PE Study

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?

"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.

We have evaluated and would like to acquire a public company. The company is trading at $10 per share and has a total of 100 million diluted shares outstanding. We have negotiated a 20 percent purchase premium. The company has an LTM EBITDA of $50 million, $100 million of net debt outstanding. We will also assume $50 million of transaction fees. The net debt cannot carry over. What are the total uses of funds?

$1,350 million. The purchase price is $10 × (1 + 20%) × 100 = $1,200,000,000. Because this is a public company, we need to be responsible for the net debt. It is stated that the net debt cannot carry over to the acquirer (us), so we need to pay it down. So we add the additional $100 in net debt plus the $50 million in transaction fees to get to a purchase price of $1,350 million.

We have evaluated and would like to acquire a private business, so we look to public comparable companies (if they exist) to assess a proper value. We assume the comparable company analysis results in a range of 5.0x to 6.0x EBITDA. The company has an LTM EBITDA of $10 million and $5MM of net debt outstanding. If we assume $1 million of transaction fees and a 5.5x EBITDA purchase price, what are the total uses of funds?

$56MM. The purchase price is 5.5 × $10. Since this is based on an EBITDA multiple, this already includes the value of the net debt, so we do not add the $5 million of debt to this. We do, however, add $1 million in transaction fees to get to total uses of $56 million.

In the cash flow statement, increases in assets are treated as? Decreases in assets treated as?

+ in assets = outflow in CFS - in assets = inflow in CFS

WHAT ARE SOME COMMON WAYS PE FIRMS INCREASE PORTFOLIO COMPANY VALUE

- Recruit better management and board members - Provide more aligned management incentives (usually via stock option pool) - Identify and finance new organic growth opportunities (new geographies, new product lines, adjacent market verticals, etc.) - Find, finance, and execute add-on acquisitions -Foster stronger relationships with key customers, suppliers, and Wall Street - Support investment in better IT systems, financial reporting and control, research & development, etc.

If you could choose 2 of the 3 financial statements in order to evaluate a company, which would you choose and why?

- choose the income statement and balance sheet because if you have them you can build the CFS yourself. (CFS = Net Income, plus/minus non-cash items on the income statements, plus rise in liabilities in the B/S, minus rise in assets on B/S)

WHEN CALCULATING ENTERPRISE VALUE, DO YOU USE THE BOOK VALUE OR THE MARKET VALUE OF EQUITY?

-Technically, you should use the market value of both debt and equity, so as to estimate the true value based on supply and demand. - In practice however, you normally use the market value of only the equity because, if a company is publicly traded, this is a very easy value to come up with simply by looking up a company's market cap.

Name three core components that contribute to the success of a leveraged buyout.

1. Cash availability, interest, and debt pay-down 2. Operation (EBITDA) improvements 3. Multiple expansion

Steps for DCF

1. Forecast unlevered free cash flow (to get operating value of company only) 2. Calculate a terminal value = lump sum value of the business past forecasts period 3. Discount the cash flows to the present at the weighted Average cost of capital 4. Add the value of non operating assets to the unlevered free cash flow (cash, investments, etc) 5. Subtract debt and other non equity claims 6. Divide the equity value by shares outstanding Point of DCF is to get you enterprise value of firm! Want to get the value to shareholders

Trends for PE in 2020

1. GPs will hold assets longer (on average in the last 10 years, companies are holding assets longer) 2. new megafunds will arise, fundraising $342B last year, 2020 is probably a year of deployment 3. asset class will fare better in 2020. Although IRRs have fallen in last twelve months ~9%, given the high returns of stocks in 2019 and given that these are very not likely to repeat, PE is posed to fare much better

Name four major components of purchase price over book value.

1. Goodwill 2. New intangible assets 3. Asset step-up 4. Deferred tax adjustments

You have $1 of revenue. How does it flow through the financial statements. Ask me any questions you need to answer this

1. Income Statement: $1 captured in revenue and would flow through COGS, and tax expenses in the Income Statement. (Q - what is the cost structure of the company? What % of sales is COGS? What is tax rate? are operating expenses all fixed for the company or are any variable expenses? ). Assume 30% COGS. Assume 20% tax rate. assume opex expenses are fixed. The $1 becomes $0.70 of Gross Profit. From there, the $1 is taxed at 20% so Net Income will be $0.6 (taxes ~ 0.14) 2. Cash Flow Statement Net Income is incremental 0.6. The incremental revenue could impact your working capital needs. Assuming it does, it could impact your inventory change (if you order more/less inventory to meet an inventory turnover ratio), accounts receivable (Q - is revenue paid in cash or accounts receivable?). Might impact days payable outstanding if you're projecting your DPO to COGS and/or if you change your inventory levels and pay suppliers credit .Changes would all be reflected in your cash flow from operations. so cash balance increases by 0.6 (only this if no impact to working capital, if there is then the final cash balance will be less). (Q - Does the company decide to change any of their financing strategies, dividend / capex, etc.? based on incremental revenue?) assuming no, then just flow through direct with incremental $0.60 in cash 3. Balance Sheet Cash increases by 0.6, in assets and in retained earnings assets also increase by 0.6 (assuming no other changes in working capital or financing strategies).

Name the core uses of funds categories.

1. Purchase price 2. Net debt 3. Transaction fees

What are the major variables to an LBO analysis? Name at least four.

1. Purchase price 2. Sources of cash 3. Interest rate 4. Time frame 5. Operations performance (EBITDA projections) 6. Cash flow (UFCF projections) 7. Exit multiple

WALK ME THROUGH THE PE INVESTMENT PROCESS

1. Source Deal (timing varies) 2. Review teaser and sign NDA to get full CIM (2-3 days) 3. Diligence Phase I: Review CIM and Submit IOI (1-2 weeks) 4. Diligence Phase II: Data Room Review and "Triage" Dilligence - this is when fuller LBO is created, IC probably sees deal for the first time (2 - 4 weeks) 5. Diligence Phase 3: Deep diligence and proffer of an LOI (2 - 4weeks) - team shifts to full on diligence mode 6. Closing (4 - 12 weeks)

4. What are some characteristics of a company that make a good LBO candidate?

1. Steady cash flows 2. Opportunities for earnings growth or cost reductions 3. A high asset base —collateral to raise more debt

HOW WOULD YOU GAUGE HOW ATTRACTIVE AN INDUSTRY IS?

1. growth rate = <3 high 2. stability = <3 stable/ predictable 3. profitability = <3 high 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). 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. 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.

What are the three drivers of levered free cash flow?

1. operating performance (revenues - costs + non cash expenses mix impact LFCF) 2. capital intensity (capex, change in NWC) - positive change in NWC = usually means higher LCFC for business 3. capital structure (debt, interest expense, tax shield) for unlevered free cash flow, drivers 1 + 2 are the same. the last driver is tax only though

What types of debt do you use in LBO?

1st = leveraged loans, 2nd = bonds, 3rd= mezzanine 1. Leveraged loans = term loans and revolver. Have strict covenants (financial or operational) or restrictions. Covenants can be maintenanced based (always enforced) or incurrence (in case of bankruptcy) Term loan= secured (1st/2nd lien), floating interest rate, short-term payback, prepaid with no penalty. Term loan + letter (A,B,C,D) where letter determines seniority. (tLA = short loan, senior) Revolver = line of credit, can be securitized against working capital like inventory or accounts receivable) 2. Bonds = normally unsecured, generally have longer term and higher cost and can't be paid back early 3. Mezzanine = hybrid equity financing

What are the steps to a DCF?

1st step: project a company's FCF for ~5 years forward 2nd step: calculate an appropriate discount rate for the profits projected in the first step, the most common method is calculated the WACC 3rd step - project the target's terminal value after the last year of projected FCF 4th step: is to discount the value of all future cash flows back to the present to calculate the present total value of the enterprise (formula is present TEV = sum of FCF all years / (1 + WACC) compounded to number of years)

COC to IRR conversion (5 year hold period)

1x = 0% 2x = 15% 3x = 25% 4x = 32% 5x = 38% 6x = 43% 7x = 48% 8x = 52%

What are the common ways of valuing a company and what are the pros and cons?

5 most common ways to value a company: i) comparable multiples, ii) precedent transactions, iii) market value, iv) LBO model, v)Discounted Cash Flow i) comparable multiples - pros: quick way to compare relative value of companies of different sizes. they scale in a way that makes it possible to glean valuation information about a company from the valuation of other companies which are both larger and smaller. less volative and less prone to assumption driven swings than bottoms up valuation methods as DCF cons: if market valuation is wrong, then your valuation of target will be wrong (e.g., if overpay this is bad). no single comp is a perfect proxy for a company ii) precedent transactions - similar to comp multiples but used for prior M&A transactions. Pros: include premium buyers sometimes pay to gain control of target. data sometimes available on private companies where public market trading information is not available cons: if wrong/overvalued, you will have wrong data set too. no single comp is a perfect proxy. precedent transaction data is sparse and spread over many years and valuations change all the time iii)market value - when public company can see the total market cap of the company to estimate the value of equity. plus net debt = TEV. Pros: market value is always up to date and instantly available for public companies. market value is determined by the individual decisions of many investors so it reflects collective work and judgment of many people. cons: market can be wrong... by a lot iv) LBO model: can be used to value both public and private companies if you can profect their abilitiy to generate free cash flow. Pros: built bottoms up, and do not depend as much on trusting the wisdom of public markets, can capture the value of optimizing a company's capital structure (often by using more debt than public market is comfortable with), can capture the value of operational improvements private owners could enable that would otherwise be difficult for a public company to execute cons: require many uncertain assumptions about a company's operating and financial performance at least 3-5 years in future, requires accesss to more data and entails a lot more work than valuations based on comparable multiples, precedent transactions, or market values v) DCF - DCF relies on 2 assumptions i) the financail value of the company depends solely on what cash profits or dividends it can generate for its owners over time, ii) value of cash profits today is different from the value of the cash in the future. pros: dcf is the most bottoms up valuation methodology available. all other valuation methodologies rely on it either implicitly or explicitly. multiples also impliclity rely on DCF principles cons: despite being theoretically sound, DCF is used less frequently than multiples in private equity. this is because the assumptions which drive a DCF are very sensitive and can lead to wildly different valuations. vi) sum of the parts- if the target is made up of distinct and separable divisions, than you can perform any valuation method on individual divisions and add them together. this method is applied if a partial or total break-up of the target is being contemplated. pros: can capture the value of breaking the business apart either partially or entirely cons: breaking up a business will cost and how resultant pieces are likely to perform can be hard to estimate

You are asked to value a company with three metrics. Which ones would you ask for?

5 year Revenue CAGR(%), LTM EBITDA($) and cash conversion(%). From there you can ball park an internal rate of return (IRR) in Excel. Example 3: Revenue CAGR; LTM EBITDA; and cash conversion ratio (cash flows / net profits - for LFCF. KNow that UFCF / EBITDA would not work because you need the FCFE rate) Compound Annaul Growth Rate - you can calculate the business projections for 5 years. Use LTM EBITDA and CAGR to get to ballpark transaction value (applying some regular multiple for revenenue size). Grow LTM EBITDA in time period. and use the cash conversion to determine the FCF and do a quick IRR. FCF conversion rate can also be a proxy for capital intensity of a business. Summary Estimate deal size based on EBITDA x purchase multiple (informed by CAGR) Ball park FCF generation over the next 5 years by applying cash conversion % to EBITDA and growth that FCF by CAGR each year.

How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?

A $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT(1-T) by $10(1-T). Assuming a 40% tax rate, it drops EBIT(1-T) by $6, but you must add back the $10 depreciation in the calculation of Free Cash Flow. Therefore your FCF increases by $4 and your valuation will increase by the present value of that $4,

What is a deferred tax asset? How is a deferred tax asset most commonly created?

A deferred tax asset is defined as an asset on a company's balance sheet that may be used to reduce income tax expense. A deferred tax asset is most commonly created after receiving a certain type of net operating loss (NOL) resulting in a carryover.

What is a deferred tax liability? How is a deferred tax liability most commonly created?

A deferred tax liability is caused by temporary accounting differences between the income statement filed for GAAP purposes and the income statement for tax purposes. One common cause of a deferred tax liability is by a differing method of depreciation in a GAAP income statement versus that in a tax income statement. A company can produce a GAAP set of financials using straight-line depreciation, for example, yet have a tax set of financials using the MACRS method of depreciation. This causes a deferred tax liability, reducing taxes in the short term.

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

A lot of variability in question but generally (higher - lowest): i) precedent transactions, ii) public comps/market valuation or DCF, iii) LBO (assuming cheap financing to sponsors). 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.

WALK ME THROUGH AN LBO MODEL AT A HIGH LEVEL

At a high level, there are 5 steps to an LBO: 1) 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.). 2) 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. 3) 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. 4) 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. 5) 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

What happens if you increase bad debt/ amortization expense? What is impact in financial statements?

Bad debt expense typically accounted for in SGA. So increasing bad debt would be like increasing expenses in the opex section of the financial statement. 1. Income statement: opex increases, EBIT decreases, EBIT margin decreases. Income taxes decrease by tax rate amount of the bad debt expense $ amount. This reduces total net income by the expense - tax amount When the period includes a bad debt write off, however, the Income statement does include the Bad debt expense balance as a line item. Items of this kind appear typically under "Operating expenses," below the Gross profit line. As a result, Bad debt expense from a write off lowers Operating profit and bottom line Net income. 2. Cash flow statement: net income reduced by the same amount. also, the company can have a Bad debt expense also appears as a non-cash expense item on the Cash flow statement). Bad debt expense from a write off is subtracted from Sales Revenues, lowering Total Sources of Cash. 3. Balance sheet: - cash is reduced by the $ amount of the final ending cash balance change - A bad debt write-off adds to the Balance sheet account, Allowance for doubtful accounts. And this, in turn, is subtracted from the Balance sheet Current assets category Accounts receivable. The result appears as Net Accounts receivable. The write off, in other words, means that Net Accounts receivable is less than Accounts receivable. - finally, retained earnings are lowered as net income is impacted by the write off expense.

HOW COULD A COMPANY HAVE POSITIVE EBITDA AND STILL GO BANKRUPT?

Bankruptcy occurs when a company can't make its interest or debt payments. Since EBITDA is Earnings BEFORE Interest, if a required interest payment exceeds a company's EBITDA, then if they have insufficient cash on hand, they would soon default on their debt and could eventually need bankruptcy protection.

Levered free cash flow calculation (Basic and complete).

Basic = Net Income + D&A -/+ change in NWC - capex More complete = cash flow from operations (recall it has net income! and NWC changes ) - capex - acquisitions (if relevant part of the business strategy)

WHEN LOOKING AT THE ACQUISITION OF A COMPANY, DO YOU LOOK AT EQUITY VALUE OR ENTERPRISE VALUE?

Because the acquiring company must purchase both liabilities and equity in order to take over the business, the buyer will need to assess the company's Enterprise Value, which includes both the debt and the equity.

4. What is the formula for cash from operating activities?

Cash from Operating Activities = Net Income + Depreciation + Deferred Taxes + Other Noncash Items + Changes in Working Capital.

If Company A has revenue stream of $100, $50, $100, $100, $100 and company B has revenue stream of $100, $98, $96, $94, $92 which one is riskier? Why?

Company A riskier becauase 1 year volality vs. company b seems to be steadily on decline

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

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.

WHAT ARE SOME DIFFERENT TYPES OF DEBT COVENANTS AND WHAT ARE THEY USED FOR?

Debt covenants are contractual agreements between lenders and borrowers (such as companies which have been bought via an LBO) that give lenders certain rights to help protect their investment. Maintenance covenants require the borrower to maintain a certain equity cushion or debt service coverage cushion to maintain their ability to repay its debt. Incurrence covenants prevent the borrower from taking certain actions which could be detrimental to existing lenders such as taking on more debt or paying out cash dividends to equity holders. Strict covenants can make an investment much riskier to a PE investor because a default on a covenant can result in the loss of the entire equity investment even if the portfolio company remains solvent. See the section on covenants for details.

Why might two companies with identical growth and cost of capital trade at different P/E multiples?

Different growth profiles, one uses operating vs. capital lease, one is an industry leader and deserves higher multiple Growth and cost of capital are not the only drivers of value. Another critical component is return on invested capital. All else equal, if one of the companies has a higher return on equity, you would expect its PE ratio to be higher. Other reasons may include relative mispricing or inconsistent calculations of EPS due to things like nonrecurring items and different accounting assumptions.

Why might two companies in the same industry have the same EBITDA and revenues but different multiples?

Different return on invested capital? different efficiency in how it uses it assets/ different working capital strategies

EBITDA vs Cash Flow From Operations vs Free Cash Flow

EBITDA is often used as a proxy for cash flows, but many investment banking analysts and associates struggle to fully grasp the differences between EBITDA, cash from operations, free cash flows and other profitability metrics. Here, we will address these differences and show examples of how each should be used in valuation. Cash from operations (CFO) as a measure of profitability First, let's look at cash from operations (CFO). The main advantage of CFO is that it tells you exactly how much cash a company generated from operating activities during a period. Starting with net income, it adds back noncash items like D&A and captures changes from working capital. CFO is an extremely important metric, so much so that you might ask "What's the point of even looking at accounting profits (like Net Income or EBIT, or to some extent EBITDA) in the first place?" We wrote an article about this here, but to summarize: Accounting profits are an important complement to cash flows. Imagine if you only looked at cash from operations for Boeing after it secured a major contract with an airliner. While its CFO may be very low as it ramps up working capital investments, its operating profits show a much more accurate picture of profitability (since the accrual method used for calculating net income matches revenues with costs). Since accrual accounting depends on management's judgement and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. Of course, we should not rely solely on accrual based accounting either and must always have a handle on cash flows. Since accrual accounting depends on management's judgement and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. Two identical companies can have very different income statements if the two companies make different (often arbitrary) deprecation assumptions, revenue recognition and other assumptions. So, the benefit of CFO is that it's objective. It's harder to manipulate CFO than accounting profits (although not impossible since companies still have some leeway in whether they classify certain items as investing, financing or operating activities, thereby opening the door for messing with CFO). The flip-side of that coin is CFO's primary downside: You don't get an accurate picture of ongoing profitability. Free cash flows vs operating cash flows Now let's talk about the other cash flow metric you were asked to compare — free cash flows. FCF actually has two popular definitions: FCF to the firm (FCFF): EBIT*(1-t)+D&A +/- WC changes - Capital expenditures FCF to equity (FCFE): Net income + D&A +/- WC changes - Capital expenditures +/- inflows/outflows from debt Let's discuss FCFF, since that's the one investment bankers use most often (unless it is a FIG banker, in which case he/she will be more familiar with FCFE). FCFF adjusts CFO to exclude any cash outflows from interest expense. It ignores the tax benefit of interest expense and subtracts capital expenditures from CFO. This is the cash flow figure used to calculate cash flows in a DCF. It represents cash during a given period available for distribution to all providers of capital. The advantage of FCFF over CFO is that it identifies how much cash the company can distribute to providers of capital regardless of the company's capital structure. The advantage over CFO is that it accounts for required investments in the business such as capex (which CFO ignores). It also takes the perspective of all providers of capital instead of just equity owners. In other words, it identifies how much cash the company can distribute to providers of capital regardless of the company's capital structure. EBITDA (vs CFO and FCF) EBITDA, for better or for worse, is a mixture of CFO, FCF and accrual accounting. First, let's get the definition right. Many companies and industries have their own convention for calculating of EBITDA, (they may exclude nonrecurring items, stock based compensation, non cash items (other than D&A) and rent expense. For our purposes, let's assume we're just talking about EBIT + D&A

Why do we care about EBITDA?

EBITDA, for better or for worse, is a mixture of CFO, FCF and accrual accounting. First, let's get the definition right. Many companies and industries have their own convention for calculating of EBITDA, (they may exclude nonrecurring items, stock based compensation, non cash items (other than D&A) and rent expense. For our purposes, let's assume we're just talking about EBIT + D&A. Now let's discuss the pros and cons. 1. EBITDA takes an enterprise perspective (whereas net income, like CFO, is an equity measure of profit because payments to lenders have been partially accounted for via interest expense). This is beneficial because investors comparing companies and performance over time are interested in operating performance of the enterprise irrespective of its capital structure. 2. EBITDA is a hybrid accounting/cash flow metric because it starts with EBIT — which represents accounting operating profit, but then makes one non-cash adjustment (D&A) but ignores other adjustments you'd typically see on CFO such as changes in working capital. See how Constant Contact's (CTCT) calculates its EBITDA and compare to its CFO and FCF The bottom line result is that you have a metric that somewhat shows you accounting profits (with the benefit of it showing you ongoing profitability and the cost of being manipulatable) but at the same time adjusts for one major non-cash item (D&A), which gets you a bit closer to actual cash. So, it tries to get you the best of both worlds (the flip-side is it retains the problems of both as well). Perhaps the biggest advantage of EBITDA might very well be that it is used widely and it is easy to calculate. Case in point: Say you are comparing EBITDAs for two identical capital-intensive businesses. By adding back D&A, EBITDA prevents different useful life estimates from affecting the comparison. On the other hand, any differences in revenue recognition assumptions by management will still skew the picture. Where EBITDA also falls short (compared to FCF) is that if one of two capital-intensive businesses are investing heavily in new capital expenditures that are expected to generate higher future ROICs (and thus justify higher current valuations), EBITDA, which does not subtract capital expenditures, completely ignores that. Thus, you may be left incorrectly assuming that the higher ROIC company is overvalued. 3. EBITDA is easy to calculate: Perhaps the biggest advantage of EBITDA might very well be that it is used widely and it is easy to calculate. Take operating profit (reported on the income statement) and add back D&A and you have your EBITDA. Furthermore, when comparing forecasts for EBITDA, CFO, FCF (as opposed to calculating historical or LTM figures), both CFO and FCF requires an analyst to make far more explicit assumptions about line items that are challenging to predict accurately, like deferred taxes, working capital, etc. 4. EBITDA is used everywhere from valuation multiples to formulating covenants in credit agreements, so it is the de facto metric in many instances for better or for worse.

Where is depreciation found in the income statement?

Either in COGS if related to direct selling expense or in SGA if related to a non direct expense (eg computer systems for non tech company)

WHAT IS THE DIFFERENCE BETWEEN ENTERPRISE VALUE AND EQUITY VALUE?

Equity Value represents residual value for common shareholders after the company satisfies its outstanding obligations (net debt, preferred stock, which is senior to common equity).

What is the difference between enterprise and equity value?

Equity value = value of the business to the owners. Equity value is the amount you would get to put in your pocket if you sold your lemonade stand. Recall in LBO you get the equity value for your assumptions with purchase price * shares. Enterprise value = explicitly value the enterprise. Enterprise value is the value of operations (not just equity)

WHAT IS FREE CASH FLOW, HOW DO YOU CALCULATE IT, AND WHY DOES IT MATTER IN AN LBO?

FCF is a measure of how much money is available to investors through the operations of the business after accounting for eexpenses like taxes, operational expenses and capital expenditures. FCF can be levered and unlevered. Unlevered FCF is used to calculate the enterprise value = the value of the whole firm available to both debt and equity invetors. FCFF = EBIT *(1-tax rate) + D&A - change in NWC - capex Levered FCF = cash flow available to just equity investors, or cash flow available after firm has met its financial obligations. here you are calculating the value of equity FCFE = Net income (already has interest expense) + D&A - change in NWC- capex - mandatory dept repayments

How do you value NOLs?

Generally you value it separately from the operations of the firm. So you would look at your projections, and offset taxable income from your projections with the NOL balance. Do this until the NOL has run out, and then discount the tax savings to PV. Again, discount rate differs depending on who you ask, but you could argue Cost of Equity as the discount rate since the NOL savings offset taxable income, which is after interest in the payment priority (i.e. tax savings flow directly to equity holders).

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

Does mid year convention result in a lower or higher valuation?

Higher valuation, since you now assume cash flows come 6 months into the year instead of 12 (so cash flows coming sooner means less discounting).

WHICH INDUSTRY WOULD YOU INVEST IN AND WHY?

Identify 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 long-term growth: Driven by new technology, an inflection point in adoption, changing consumer preferences, etc. A shift in competitive rivalry: E.g. competitors are beginning to compete on brand, quality, service, technology, etc. instead of price. E.g. a major competitor is exiting the industry. A shift in supply chain dynamics: E.g. the industry is consolidating. This could lead to both add-on acquisition opportunities as well as better bargaining power relative to suppliers and customers. Barriers to entry increasing: E.g. patents, proprietary technology, brand, minimum efficient scale, etc. are becoming more important Threat from substitutes declining: E.g. the products and services the industry provides are becoming more unique and essential to customers.

What is PIK?

In Debt financing can have instruments that allow companies to not pay back interest right away. PIK can charge interested (higher charge) when debt is due // student loans

How would you evaluate the buy vs. rent decision in NYC?

In order to do a proper comparison, let's assume that I have enough upfront capital to make a down-payment, otherwise obviously I have to rent. Let's also assume the investment period is 10 years. Assuming I buy, during this investment period I have to pay monthly mortgage, real estate tax and maintenance fees (which will be offset by some tax deductions on interest and depreciation). I assume I'll be able to sell the property at a price that probably reflects the historical growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow due to a sale, I can calculate my IRR. I would then compare this IRR against the IRR from renting as follows: First, I would estimate the rental cost of a comparable property, factoring in rent escalations over a 10-year period. In addition, since I don't have an initial down-payment to make, I would put that money to work elsewhere - say as a passive investment in the stock 39 | P a g e market. I would assume an annual return over the 10-year period consistent with the historical long-term return on the stock market (5-7%). I would then be able to calculate an IRR based on these inflows and outflows and compare the IRRs and make a decision. Of course, I would keep in mind that this comparison isn't perfectly apples to apples. For example, investing in a NYC property is riskier than investing in the stock market due to the leverage and the lower liquidity. NYC real estate is liquid but not as liquid as public stocks. For example, if I get two identical IRRs, I would probably go with renting, since it wouldn't appear that I'm being compensated for the added risk.

Why is each of the 3 financial statements by itself inadequate for evaluating a company?

Income Statement - wont tell you alone whether a company generates enough cash to stay afloat or whether it is solvent. you need the B/S to tell you whether the company can meet its future liabilities and the CFS to see if it is generating enough cash to fund operations and growth Balance Sheet -B/S alone wont tell you whether a company is profitable because it is only a snapshot on a particular date.. a companny with few liabilities and many assets could be losing a lot of money every year CFS - wont tell whether a company is solvent because it could have a massive long term liabilities dwawwrfing its ability to make cash each year - CFS wont tell you whether ongoing operations of the business are actually profitable

If accounts receivable increases by $15, please explain the effects on the income statement, cash flow statement, and balance sheet.

Income Statement a. Revenue increases by $15. b. Taxes (assume 40 percent) are $6. c. Net income increases by $9. Cash Flow Statement a. Net income increases by $9. b. Accounts receivable decreases by $15. c. Total cash decreases by $6. Balance Sheet a. Total cash decreases by $6. b. Accounts receivable increases by $15. c. Retained earnings increases by $9.

If accrued expenses increases by $10, please explain the effects on the income statement, cash flow statement, and balance sheet. Assume accrued expenses are related to SG&A.

Income Statement a. SG&A increases by $10. b. Taxes (assume 40 percent) are $4. c. Net income decreases by $6. Cash Flow Statement a. Net income decreases by $6. b. Accrued expenses increases by $10. c. Total cash increases by $4. Balance Sheet a. Total cash increases by $4. b. Accrued expenses increases by $10. c. Retained earnings decreases by $6.

How does a PIK security affect the 3 financial statements? Do a walk through of the effect on all financial statements if you had $100M in PIK debt with 4% interest rate.

Income Statement: Interest expense must be recorded (regardless of the fact that it is not being paid out in cash - interest expense up $4 More interest expense results in a income tax shield of 1.6 dollars assuming a 40% tax rate. This results in a tax expense that is lower by $1.6 Net Income is down by $2.4 Statement of Cash Flows Net Income is down by $2.4 from the income statement PIK interest is then added back as it is not a cash expense (paid out in the form of additional debt) Net Cash is up by $1.6 Balance Sheet Assets side of the balance sheet is up by $1.6 due to the cash flowing in from the statement of cash flows Liabilities side of the balance sheet is up by $4 assuming that there is additional debt principal issued for the interest payment Shareholder's Equity is down by $2.4 flowing in from net income on the income statement

How would $10 decrease in depreciation expense effect the financial statements?

Income Statement: $10 decrease in depreciation expense would reduce expenses by $10, operating income increases by $10 Earnings before taxes increases by $10 but taxes are impacted (assume ~40% tax rate ), you pay $4 (10*(1-.40%) in taxes extra. Thus net income increases by $6 only Cash Flow Statement - Net income increased by $6 and cash from operations increased by $6 - but as depreciation is non-cash item, you will decrease the depreciation by $10 because you add back depreciation ->thus, ending cash is decreased by $4 from the $6 net income increase and $10 depreciation decrease Balance Sheet Statement - cash decreases by 4% - PPE increases by $10 because of depreciation - overall assets increase by $6

levered free cash flow drives equity value. Why?

LCFC cash can be used for: 1. repayment of debt 2. putting cash in bank account 3. giving $ to shareholders all three options increase equity value due to effect on enterprise value

What's the difference when valuing a liquidating/ distressed company?

Like FIG you pay more attention to the book value of a company versus the market value

HOW WOULD YOU GAUGE A COMPANY'S COMPETITIVE POSITION?

Market share: High market share relative to competitors is usually a sign of competitive strength. Firms with higher market share are more likely to enjoy brand awareness, close relationships with key customers/suppliers, economies of scale, etc. Recent share trends also matter. Companies which are gaining share tend to be better positioned competitively. Profit margins: High profit margins (such as Gross Margin, EBIT Margin, Net Income %, etc.) are frequently a sign of competitive strength. Companies with higher margins are usually more cost efficient and/or able to charge premium prices due to a superior product offering. Recent expansion of margins is also frequently a positive signal. Brand perception: Brand awareness can be a very important competitive strength indicator, especially for consumer-facing businesses. Equally important is how customers perceive the brand when they are aware of it. The best signal of competitive strength is high unaided customer awareness, associations with positive attributes customers care about most, and a high willingness to recommend the brand to friends and family. Product breadth and quality: In many industries it is important for competitors to carry a full line-up of products that can meet all or most of customers' needs. For example, a farm equipment manufacturer should probably manufacture not only tractors, but also tillers, harvesters, and many other things a farm equipment wholesaler/retailer is likely to carry. It is equally important, of course, that the products and services a company offers are well designed, well manufactured, and highly regarded by customers. Management team quality: A bad management team can ruin the best business. A good management team can sometimes work miracles. Assessing management team strength is highly subjective, but it's something PE professionals spend a lot of time discussing. Other signs of competitive strength: Lowest-cost product / service delivery model Strong intellectual property (IP) such as patents Low levels of customer "churn" (customers rarely stop being customers) Excellent physical locations (important for retail companies) Diversified customer and supplier base Diversified revenue sources High levels of recurring revenue

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

NWC = current assets (excluding cash) - 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 - NWC during the previous period.

What is Cash On Cash (CoC) or multiple of inveated capital (MOIC)?

Non time based metric (timing in cash flows wont impact) Cash generated (sell price) / cash invested ( purchase price)

Is EBITDA a good proxy for cash flow?

Not really. That's because even though EBITDA does add back D&A - typically the largest non-cash expense - it does not capture any working capital changes during the period. It also doesn't capture cash outflows from taxes or interest payments. Those adjustments would need to be made to get to operating cash flows. EBITDA also doesn't capture stock-based compensation (SBC) expenses required to get to operating cash flows (although an increasingly used "adjusted EBITDA" calculation does add back SBC).

Enterprise value =

Operating assets - operating liabilities + net debt = equity value (direct method of getting enterprise value) Equity value + net debt = enterprise value (indirect method of getting enterprise value)

WHAT IS OPERATING LEVERAGE?

Operating leverage is the percentage of costs that are fixed versus variable. A company whose costs are mostly fixed has a high level of operating leverage. If a company has a high level of operating leverage, it means that much of any increase in revenue will fall straight to the bottom line in the form of profit, because the incremental cost of producing another unit is so low. Operating leverage is the relationship between a company's fixed and variable costs. A company with more fixed costs has a higher level of operating leverage. While a company with a high degree of operating leverage will have a higher earnings growth potential than a company with a largely variable cost structure, certain financial institutions will prefer to lend to businesses with a variable cost structure to help mitigate their downside risk - the financial institution is comforted by the fact that the company they are lending to still has the ability to cut back on some of their expenses should they see an economic downturn approaching or other signs of a decrease in financial performance. Equity investors are the investors that benefit the most from earnings growth potential, and as such will prefer to invest in companies with a higher degree of operating leverage.

WOULD YOU RATHER ACHIEVE A HIGH IRR OR A HIGH MOM ON A DEAL? WHAT ARETHE TRADEOFFS? WHAT FACTORS MIGHT INFLUENCE YOUR ANSWER?

PE firms try to achieve high IRRs and high MoMs on deals, but sometimes tradeoff choices between these two common returns metrics do arise. Two common reasons to prefer a higher IRR are: 1. 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. 2. 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. Two common reasons to prefer a higher MoM are: 1. 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. 2. 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. As you can see, the choice between MoM and IRR can be complicated and involves several considerations. As a general rule PE firms prefer to hold on to portfolio companies and grow MoM as long as the annual rate of return the portfolio companies are generating meets or exceeds the rate expected by the PE firm's LPs.

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

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.

WHAT IS THE DIFFERENCE BETWEEN ACCOUNTS PAYABLE AND PREPAID EXPENSES?

Prepaid expenses have been paid and the product/service will be expensed in income statement as they occur. Accoutns payable are liabilities for good/services not received or recognized but not yet paid for in cash.

How would you value a private equity firm?

Private equity firms generate two types of cash flows: management fees and performance fees. Each have different risk profiles and thus merit a sum of the parts approach. 46 | P a g e The first type of cash flow, and the easiest to model, is related to management fees. Private equity firms charge management fees of 1-2% on total capital raised. The most common valuation approach for this is to apply a market multiple to the current or next year forecast for management fees. The second cash flow comes from the far more difficult to predict performance fees. Private equity firms charge 15-20% of the returns on the investments (portfolio companies) they manage. Since these fees are realized when sponsors exit their investments, they are lumpy and difficult to forecast. The investments themselves are illiquid, highly leveraged and thus highly sensitive to future market conditions. Thus, the typical approach here is to also apply a multiple on these cash flows, but a much lower multiple than that applied to management fees.

What is retained earnings?

RE = prior period RE (net worth) + net income - dividends

A company has $100 million of EBITDA. It grows to $150 million in five years. Each year you paid down $20 million of debt. Let's say you bought the company for 6.0x and sold it for 7.0x. How much equity value did you create? How much is attributed to each strategy of creating equity value?

Remember, the three ways value is created are (1) EBITDA growth, (2) debt paydown, and (3) multiple expansion. The purchase price is $600 million = $100 million * 6.0x. The exit value is $1,050 million = $150 million × 7.0x. This is a profit of $450 million, plus you paid down debt of $100 million = $20 × 5, so your total equity value increased by $550 million ($450 million + $100 million). $100 million of the total equity value is of course due to debt paydown. The EBITDA growth value is determined by assuming a 6.0x exit (no multiple expansion). So, 6.0 × $150, or $900 less the $600 is the value increase based on EBITDA growth, or $300 million. The remaining is based on multiple expansion. So (7.0x - 6.0x) × $150 million or $150 is the value based on the multiple expansion. $150 + $100 + $300 = $550.

Would you rather increase revenues by $100M or reduce costs by $100M? Why? Would it matter if it were fixed or variable?

Revenue because there could be more implications on what could be done/ could mean improve commercial operations. historically PE has done cust cutting but part of value add now revolves top line growth, driving improved EBITDA multiple expansion. if $100M costs reduction in variable, this will move parallel to revenue trends either way.

Guidelines for Approaching an Investment Case

Review the market at a high level Use Porter's Five Forces - to determine competitiveness / attractiveness of industry Bargaining power of suppliers Bargaining power of buyers Threat of substitutes Who are major competitors? Threat of new entrants Industry rivalry Discuss revenue drivers Price / volume Volatility / seasonality Revenue quality (e.g. recurring revenue) Are there long-term contracts in place so you have revenue visibility, or do these contracts renew at will / annually? If you don't have this information, say you'll review it during further diligence Customer concentration: What % of total revenue is made up by 1, 3, 5 customers? What is the history of turnover, if any, for major customers (only works for enterprise clients, consumer businesses may have same store sales) Discuss cost drivers Fixed vs. variable What direction are the top 2-3 costs headed? Increasing / decreasing, why? Get to EBITDA margins, trends Discuss capex / change in WC / cap. software / other capitalized costs Get to FCF, trends Compare entry vs. exit multiples Understand leverage / debt paydown Understand returns at high level. Do simple paper LBO model Note: Think of walking through a case as discussing levers of LBO model

How are PE return requirements different from what you would require from the S&P? What was the S&P return for the past 10 years? What commands the premium that you expect PE to have over the S&P?

S&P return = ~10% in last 10 years. So a PE return of ~15% - 25% is much better than the S&P. Remember that for an investor like PE, the cost of capital is = to the required return.

What's the difference between WACC and IRR?

The IRR is the discount rate on a stream of cash flows that leads to a net present value of 0. The WACC (or cost of capital) is the minimum required internal rate of return for both debt and equity providers of capital. Thus an IRR that exceeds the WACC is often used as criteria for deciding whether a project should be pursued.

Which is the better investment opportunity based on this information? Assume everything about the companies is the same except for what is given in the information, and assume the exit multiple is the same as the entrance multiple. Company A: EBITDA: $100 million Projected annual revenue growth: 5 percent for the next five years Purchase price: 6x EBITDA/5x Debt Company B: EBITDA: $100 million Projected annual revenue growth: 10 percent for the next five years Purchase price: 7x EBITDA/5x Debt

The answer is Company B. Hint: If you do not have access to a calculator to compound the interest, you can ignore compounding. You will still be able to get an understanding of what the potential investment opportunity is. So, assuming constant EBITDA margins, EBITDA for Company A in year 5 will be about $125 million = $100 million * [1 + (5% * 5 )], and Company B will be $150 million = $100 million * [1 + (10% * 5 )]. If the purchase price was 6x EBITDA for Company A, and 5x of that was leverage, then 1x EBITDA was the equity invested. So $100 million (1 × $100 million) was the equity invested in Company A, and $125 million (1 × $125 million) was the expected equity returned in Company A. The equity investment in Company B is 2x EBITDA. So, $200 million (2 × $200 million) was the equity invested in Company B, and $300 million (2 × $150 million) was the expected equity returned in Company B. So the expected return in Company A is 125/100 or 1.25x versus 300/200 or 1.50x. Since both companies are raising the same amount of debt, we don't really need to factor this into the equation. Actually, since Company B is more profitable, it is most likely the case that they will produce more cash and pay down more debt, thus making the Company B investment even more profitable.

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

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." - 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

If you have two companies that are exactly the same in terms of revenue, growth, risk, etc. but one is private and one is public, which company's shares would be higher priced?

The public company will most likely be priced higher due to the liquidity premium one would pay to be able to quickly and easily buy and sell the shares in the public capital markets. Another reason the public should be priced higher would be the transparency the firm is required to have in order to be listed on a public exchange. Publicly traded companies are required to file their financial statements, allowing investors to view them. The public company will likely be priced higher for a few reasons. The main reason is the liquidity premium an investor would be willing to pay for the ability to quickly and easily trade their stock on the public exchanges. A second reason would be a sort of "transparency premium" an investor would pay since the public company is required to file their financial documents publicly

How many years would it take to double a $100,000 investment at a 9% annual return (no calculator)?

The rule of 72 says that in order to figure out how long it would take to double an investment, divide 72 by the investment's annual return. In this case, the rule of 72 suggests that it would take approximately 72/9 = 8 years.

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: i) LBOs are highly levered thus making PE investments riskier than public stocks. ii) PE investments are much less liquid than public stocks; it can take up to ten years to realize returns.

WHAT CONSTITUTES A GOOD LBO TARGET?

They key is price. Almost any target would make a good buyout candidate at a low enough price. Is there any company you wouldn't buy for a dollar? I caveat my answers to questions like these by asserting that "deals which check all the boxes are usually very expensive" and "all problems may be overcome with price."

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

Three ratios to determine: 1. total leverage ratio, 2. interest coverage ratio, 3. minimum equity ratio. would estimate debt capacity under each ratio and take the lowest of the three. 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: The blended interest rate depends on prevailing interest rates and how the overall LBO debt package is structured, but roughly 8-9% is a safe assumption. Minimum Equity Ratio: Long gone are the days when PE firms could routinely buy targets for 5-10% Equity and 90-95% debt as a percentage of the total acquisition price. These days lenders demand that about 20-30% of the total acquisition price be equity. As such, you could estimate: maximum debt =0.75 (total acquisition price)

What is IRR?

Time based metric Discount rate that makes the sum of future cash flows = 0

What is the difference between APV and WACC?

WACC incorporates effect of interest tax shields into the discount rate o Typically calculated from actual data from balance sheets and used for a company with a consistent capital structure over the period of the valuation APV adds present value of financing effects to NPV assuming all-equity value o Useful where costs of financing are complex and if capital structure is changing o Use for Leveraged Buyouts

What is WACC and why matters for PE?

WACC used in DCF but matters because determines the cost of financing for candidate (especially important for LBO candidates) WACC = Rd * (1 - tax rate) * (D/D+E) + Re * (E/D+E) Rd= rate of debt Re = rate of equity

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%. 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. 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.

Whats another (tax advantage) of funding a deal with debt?

You get tax savings given intereet in debt is tax deductible. Can get up to 30% EBIT tax or EBITDA based on tax advantage)

Would you rather have an extra dollar of debt paydown or an extra dollar of EBITDA?

You would rather have the extra dollar of EBITDA because of the multiple. At exit, the sale price is dependent on the EBITDA times the exit multiple. So, an extra dollar of debt paydown increases your equity value by only one dollar; an extra dollar of EBITDA is multiplied by the exit multiple.

What would you prefer to see driving a company's top line growth? An increase in the price of the product or an increase in the volume sold?

aking price without a steep volume decline is indicative of a strong brand. Price elasticity is the way to monitor this (e.g. if we raise price 1%, we lose 1% volume, 2%, etc). However, if the ultimate goal is profitability and generating cash flow, you can cut price and see an uptick in volume, but you may be squeezing margins too much. an increase in volume correlates to an increase in market share, which is a half truth - an increase in volume (at a rate higher than competition/the category) correlates to an increase in volume share, but not necessarily value share. Companies also monitor value share, so you need to specific what type of share you're referring to. Most companies try to grow at least in line with the category, both in volume and value share, but would prefer value as $$$ beats units. You can pull either volume lever or price lever, taking into account customer/consumer needs, COGS inflation or deflation, supply-chain issues, etc. If a company raises prices, but still remains in-line with competition and the category as a whole in volume, that would be considered a significant win. If a company cuts price and sees a volume uptick, that's "expected". If they cut price and don't see a significant volume upswing (to the tune of generating volumetric driven cash flow increases) then that's considered a big loss and you're damaging a) your ability to take pricing in the future and b) pricing power of the category as a whole. This might sound simplistic, but volume is only lucrative if you make money (e.g. generate enough efficiencies to stabilize profitability per unit, then the sheer volume of units outshining what would've been pulling the pricing lever).

6 key drivers to determine the succes of a deal:

buy the company for less than you sell it = MULTIPLE EXPANSION raise a lot of cheap debt to fund the deal = RAISE CHEAP DEBT (USES), low leverage profile pay down the debt = (cash flow generating, steady business) Ability to improve the company's finances (top and bottom lines) = improve busoness Ability to manage the company without additional significant investment =no capex, good mgmt Ability to sell the company within 3-5 years

What is the cash conversion cycle? what is cash conversion?

cash convesion = measure of how long it takes a company to convert initial investment in working capital to subsequent cash collection. cash conversion cycle = Amount of time it takes to receive a cash inflow (Customers) after making a cash outflow (Vendors) Inventory Conversion Period + Receivables Collection Period - Payables Deferral Period : Cash Conversion Cycle (Inventory Really (-Pays) Cash)

In what way is deferred revenue different from accounts receivable?

deferred revenue = liability because the company has already collected money from customers for goods/services it has not fully delivered. accounts receivable = asset because the company has delivered goods or services for customers and has not yet paid

What is enterprise value? What is equity value? Differences in calculations

enterprise value = transaction value = Enterprise value = equity value (market cap or shares purchased * offer price) + debt - cash equity value = purchase price = enterprise value / transaction value - debt + cash

WOULD YOU BE CALCULATING ENTERPRISE VALUE OR EQUITY VALUE WHEN USING A MULTIPLE BASED ON FREE CASH FLOW OR EBITDA?

enterprise value = value to all investors (debt and equity holders) EBITDA and free cash flow represent cash flows that are available to repay holders of a company's debt and equity, so a multiple based on one of those two metrics would describe the value of the firm to all investors. A multiple such as P/E ratio, based on earnings alone, represents the amount available to common shareholders after all expenses are paid, so if you used this multiple, you would be calculating the value of the firm's equity

How does the P/E ratio change when a firm moves from pure equity to equity/debt structure?

explain that there are a variety of moving pieces but that all else being equal the P/E multiple will rise because of the effect of additional interest expense. The Leverage Impact on the P/E Ratio When considering the impact that issuing additional debt will have on the multiple - you should consider the numerator and the denominator separately. Looking first at the denominator - earnings will be directly impacted as this is net income or EPS from the income statement. Therefore, with additional debt, the company will be paying additional interest which will lower the earnings of the company. A lower denominator will result in a higher P/E multiple. However, in an ambiguous prompt such as this we don't know what the debt is being used for. If debt is issued to make an investment that could increase earnings - the earnings could actually grow result in in a higher P/E multiple. As mentioned above, this debt could go to a variety of different projects which will impact the P/E ratio in different ways: Make a strategic investment - example: Amazon buys Whole Foods with debt Repurchase shares - example: Coco-Cola buys back stock with debt Fund current operations in a difficult environment - example: Sears issues to debt to stay in business Potentially sit on the balance sheet or pay back existing debt (i.e. refinance) The first three scenarios would be a boost for investor's sentiment regarding the company which could increase the share price and therefore increase the P/E multiple. Making strategic investment - could have a positive impact on sentiment for the company and will also increase the EPS of the business (in most scenarios) Share repurchases - if a company repurchased shares that would also lower the share count and therefore increase the EPS and lower the P/E of the company Issue debt to fund operations - keep business afloat which creates positive price sentiment In all of these scenarios the earnings will be lowered by interest expense but may be increased depending on what the debt is being used for. With all this in mind, it is impossible to say whether the P/E multiple will go up or down

what might cause 2 companies with identical financial statements to be valued differently?

future prospects of the company may be different than the financial statements tell us. the value of the company depends on the expected future performance, this financial statements alone are insufficient to value a company. examples of potential differences include: - 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 do you think PE target returns are what they are?

given the level of risk required, given what LPs demand and require based on other asset classes. on average industry requires ~22% IRR or roughly ~3X MOIC

WHAT ARE SOME COMMON AREAS OF DUE DILIGENCE?

high level categories include commercial, valuation, accounting and legal.

Explain comparable multiples valuation method

most common valuation method, as a multiple is simply a ratio of the value of teh company relative to some quantitative measure of its performance. Most common multiple is TEV/LTM EBITDA. investors willing to pay higher for company expected to perform better in teh future (e.g., stronger competitive position). you use multiples by grouping compaies which have similar charectiristics. good comps are competitors or companies in the same industry, companies that perform similar functions, or those that have similar profile to target.

Do you add Net Debt in the uses when purchasing a company off stock price? What about in private company when purchasing off EBITDA multiple?

public company = purchase equity = ADD NET DEBT When purchasing off EBITDA multiple = private company = DO NOT ADD NET DEBT

In M&A context, TEV = ? and equity value =?

total enterprise value = transaction value of an M&A deal (including any cash needs at close and debt repayments) equity value = purchase price