppliers' Bargaining power. If industry participants are more consolidated than their customers it's a good sign for profitability. Threat from new entrants: How strong are the industry's Barriers to Entry (BTEs)? Strong BTEs include essential/exclusive intellectual property, high fixed capital investment requirements, high minimum efficient scale thresholds, and high value placed on brand and existing relationships. Highly profitable industries with low BTEs are likely to lose profitability over time as new competitors pile in. Threat from substitute products: A good signal is when the industry's products or services meet essential customer needs which cannot be met other different ways. Existing competitive rivalry: It's a good sign if the existing competitors have established a pattern of competing on factors other than price and on focusing on growing the industry rather than taking market share from each other.

IF I GAVE YOU $X, HOW WOULD YOU INVEST IT?

Discuss a few of the investment options available to you State what your investment goal, risk appetite, and time horizon is Compare and contrast the risks, rewards, and time horizons of these options Pick the investment options which best fits these criteria The investments options with which I am most familiar are private equity co-invest, bonds, and equities, so I would limit my investments to those areas because I would not invest in something I do not understand well. I have a long way to go before retirement, so my main investment goal is a high rate of return. However, I would also like to purchase a home in about five years, so I will require liquidity around that time. In order to meet my goals, I would invest 10% of my assets in PE co-invest because historically it offers the highest long-run return. I would not invest more than 10% because co-invest is highly illiquid and too correlated with the fortunes of my employer. I would invest 60% of my assets in passive equities funds, split evenly between domestic and international stocks to take advantage of equity's historically solid returns while increasing diversification. I would then invest the final 30% of my assets in a low-cost medium-maturity bond fund because such bonds are relatively uncorrelated with equity investments and ensure I will be able to buy a home in five years.

TEV / EBIT

EBIT is a better metric than EBITDA when comparing companies with different levels of D&A which EBITDA doesn't capture. Different levels of D&A are commonly found in companies which have different levels of capital intensity (i.e. different levels of capital investment into PP&E).

Equity Holders

Equity holders are investors who have provided the company with cash financing in exchange for a direct ownership stake in the company. Equity holders own shares of the company and can usually vote on important matters such as who sits on the company's board and who should be the company's CEO, CFO, etc. Equity holders control the company's strategic direction and investment decisions through the people they appoint to run the company. In addition, equity holders are the direct beneficiaries of a company's net income profits. Equity holders can decide whether the company pays its net income out to them via dividends/share repurchases or re-invests its net income to grow the business and generate more net income in the future. Equity holders have a lot of control over the company and benefit from nearly all of the financial upside when the company grows.

Gauging growth rate

Estimate the industry's historical growth rate from industry reports or from the aggregate revenue growth rates of participant companies. Discover the primary drivers of historical growth (e.g. technology improvement, untapped market penetration, growing product/service adoption, price growth, etc.) from industry reports, participant's public disclosures, or calls with industry experts. Discover how growth drivers are trending and project future growth from educated assumptions about the main drivers

Terminal Value Calc

FCF (in period t+1) / (WACC - g) FCF(t+1) is your forecast for FCF one period (year) after your last year of projected DCF periods. If you made your DCF forecast for 5 years, then FCF(t+1) would be your FCF forecast for year 6. The variable g is called a perpetuity growth rate. This is the average annual rate of growth you expect the company's FCFs to achieve in the long run. Most of the time g is estimated to be something close to the long-run annual growth rate of either the company's industry or the broader economy. For mature markets like the US, 2-3% is a common range for g. If you estimate g to be significantly higher than the long-term industry or country growth rate, you should have a really good reason, because any company which forever grows faster than the broader economy would mathematically eventually take over the entire economy.

Net Property, Plants & Equipment

Factories, buildings, machines, vehicles, etc (PP&E) This is a non-current asset on the B/S

WHAT COMPANY WOULD BE A GOOD LBO CANDIDATE TODAY AND WHY?

Has a lot of stable and predictable free cash flow to pay down debt relative to how much you would have to pay to acquire it. A free cash flow yield (FCF / purchase price) of 10+% is a solid benchmark Could benefit from a strategic overhaul which would be difficult to execute as a public company Is having significant operational difficulties which would require a lot of time, patience, and capital to address Has a bad management team or governance structure which a PE firm could improve Has a lot of room to grow either organically or via acquisition if backed with enough patient long-term capital

Changes in Net Working Capital

High working capital businesses suck up cash and are less attractive to PE companies If companies have the same growth revenue, initial purchase price, companies with lower working capital are more attractive Change in NWC is simply the difference between the current period NWC and the prior period NWC. To calculate change in NWC, we usually subtract the prior fiscal year's (or quarter's) NWC from the current year's (or quarter's) NWC so the formula is: NWC (current period) - NWC (previous period)

Why would you prefer a high IRR than MoM?

IRR is the most important single metric by which many LPs judge the performance of PE firms because LPs such as pension funds and endowments need to hit certain return rate thresholds in order to meet their commitments to their constituents. An LP won't be impressed with a 2.0x MoM if it take 10 years to materialize, because the IRR on that return would be far below the LPs requirements for the PE portion of its portfolio. Funds which achieve "top quartile" IRRs usually have little trouble raising subsequent funds, whereas funds with low IRRs struggle to raise future funds. Therefore, PE funds are careful not to let IRRs drift below the level their LPs expect. Most PE funds don't get their carried interest unless their IRR exceeds a certain "hurdle rate". Hurdle rates and the mechanics of hurdle rate accounting are varied and complicated, but most funds must clear a 6-17% IRR in order to receive their full carried interest percentage. Therefore, if a fund's IRR is below or near its hurdle rate, PE funds are especially financially incentivized to boost IRR.

If NWC is positive

If change in NWC is positive it means that the company spent additional cash to fund its operations over the current period. Companies with consistently positive NWC usually need more and more cash to fund their operations as they grow, which is a drag on FCF and debt capacity.

If NWC is negative

If the change in NWC is negative it means that the operations were actually self-funding and produced excess cash in addition to the company's regular profits. Companies with consistently negative NWC, on the other hand, generate more and more cash from NWC as they grow, which is a boon to FCF and debt capacity.

Market Value Valuation

If your target is publicly traded, estimating its value is easy because the market does the work for you. The total market capitalization of a company is the market's estimate of the value of its equity. As long as the company is not in financial distress, then the face value of its long term debt less its excess cash equals the market's estimate of the value of its net debt. If you add market capitalization value to the value of net debt you will get the market's valuation of the target's TEV. These values fluctuate daily along with the target's stock price. As a general rule, the larger the company, the more heavily it is covered by stock analysts and traded by sophisticated investors. Therefore, as a general rule, larger companies are more efficiently valued by the market than are smaller companies.

Interest Tax Shield

Interest payments on debt are tax deductible (this is referred to as an Interest Tax Shield or ITS) The savings a firm gets by using debt to right off the interest expense. Since interest expense lowers the amount of income upon which taxes are paid, it is seen as a "tax shield", shielding a company from having to pay more in taxes.

HOW WOULD A $100 DECREASE IN DEPRECIATION EXPENSE ON THE INCOME STATEMENT IMPACT ALL THREE MAJOR FINANCIAL STATEMENTS?

Income Statement When depreciation decreases by $100, EBIT and EBT increase by $100. When EBT increases by $100m, net income increases by ~$60 (assuming a ~40% corporate tax rate which means an extra $40 is paid in taxes). Balance Sheet Since net income increased by $60, shareholder equity also increases by $60. Since an extra $40 is paid in cash taxes, cash decreases by $40. Since depreciation decreased by $100, net PP&E increases by $100. The balance sheet remains in balance since liabilities went up by $60 and assets went up by$60. Cash Flow Statement Net income increased by $60 which increases cash from operations, but PP&E increased by$100 which decreases cash from operations. The net impact is that cash from operations declines by $40 which happens to match both the only cash expense incurred by the drop in depreciation (taxes) as well as the drop in cash on the balance sheet.

Steps to Complete Full LBO

Lay out assumptions Sources and Uses Pro Forma B/S Income Statement Working Capital Schedule Debt and Interest Link in Completed Balance Sheet Returns Analysis Cash Flow Statement

Non-Current Liabilities

Liabilities that are scheduled to be paid after one year Long-term debt, deferred taxes, deferred (or unearned) revenue

deferred (or unearned) revenues

Liability arises when the company is paid for goods and services it has not fully delivered (i.e. 2-year magazine subscription paid upfront)

HOW WOULD YOU GAUGE A COMPANY'S COMPETITIVE POSITION?

Market share, profit margins, brand perception, product breadth and quality, management team quality Other: strong IP, low levels of customer churn, excellent physical locations, diversified customer and supplier base, diversified revenue sources, high levels of recurring revenue

OTHER INVESTING ACTIVITIES

Most CFSs break out Other Investing activities into such line items as the purchases and sales of securities, investments, and corporate divisions/entities. These items are rarely an important part of an LBO model so we won't dive deeply into them here. Just remember that when a company sells items of this nature cash from Investing Activities goes up, but when the company buys items of nature cash from Investing Activities goes down.

Comparable Multiples

Multiples are the most commonly used type of valuation (and metric) in PE. A multiple is simply the ratio of the value of a company relative to some quantitative measure of its performance. The most common multiple in PE is Total Enterprise Value (TEV) / LTM EBITDA. Investors are willing to pay higher multiples for companies which they expect will perform better in the future.

CF from Operating Activities

Net Income D&A Deferred Taxes Equity Compensation Inventories A/R A/P Deferred Revenue

Non-Current Assets

Net Property, Plants & Equipment, Net Non-Tangible Assets, Goodwill Assets which will be economically useful for more than one year

IRR

Net internal rate of return (net IRR) is a performance measurement equal to the internal rate of return after fees and carried interest are factored in. It is used in capital budgeting and portfolio management to calculate an investment's yield or overall financial quality by calculating an expected rate of return. Practically, net IRR is the rate at which the net present value of negative cash flow equals the net present value of positive cash flow. A net internal rate of return is expressed as a percentage.

Net Operating Loss (NOL)

Net operating losses ("NOL") are a tax credit created when a company's expenses exceed its revenues, generating negative taxable income as computed for tax purposes. NOL can be used to offset positive taxable income, reducing cash taxes payable. When modeling, create a tax schedule: EBT (Pre-NOL) NOL (BOP) Recognized NOL NOL (EOP) EBT (Post-NOL) Taxes

Example of a situation where you might have to choose between IRR and MoM

PE firms try to achieve high IRRs and high MoMs on deals, but sometimes tradeoff choices between these two common returns metrics do arise. For example, let's say a PE firm bought a company for $100 and, three years later, has a choice to either sell it immediately for $180 or wait another year and sell it for $200. In this scenario the PE firm would achieve a 22% IRR and a 1.8x MoM by selling after year three versus a 19% IRR and 2.0x MoM by selling after year four. This tradeoff exists because a longer hold period counts against IRR but does not count against MoM.

Paid in Capital

On the shareholders' equity of the balance sheet Paid in capital is the payments received from investors in exchange for an entity's stock. Paid in capital can involve either common stock or preferred stock. These funds only come from the sale of stock directly to investors by the issuer; it is not derived from the sale of stock on the secondary market between investors, nor from any operating activities Paid in capital is somewhat different from the term additional paid-in capital, because paid in capital includes both the par value of stock sold and the additional paid-in capital representing the price at which stock is sold above the par value. Thus, the formula for paid in capital is: Paid in capital = Par value + Additional paid in capital

OPERATING EXPENSES (AKA OPEX OR SOMETIMES SIMPLY SG&A)

Opex measures the expenses a company incurs during the income statement period but are not directly incurred in the production and/or delivery of specific goods or services. Expense categories which fall under Opex are typically those which are relatively fixed from period to period regardless of how many units of its products the company sells. Common Opex categories include administrative overhead, occupancy costs, advertising and marketing, and R&D

Employee Option

Options typically cant be exercised for 5-10 years after their grant BUT IF THERE IS A CHANGE OF CONTROL (the company is bought) they can be exercised immediately. So when you buy the Company, you need to take into account these new shares that you will have to pay the purchase price for

Other Income

Other income refers to profits the company receives from non-core operations or minority interest in other companies. Other income is rarely at issue during PE interviews. If you ever need to model it you can usually just keep it constant from period to period because it is by definition not a core part of whatever company you are looking at.

Pros / Cons of DCF

PRO: DCF is the most ground-up valuation methodology available. All other valuation methodologies rely on it either implicitly or explicitly. The market value of securities is predicated on the cash value investors expect to receive from them in the future in the form of dividends and capital gains (stock price appreciation). Multiples also implicitly rely on DCF principles. Investors are willing to pay higher multiples for companies which they expect will become more profitable in the future and lead to more dividends and capital gains. CON: Despite being theoretically sound, DCF is used less frequently in PE than multiples, LBO, and precedent transaction analysis because the assumptions which drive a DCF are very sensitive and can lead to wildly different valuations. In addition, most of the value in many DCFs lies in the TV which is frequently estimated using comparable multiples analysis anyway.

Pros / Cons of LBO Modeling

PROS: LBO models are built from the ground up and do not depend as much on trusting the wisdom of the public markets (which can be very wrong). LBO models can capture the value of optimizing a company's capital structure (often by using more debt than the public market is comfortable with) . LBO models can capture the value of operational improvements private owners could enable that would otherwise be difficult for a public company to execute CONS: LBO modeling requires making many uncertain assumptions about a company's operating and financial performance at least 3-5 years into the future. LBO modeling requires access to more data and entails a lot more work than valuations based on comparable multiples, precedent transactions, or market values

Pros / Cons of multiples Valuation

PROS: Multiples are a quick way to gauge the relative value of companies of different sizes. They scale in a way which makes it possible to glean valuation information about a company from the valuation of other companies which are both larger and smaller. Multiples are less volatile and less prone to assumption-driven swings than bottoms-up valuation methodologies such as the Discounted Cash Flow CONS: If the market's valuation of the comps is wrong, then your valuation of your target will be equally wrong. No single comp is a perfect proxy for a different target company. Finding enough solid comps to average out the idiosyncratic differences can be difficult.

Pros / Cons of Precedent Transactions Valuation

PROS: Precedent transactions include the premium buyers sometimes pay to gain control of a target in order to make operating improvements, exploit its cash generating capacity, and take advantage of any synergies. Precedent transactions data is sometimes available on private companies where public market trading information is not available CONS: Precedent transactions have all the same cons as comparable multiples. In addition, precedent transaction data is frequently sparse and spread over many years. Precedent transactions data from previous years may be less relevant if the industry has undergone significant change and/or the market has passed through various cycles.

Balance Sheet and Cash Flow Statement Links

PURPLE: Balance sheet cash is the beginning cash of one CFS period and the ending cash of another CFS period YELLOW: D&A decreases PP&E, non-tangible assets, and goodwill; capex and some other investing activities increases PP&E, non-tangible assets, and goodwill. GREEN: Increases in these assets on the balance sheet decreases cash from operating activities; decreases in these assets increase cash from operating activities. RED: Increases in these liabilities on the balance sheet increase cash from operating activities; decreases in these liabilities decrease cash from operating activities. BLUE: Increases in debt increase cash from debt, and decreases in debt reduce cash from debt; increases in cash from equity increase shareholder equity, and decreases in cash from equity reduce shareholder equity; shareholder dividends reduce shareholder equity.

Net Working Capital

Proxy for how much cash/liquidity a company needs to fund its daily business operations. The most basic formula for NWC is "current assets minus current liabilities" on the balance sheet CASH AND CASH EQUIVALENTS EXCLUDED FROM CALC NWC = Accounts Receivable + Inventory + Prepaid Expenses - Accounts Payable - Accrued Expenses It is up to your judgment to decide which current assets and liabilities to exclude from the calculation. Your guiding principle should be to ask yourself whether each particular current asset or liability is necessary for funding daily operations. Positive NWC businesses tend to be ones which have to pay cash to their suppliers faster on average than they get paid by their customers. Might need to calculate this and use inventory days, A/R days, and A/P days

WHAT ARE SOME COMMON WAYS PE FIRMS INCREASE PORTFOLIO COMPANY VALUE?

Recruit better management team and board members Provide more aligned management incentives Identify and finance new organic growth opportunities Find, finance and execute add-on acquisitions Foster stronger relationships with key customers Support better IT systems, Financial reporting and control, R&D, etc.

EQUITY COMPENSATION

Some companies pay their employees (especially senior managers) with equity such as stock options or grants instead of cash (salaries and bonuses). This form of compensation is expensed on the income statement as part of operating expenses, but no cash is actually paid during the current period, so equity compensation is added back to Net Income in the CFS

Discounted Cash Flow Valuation

The DCF model relies on two assumptions. First, the financial value of any company depends solely on what cash profits or dividends it can generate for its owners over time. This assumption implies that any two companies which will produce equivalent cash profits for their owners at all times and in all scenarios in the future must have equal financial value. Second, the value of cash profits today is different from (and almost always more than) the value of cash in the future. This assumption is made because if you have cash today you can invest it and have more cash in the future. Therefore, $100 today is worth more than $100 in the future (assuming you have investment options with positive nominal returns). For this reason, expected future cash flows in a DCF must be "discounted" to reflect the "time value of cash".

Why is the Balance Sheet inadequate by itself?

The balance sheet alone won't tell you whether the company is profitable because it is only a snapshot on a particular date. A company with few liabilities and many valuable assets could actually be losing a lot of money every year.

Why is the Cash Flow Statement inadequate by itself?

The cash flow statement won't tell you whether a company is solvent because it could have massive long-term liabilities which dwarf its cash generating capabilities. The cash flow statement won't tell you whether the company's ongoing operations are actually profitable because cash flows in any given period could look strong or weak due to timing rather than the underlying strength of the company's business.

HOW MIGHT YOU STILL CLOSE A DEAL IF YOU AND THE SELLER DISAGREE ON THE PRICE OF THE ASSET DUE TO DIFFERENT PROJECTIONS OF ITS FUTURE OPERATING PERFORMANCE?

The classic PE solution to this common problem is called an "Earn-out". Sellers are frequently more optimistic about the future performance of a business than PE investors are willing to underwrite. In such cases either party may propose that the sellers are paid a portion of the total acquisition price up-front, while a portion is held back (frequently in an escrow account) until the business' actual future performance is determined. If the business performs like the seller expects then the seller is paid the remainder of the purchase price some months or years after the close of the deal. If the business under-performs the seller's expectations then the buyer keeps some or all of the Earn-out money. This type of structure is a common way of bridging valuation gaps between buyers and sellers.

HOW WOULD YOU CALCULATE CHANGE IN NET WORKING CAPITAL (NWC)?

The classic formula for NWC is current assets (excluding cash) less current liabilities. For a lot of businesses, it is sufficient to define NWC as: NWC = Accounts Receivable + Inventory-Accounts Payable. Change in NWC is simply the difference between NWC in the current period less NWC during the previous period

Levered versus Unlevered Free Cash Flow

The difference between levered and unlevered free cash flow is expenses. Levered cash flow is the amount of cash a business has after it has met its financial obligations. Unlevered free cash flow is the money the business has before paying its financial obligations. Operating expenses and interest payments are examples of financial obligations that are paid from levered free cash flow. The difference between the levered and unlevered cash flow is also an important indicator. The difference shows how many financial obligations the business has and if the business is overextended or operating with a healthy amount of debt. It is possible for a business to have a negative levered cash flow if its expenses are more than what the company earned. This is not an ideal situation, but as long as it's a temporary issue, investors should not be too rattled.

WHAT MIGHT CAUSE TWO COMPANIES WITH IDENTICAL FINANCIAL STATEMENTS TO BE VALUED DIFFERENTLY?

The financial statements do a good job of describing a company's historical performance, but they do not necessarily tell us everything we need to know about a company's future performance. Since the value of a company depends primarily on its expected future performance, the financial statements are insufficient. Some important things financial statements don't tell us include, but are not limited to: The future growth of the company's industry The company's competitive position including share, relationships, patents, etc. The reputation and capabilities of the company's management team The quality of the company's future strategy

Why is the Income Statement inadequate by itself?

The income statement alone won't tell you whether a company generates enough cash to stay afloat or whether it is solvent. You need the balance sheet to tell you whether the company can meet its future liabilities, and you need the cash flow statement to ensure it is generating enough cash to fund its operations and growth.

Money Market

The money market is the trade in short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by individual investors and money market accounts opened by bank customers. This is typically encompassed in cash and cash equivalents on the B/S

Income Statement and Cash Flow Statement Links

The only major direct connections between the income statement and the cash flow statement are that the Net Income and the D&A portions of the Cash from Operating Activities come from the income statement. The rest of the connections between the income statement and the balance sheet go through the balance sheet.

WACC Formula

WACC = (Market Cap of Equity / TEV)*(Cost of Equity from CAPM) + (Face Value of Debt / TEV)*(Yield on Debt)*(1-Tax Rate)

What is an important question to ask when LBO modeling?

What the debt paydown policy will be for the company What the minimum cash is on the business

WHY DOES PE GENERATE HIGHER RETURNS THAN PUBLIC MARKETS?

The short answer is that PE LPs demand higher returns than public market investors which causes PE investors to price their deals to an IRR of 20% or higher. PE LPs demand these high returns for two main reasons: LBOs are highly levered thus making PE investments riskier than public stocks. PE investments are much less liquid than public stocks; it can take up to ten years to realize returns.

WHY DOES PE USE LEVERAGE? OR HOW DOES LEVERAGE INCREASE PE RETURNS?

The short answer is that PE returns are calculated based on return on their invested equity. Using leverage to do deals allows you to use less equity which means the ultimate returns are larger in comparison to the amount of equity initially invested. Another way to look at it is that the cost of leverage (debt) is lower than the cost of equity because equity is priced to an IRR of 20%+, whereas the annual interest expense on debt is usually below 10%. Yet another way to look at it is using a lot of debt makes the return on equity much more volatile and much riskier because the debt must be repaid before the equity gets any return. The high returns on PE equity may be seen as the fair return associated with the extra risk associated with high leverage.

IF YOU HAD TO VALUE A COMPANY BASED ON A SINGLE NUMBER FROM ITS FINANCIAL STATEMENTS, WHAT WOULD THAT NUMBER BE?

The single most important value determinant for most companies is its Free Cash Flow (FCF) because FCF is how owners pay themselves dividends and pay down debt. If you could know a second fact about the company before estimating its value you would want to know how quickly its FCF is growing.

Gauging stability

The stability and predictability of an industry is usually easy to gauge by determining its growth drivers and examining its performance over a few business cycles. If the growth drivers depend on entrenched secular trends (e.g. the healthcare industry in a country with a demographically aging population) then the industry will be more predictable than one which depends on taste/trends/fads (e.g. fashion brands). If the products the industry produces are "must haves" for customers (e.g. electricity or food staples), then the industry will be more resistant to recessions than an industry which produces luxuries (e.g. cruise lines or expensive cars). If the products the industry produces are commoditized, then its fortunes tend to oscillate with the business cycles of its customers (e.g. mining or semiconductors), whereas industries with strong intellectual capital/differentiation tend to be less cyclical (e.g. enterprise software or medical devices).

HOW WOULD YOU GAUGE HOW ATTRACTIVE AN INDUSTRY IS?

The three most important measures of an industry's attractiveness are its growth rate, stability, and profitability. The most attractive industries are predictable/stable, high growth, and high profitability. However, keep in mind that attractive companies can exist in unattractive industries if they have a strong competitive advantage. For example, the airline industry is low growth, cyclical, and unprofitable, but Southwest Airlines has been successful for many decades due to their differentiated business model. Even unattractive companies in unattractive industries might sometimes make good investments if you can buy them at the right price and/or remedy some of what ails them.

HOW WOULD YOU DETERMINE AN APPROPRIATE EXIT MULTIPLE ON A PE DEAL?

There are a few common way to do this. See the sections Comparable Multiples, Precedent Transactions, and LBO Model. Comparable multiples analysis will tell you what multiples similar public companies are trading for on the stock market. Precedent transactions will tell you what the multiples were on deals involving similar targets. An LBO analysis (in this case referred to as a Next Financial Buyer analysis) will tell you what multiple a financial sponsor would be willing to pay in the future.

Why are investors willing to pay an acquisition premium?

There are several reasons why investors might be willing to pay acquisition premiums: Some buyers, especially strategic buyers, expect to realize synergies with the acquired asset which makes the asset more valuable to the acquirer than to previous shareholders. Majority control of a company allows the new owners to choose how to spend the company's capital, including how and when to take dividends or exit the investment. Unlike public shareholders, PE owners have a great deal of influence over how and when they will get cash out of their investment. Buyers of public assets frequently believe that the company will be worth more under their control than its public valuation. They believe they can add value by getting better management, setting a better strategic direction, fixing operating problems, etc. Majority control is what gives buyers the power to execute such plans.

WHICH VALUATION TECHNIQUES USUALLY PRODUCE THE HIGHEST VS. LOWEST VALUES? WHY

There is a great deal of variability among the outcomes of different valuation techniques for different industries and companies. Some banker interview guides state that there is a commonly accepted order of valuations with precedent transactions at the top and market valuation at the bottom. However, the reality is that it is difficult to predict which techniques will yield higher or lower valuations. The most I would say is as follows: The cost of PE equity is higher than nearly any other form of capital, so in an efficient market, PE-backed LBO valuations should tend to be on the lower side on average. Of course there are times when this is not the case, especially when a company is under-levered or poorly managed. Precedent transactions tend to be on the higher side, especially when the buyer is "strategic" because such buyers frequently pay both a control premium and a synergy premium. Public comps / market valuations tend to be roughly in the middle of the pack depending on whether the market is hot or cold. DCF analyses are also middle of the pack on average, but there is a wild variability in DCF analyses on both the high side and the low side because DCF analyses are extremely sensitive to input assumptions.

WHICH INDUSTRY WOULD YOU INVEST IN AND WHY?

This is another common way to ask the previous question about how attractive an industry is. The trick to this question is that it's not simply about identifying a good industry, but rather is about identifying an industry which is improving. If an industry is already high-growth and profitable, the valuations of acquisition targets are also likely sky high. Investing is about buying undervalued assets rather than simply good assets. If you identify a bad/mediocre industry which is about to improve, you could probably find a lot of undervalued acquisition targets in it. Therefore, look for industries which are experiencing some of the following: Acceleration in the long term A shift in the competitive rivalry A shift in the supply chain dynamics Barriers to entry increasing Threats from substitutes declining

TEV / Revenue

This metric is used for companies which aren't profitable or have highly cyclical levels of profitability (such as commodity businesses).

Price / Earnings (aka P/E Ratio)

This metric typically equals the market value (market capitalization) of the equity of a publically traded company over its LTM Net Income. This is the most common valuation multiple for publically traded stocks. Keep in mind that this metric applies only to the equity value of the company rather than its TEV. This is because net income belongs to a company's equity holders since debt holders are paid interest before any money flows to equity holders.

WHAT ARE SOME COMMON AREAS OF DUE DILIGENCE?

This question may be asked broadly as above, or it may be asked specifically about a particular deal (e.g. what would you most want to diligence before buying company X?) See the section Common Diligence Topics. If the question is asked broadly, you can describe the high level categories (commercial, valuation, accounting, and legal) and give a few examples from each category. If the question is asked about a specific company, you will need to use your best judgment to decide which issues from the common diligence topics section (in addition to any personal experience you have) are most relevant

Net Non-Tangible Assets

Trademarks, copyrights, patents, etc. (Net of accumulated amortization) This is a non-current asset on the B/S

Treasury Method

Under an assumption called "the treasury method", you assume that you use the cash proceeds from option exercise to repurchase shares. The treasury stock method assumes that acquirers will use option proceeds to buy back exercised options at the offered share price. New shares = common shares + in the money option - (options x strike/offered price) Example: So while initially you have 382 million FD shares, you take the $200 million in proceeds from the option exercise, and repurchase shares at the offer price ($23 per share). This results in a repurchase of $200 / 23 = 8.7 million shares. 382 - 8.7 gets us to the 373.3 fully diluted shares amount above

WHAT IS AN ACQUISITION / CONTROL PREMIUM AND WHY IS IT PAID?

When a PE buyer (or any investor) acquires a majority share of a publicly traded company, it nearly always pays more per share than the company was trading at prior to acquisition. The percentage by which the acquisition price per share exceeds the pre-acquisition trading price per share is called a control premium (aka acquisition premium). The trading price per share prior to acquisition is commonly calculated as a 30 to 90-day trailing Volume Weighted Average Price (VWAP) prior to the day news of the pending acquisition becomed public. For example, if the 30-day VWAP of a stock is $20 on the day an acquisition is announced for $25 per share, then the acquisition premium is$25/$20-1 = 25%. The size of control premiums varies, but they are usually between 10% and 50%.

When calculating management options at close, how do you treat a dividend recap?

You need to subtract the proceeds from the dividend recap from the equity value at closing of the buyout

Goodwill

difference between the total price a company paid to buy another company and the market value of the identifiable net assets it acquired. Equal to the sum of: purchase of equity, plus transaction fees, less book equity, plus existing goodwill, less intangibles write-up