Private Equity

What makes an ideal LBO candidate? Provide 4 factors

- Price is the most important factor because almost any deal can work at the right price - but if the price is too high, the chances of failure increase substantially. - Stable and predictable cash flows are important, - There shouldn't be a huge need for ongoing CapEx or other big investments - There should be a realistic path to exit, with returns driven by EBITDA growth and Debt paydown instead of multiple expansion.

What are 7 ways PE firms can improve portfolio company operations?

1. Improve Management :There is some evidence that PE firms are willing to give management a larger share of equity upside which may allow PE firms to attract more talented management. 2. Optimizing Incentives: Some companies have poorly aligned incentives. Perhaps top management needs more equity upside to take advantage of their entrepreneurial capabilities. Perhaps the sales force needs to be compensated based on the profits rather than the revenue their accounts generate. Perhaps separate divisions need to be given reasons to cooperate rather than protect their own fiefdoms. 3. Funding and Supporting Accretive M&A: Commonly referred to as the "roll-up" strategy. There are many highly fragmented industries out there which are ripe for consolidation. Some PE companies buy one of the leading competitors which they see as a "scalable platform" and then help it to buy and integrate several smaller rivals. This strategy creates value in a couple of ways. First, truly scalable businesses realize synergies when they merge and become more profitable together. Second, larger companies with higher market share are generally seen as stronger and more stable competitors that should trade at higher multiples. For this reason, "tuck-in" acquisitions can frequently be done at multiples which are lower than that of the "platform" business, a phenomenon known as "multiple arbitrage". 4. Cut Costs: Public companies and family-owned businesses are sometimes unwilling or unable to cut costs which are economically suboptimal or outright wasteful. PE firms are generally less skittish about cutting overheads, extravagant perks, and redundancies. 5. Restructure or Turn Around Business: Some businesses require difficult long term changes to re-position them in changing markets. Such restructurings frequently require short-term pain, investment, and patience to realize long-term success. PE is uniquely positioned to support such restructurings because its investment horizon can be several years or longer and it does not have to keep up with the quarterly public markets earnings treadmill. 6. Professionalizing a small or family business: Many middle market PE firms add value simply by purchasing under managed family businesses or small companies who are looking to grow to the next stage and introducing standard business practices. We're talking about "Management 101" stuff here such as investing in IT systems, standardizing accounting practices, creating talent management systems, introducing activity-based costing, optimizing pricing, etc. The trading multiple of a business can go up by quite a bit simply by bringing the business up to professional standards. 7. Driving Synergy between Portfolio Companies: Some PE firms with large portfolios have been able to drive value by getting their portfolio companies to collaborate. For example, some of the mega funds have recently started an initiative to consolidate the massive combined purchasing power of the companies they control. In this manner they have been able to decrease the costs of some of the common goods and services their portfolios companies buy. Another example is when a PE firm buys a company which is a natural customer of or supplier to other existing portfolio companies. The PE firm can facilitate these companies coming together (where it makes economic and strategic sense of course) in order to make one or both better off.

Free Cash Flow: what does it determine in Private Equity? What does FCF actually do and how does each stakeholder get paid out?

FCF is the lifeblood on an LBO because FCF determines how much debt a company can service which then determines how much leverage an LBO can use. The conceptual explanation of FCF is that it is the total amount of cash profits that a company can pay out to its owners, be they equity holders or debt holders. Equity holders are generally paid with dividends, whereas debt holders generally get interest payments. The fastest way to calc FCF = EBIT * (1 - Tax Rate) + D&A - CapEx - Change in NWC

WHAT CONSTITUTES A GOOD LBO TARGET?

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What is IRR formula for a single return cash-flow? What is the MoM formula?

For example, let's say a PE firm invested $1 million in a deal and realized a return of $3 million after five years. Its IRR would be (3/1) ^ (1/5)-1 = 24.6% MoM is very easy to calculate = (Sum of all Net Returns) / (Cash invested)

HOW DO YOU GAUGE INDUSTRY GROWTH RATES

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.

WOULD YOU RATHER ACHIEVE A HIGH IRR OR A HIGH MOM ON A DEAL? WHAT ARE THE 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. 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. 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.

WALK ME THROUGH THE PE INVESTMENT PROCESS

See the sections Deal process, Deal Selection, and Deal Funnel. Walk the interviewer through the process from sourcing to closing at a high level in ~2 minutes. No need to touch on every detail. If the interviewer wants more details he/she will ask

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

What's been the most disappointing thing you've experienced in your career so far?

This is a very nice way of asking if you've learned from your mistakes. Nobody's going to get it right all the time, and they're going to want to know how you deal with adversity. Now, if your actions directly resulted in torpedoing a billion-dollar M&A deal ... perhaps you may not want to mention that! But be prepared to talk about a project or deal that didn't go as planned. Don't blame others too much, either. Take responsibility for your part and explain how you've changed your approach since. Come off as having learned something from the experience.

What are you most proud of in your career to date?

This is another opportunity to talk about things you've done to help create value. It can be an investment you identified or a trend you spotted, or any of the things mentioned above. But make it a good one, and make it relevant to the private equity firm's goals.

Walk me through the steps in an IPO?

6 - 12 months before: - Finalize preparation of historical interim and annual financial information (consider translation of financial information if filing in Quebec). - Make necessary changes to the executive board and begin recruiting additional board members. - Start building financial model and business plan. - Meet with stock exchange representatives and discuss the transaction with the relevant stock exchange. - Consider investor relations strategy and equity story. - Implement financial reporting procedures and controls. - Agree on draft timetable. 1.5 - 6 months before: -Finalize timetable. - Consider adequacy of working capital and use of proceeds. - Produce draft prospectus and other documents and ensure compliance with all reporting requirements. - Do initial review of pricing issues. - Review public relations presentations. - Begin initial marketing. - Commission expert reports, if required. - Appoint non-executive directors. - Eliminate dealbreakers and resolve any potential litigation or due diligence issues. - Prepare roadshow presentations to targeted potential investors. 0 - 1.5 months before - Begin formal marketing. - Price and allocate the offering. - File the preliminary prospectus. - Have underwriter perform marketing of securities ("book building"). - Admission to stock exchange is granted and trading commences after receipt of the final prospectus

WACC: - What do you need to know for PE interviews? - One wrinkle in the WACC formula? - What is the WACC formula

A lot can be said about WACC. For PE interviews you just need to know 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. One wrinke: 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. 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). The WACC formula = (Market Cap. Equity / TEV)*(Cost of Equity from CAPM) + (face value of debt / TEV)*(Yield on debt)*(1 - Tax Rate)

WHICH INDUSTRY WOULD YOU INVEST IN AND WHY?

Another common way to ask 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 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 do you think is going to happen to LBOs/M&A/private equity in the coming months and years?

As we've discussed already, the private equity industry is going through a difficult transition period. You need to be up to speed on the state of major deals out there, financing, future growth, fund raising, the whole thing. Don't be surprised if a piece in The Wall Street Journal or The Daily Deal from that very morning is mentioned, and be prepared to respond to it. Naturally, areasonably bullish outlook for the industry is likely an asset—why else are you applying?—but don't sugarcoat it, either. Talk about the challenges facing the industry in a reasonable way, how the industry might overcome them, and why you ultimately think the industry will continue to grow and prosper.

Define: - Sharpe Ratio - Sortino Ratio What's the difference? Whats a good ratio value?

Both allow you to determine if a portfolio's returns are due to smart investing, or just a higher level or risk. Sharpe Ratio - A risk adjusted measure of portfolio return, to evaluate a portfolio's performance Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return Sharpe penalizes both upside & downside volatility Sortino - A risk adjusted measure of portfolio return, that uses only returns that fall below a minimally accepted target (bad risk) Sortion only penalizes upside volatility For both: a ratio of 1 is good, 2 is better, and 3 is amazing

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 noncash items on the income statement, plus rise in liabilities on the balance sheet, minus rise in assets on the balance sheet.

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 • 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: = LTM EBIT / (1.5 * BlendedInterestRate) 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 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.

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.

HOW DO YOU GAUGE INDUSTRY PROFITABILITY

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: 1 • 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. 2 • 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. 3 • 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. 4 • 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. 5 • 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.

HOW DO YOU GAUGE INDUSTRY STABILITY

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).

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

How much value PE firms actually add is an open question, but the following methods are frequently mentioned: • 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 I GAVE YOU $X, HOW WOULD YOU INVEST IT?

I usually answer this question by following these steps: • 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-investment, 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.

Why does an LBO work? Walk me through the steps

In an LBO, a PE firm acquires a company using a combination of Debt and Equity, operates it for several years, and then sells it; the math works because leverage amplifies returns; the PE firm earns a higher return if the deal does well because it uses less of its own money upfront. Assumptions for PDIR Sources & Uses Adjust the BS Financial Projections / Levered CF / Debt Schedule Exit assumptions Step 1: Make assumptions for the Purchase Price, Debt and Equity, Interest Rate on Debt, and Revenue Growth and Margins. Step 2: Create a Sources & Uses schedule to calculate the Investor Equity paid by the PE firm. Step 3: Adjust the Balance Sheet for the effects of the deal, such as the new Debt, Equity, and Goodwill. Step 4: You project the company's statements, or at least its cash flow, and determine how much Debt it repays each year. Step 5: You make assumptions about the exit, usually using an EBITDA multiple, and calculate the MoM multiple and IRR.

TELL ME WHY EACH OF THE FINANCIAL STATEMENTS BY ITSELF IS INADEQUATE FOR EVALUATING A COMPANY?

Income Statement • 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. Balance Sheet • 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. Cash Flow Statement • 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.

You buy a $100 EBITDA business for a 10x multiple, and you believe that you can sell it again in 5 years for 10x EBITDA. You use 5x Debt / EBITDA to fund the deal, and the company repays 50% of that Debt over 5 years, generating no extra Cash. How much EBITDA growth do you need to realize a 20% IRR?

Initial Investor Equity = $100 * 10 * 50% = $500 20% IRR Over 5 Years = ~2.5x multiple (2x = ~15% and 3x = ~25%) Exit Equity Proceeds = $500 * 2.5 = $1,250 Remaining Debt = $250, so Exit Enterprise Value = $1,500 Required EBITDA = $150, since $1,500 / 10 = $150

A PE firm acquires a $100 million EBITDA company for a 10x multiple using 60% Debt. The company's EBITDA grows to $150 million by Year 5, but the exit multiple drops to 9x. The company repays $250 million of Debt and generates no extra Cash. What's the IRR?

Initial Investor Equity = $100 million * 10 * 40% = $400 million Exit Enterprise Value = $150 million * 9 = $1,350 million Debt Remaining Upon Exit = $600 million - $250 million = $350 million Exit Equity Proceeds = $1,350 million - $350 million = $1 billion IRR: 2.5x multiple over 5 years; 2x = 15% and 3x = 25%, so it's ~20%.

Cost of Equity - What is CAPM - CAPM Formula - What are each components of the CAPM formula and what are their typical %? - Beta, what does = 1, 0<1, and >1 mean for a stock? - Common examples of low and high beta companies?

The Capital Asset Pricing Model (CAPM) is a model which describes the relationship between the riskiness of assets and the rate of return investors should expect in order to willingly bear those risks. While CAPM is a foundational theory in finance, because it isn't used much in PE aside from using it to estimate the cost of equity, we won't dive into the details. Just remember the following equation: Cost of Equity = RiskFreeRate + Beta * EquityRiskPremium RFR = Usually equal to the yield on safe government bonds (2-4% is a safe assumption in developed markets like the US Equity Risk Premium = The premium return over the Risk Free Rate investors demand in order to take the risk of investing in a diversified "Market Portfolio" of equities. Typically 5-6% in developed markets like the US. Beta = A measure of how levered a particular stock's returns are to the diversified Market Portfolio of equities. 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 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 high Betas include semiconductors and durable assets (like cars) because demand for them soars when the economy is doing well but plummets during recessions.

Where are the next opportunities for private equity?

The answer to this depends on the position, of course. If you're interested in fund raising, talk about new potential sources of funds, including any ideas floating around about public offerings and the like, or potential new sources of private placements. If you're in deal-making or operations, be ready to discuss the trends you've read about recently, such as emerging market LBOs or a particular domestic sector. New financing plans are always welcome, too.

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.

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.

HOW WOULD YOU GAUGE HOW ATTRACTIVE AN INDUSTRY IS?

The three most important measures of an industry's attractiveness are: - growth rate - stability - profitability Attractive companies can also 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.

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.

Tell me what you did in your last position that helped your company find value?

This goes to the very core of what it means to work for a private equity firm.You should be able to walk into an interview with four to five solid examples of how your actions directly saved your previous employers money. This could be from developing operational efficiencies to ferreting out information that helped save money on an M&A deal. Maybe your research helped a company develop a new product line, or your ideas spurred cost savings on benefits. Whatever it is, be prepared to talk frankly and in detail about how you are an agent of value creation.

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

This is a common interview question in both banking and PE and comes in many forms (e.g. what happens when A/R increases, Inventory decreases, tax rate increases, capex decreases, etc.) so you need to familiarize yourself with how the financial statements connect in the Financial Statement Connections section. 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.

WALK ME THROUGH ONE OF THE DEALS ON YOUR RESUME

This is one of the most common questions in a PE interview if you come from a deal-oriented background. The interviewer might let you choose a deal to discuss or pick one at random from your CV. The interviewer might ask you anything from a simple high level overview all the way down to a detailed discussion of the investment thesis, purchase price, operating forecast, and expected returns. This type of question is used to gauge the following: •• Your investment judgment •• Your knowledge of the PE investment process •• Your ability to focus on the most important issues •• Your knowledge of PE financing, accounting, and modeling •• Your deal memory for deal facts and context •• Before you walk into any PE interview, you should reacquaint yourself with the following facts about every deal on your CV: •• Purchase price, including the multiples of EBITDA and EBIT it represented •• Sources and uses of capital •• The investment thesis and its primary drivers •• The key diligence issues and findings •• The base operating case/projection •• Key risks and upsides •• Projected returns (IRR & MoM) •• Key members of the management team ••What your role was and what value you added to the team ••Whether you personally thought it was a good deal and why

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.

WALK ME THROUGH AN LBO MODEL AT A HIGH LEVEL

This question may come as a stand-alone question, as part of a case question, or as part of a question about one of your past deals. 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

TEV: - Calculation - What does it measure - How are each of its components calculated?

Total Enterprise Value (TEV) = Value of Equity + Value of Debt - Excess Cash. TEV measures the financial value of a company to all financial stakeholders: all equity holders and debt holders. Equity holders are obviously owners because they control the company, but debt holders are also owners in a sense because they could gain ownership/control of the company if it fails to make interest payments or repay principal on time. Equity Value: usually calculated using the market value (market capitalization) of a company. Debt Value: Total face value of outstanding debt on the balance sheet. Excess cash: Cash on the balance sheet which is not needed for the ongoing operation of the business.

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.

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

You always want to have one or two good pitches in your back pocket in case you get asked this question. 1. 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 2. Could benefit from a strategic overhaul which would be difficult to execute as a public company 3. Is having significant operational difficulties which would require a lot of time, patience, and capital to address 4. Has a bad management team or governance structure which a PE firm could improve 5. Has a lot of room to grow either organically or via acquisition if backed with enough patient long-term capital

If you wanted to evaluate an investment opportunity for PE and can only ask for three things, what would you ask for and why? No details are provided about the company (not what it does, not what industry it's in, so on)

You have to understand what they're trying to determine with this question. If they're trying to determine if you understand private equity investing, how/why it works and how to analyze an investment. Industry is important, but obvious. - 5 year Revenue CAGR(%) - LTM EBITDA($) - Cash conversion(%). From there you can ball park an IRR in about 5 minutes in Excel. While you need to know about the management team and industry outlook etc... for this type of quick "should we spend any time on this" type analysis, you're not going to dig into the industry and management team. You're not going to build out a big elaborate model and make all these assumptions based on the industry you're given. the problem interviewers get into is they get intimidated by these sort of questions and tend to give very broad and general answers, which doesn't work for a "should I invest in this company"-type question. You need to get specific in your answer as to what data you would need, so that you get specific answers from the interview. From there you have to be able to say YES I would invest or NO i would not. If you get your 3 asks... can you give him an investment answer? Lets take a shot at it... If you asked for something like FCF, Cap structure and management experience. - Company will generate $450 million over the next 5 years - the industry is healthcare/pharma (they manufacture pharmaceuticals for race horses) - the CEO has 25 years of experience in pharmaceutical manufacturing, he has an undergrad degree in biochem and an MBA, CFO has 20 year experience at a big pharma company, COO similar background Should you invest in this company? Almost all members of an executive teams will each have 15-30 years experience, some sort of higher education degree etc... they'll all be "impressive" on paper. If you had asked for 5 yr revenue CAGR, LTM EBITDA and cash conversion you'd have gotten the following to work with: - 5 yr rev cagr is 5% - LTM EBITDA is $70 million - Cash conversion is 50% (unlevered) ---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR) ---- can ball park FCF generation over the next 5 years by applying cash conversion % to EBITDA and growth that FCF by CAGR each year ---- slap a boilerplate cap stucture on it, come up with an IRR and you know if its in the realm of do-able or not If its showing a 11% IRR do I give to shits if the CEO and CFO are the smartest guys in the world? Do I care which industry they are in? I would ask for those 3 things and explain how I would use them to ball park an IRR. Then I can gauge if I should spend more time on this or not. If the IRR is in an attractive range I'd want to dig in more. Understand the business model, the industry outlook, where comps are trading at, any potential fatal flaws (i.e. material litigation, environmental liability issues, etc...). The only reason you care about revenue is because it drives your EBITDA, if you can get to EBITDA you don't care about revenue. The only reason you care about EBITDA is because it drives FCF and because it drives valuation. Capital structure is meaningless. You want to keep your answers as simple as possible, why would you voluntarily propose some convoluted share structure? You want assumptions to be as simple as possible, you purchase the company outright, no breakage costs, etc...

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

yup

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