Peak Frameworks PE Q&A guide - Investing Questions

- Assuming common equity, no impacty on IRR or MoM - Rollover reduces gross amount of $ you receive at end as it reduces your initial investment, but no impact on IRR or MoM because still same proportion of money • If management rollover amount was higher, you would have to put in less money as the private equity firm, but you would still be paid proportionally to how much you put in. - Your ownership % would decrease, but your relative IRR and MoM would be identical. All common equity receives the same IRR and MoM in the transaction. - Management promote does reduce your IRR, as it comes straight from

How does the size of management rollover affect the IRR of an LBO investment? What about MoM? What about same question for mgmt promote? What decreases?

1. Management rollover describes reinvested capital from existing shareholders in the OldCo, for example management teams or existing sponsors. 2. Rollover Equity ordinarily appears as a "Source" and will implicitly be embedded into the Purchase Equity "Use" line item. No actual cash is actually changing hands for the roll over. If an investment is rolled over, there has been no change to it in the capital structure. 3. For example, if the management team has agreed to stay on with the company and not sell their existing shares, they will "roll over" some value of their existing shares and have equity in the new company. However, the management team would not have actually put in any new cash to do this. 4. Management's ownership stake will be calculated as Rollover Equity / (Rollover Equity + New Equity). 5. This decreases the amount of equity the sponsor has to contribute

How is rollover equity treated in the Sources & Uses section? Is any new cash exchanged? How does it impact the equity the sponsor has to contribute? How do you calculate the management ownership stake?

1. Generally, want 20-40% equity. This can be as high as 50%, but typically you want higher leverage without endangering business as less equity equals higher returns all else held equal 2. The smaller the equity investment, the greater the return (assuming ownership remains the same and all else being equal). A. In running your model, you should target >2.0x first year interest coverage (EBITDA / Interest Expense) and definitely exceed 1.0x. B. You should be able to pay down all senior / first lien debt within 5 years. C. Total debt is often between 4.0x - 6.0x LTM EBITDA.

How much debt is right to put on a business? How much leverage is put on a typical private equity investment? What statistics should you target/look out for in running your model to gauge what appropriate debt the company can support is? Is there a specific tranche that should be paid down on a certain timeline?

In practice, raising debt may not directly impact what you calculate on your DCF because a DCF deals with unlevered free cash flow and should be capital structure neutral. Nuance 1. Increasing debt substantially could increase your cost of debt, which would increase your WACC, and decrease the overall value of the business. Nuance 2. Increasing the debt amount would also increase your debt % of total capitalization, which could decrease your WACC, because the cost of debt is cheaper than cost of equity-- so more debt to cap lowers cost of capital portion of WACC formula. This increases value of busines Nuance 3. Relatedly, increasing debt would increase the levered beta, which would increase your CAPM, which would increase your cost of equity and increase your WACC. In turn decreasing value of business.

How would raising debt in year 3 impact your company's DCF analysis? Nuance 1: How does increasing debt substantially affect cost of debt? How would this affect WACC and value? Nuance 2: How does incrasing debt amount affect your debt to cap? How does that affect WACC? How does that affect value Nuance 3. How would increasing debt impact levered beta? How would this in turn impact CAPM and cost of equity? How would this impact WACC? And how would this then impact value of the business?

Generally, the 2 companies would yield the same return. When calculating returns, a company's pre-existing debt does not directly impact IRR. But there are 3 considerations (1) (Pro Pre-Debt) Company's historic ability to support debt may indicate ability to support debt going forward, which would be a positive feature. A company with existing debt relationships and an understanding of the credit markets would also be a slight benefit. (2) If making a minority investment, you can't change the cap structure, so you'd want to be comfortable with the cap structure going in (3) (Anti Pre-Debt) The presence of make-whole premiums (paying penalty to debtohlders to buy out the debt) could increase transaction costs and decrease returns

(Existing Debt on Balance Sheet) All else being equal, would you prefer to purchase a company with no debt on its balance sheet or a company with 3x LTM EBITDA of debt on its balance sheet? (1) What rationale might make you feel more favorably toward a target having pre existing debt? (2) Under what scenario would you want to be comfortable with the company's existing cap structure? (3) Under what scenario would you feel less favorably toward pre-existing debt

question 1: Revenue: $1,000 x 100 units sold x $10 price per unit. Variable Costs (COGS): 100 units * $5 cost per unit. (-) Fixed Costs (SGA) We then deduct $300 in fixed costs to arrive at $800 in total costs. = EBITDA: $200 ($1,000 less $800) and an EBITDA margin of 20%. • Breakeven: Point in which the number of units sold clears the fixed costs of the company. = $300 in fixed costs divided by the profit per unit of $5 implies that the business needs to sell 60 units to break even. Question 2: Algebra 1. Revenue - Costs = EBITDA 2. (Total Units * Price) - (Total Units * Cost) - Fixed Costs = (EBITDA Margin * Revenue) 3. (Total Units * Unit Profit) - Fixed Costs = (EBITDA Margin * [Total Units * Price]) 4. Total Units x $5 - $300 = (40% * [Total Units * $10]) 5. Total Units = 300 Question 3 1. Revenue - Costs = EBITDA • (Total Units * Price) - (Total Units * Cost) - Fixed Costs = (EBITDA Margin * Revenue) 2. (Total Units * Unit Profit) - Fixed Costs = (EBITDA Margin * [Total Units * Price]) 3. $500 - Fixed Costs = (40% * [Total Units * $10]) 4. Fixed Costs = $100. Therefore, Company ABC must reduce Fixed Costs by $200 (to go from $300 to $100).

1. Company ABC sells 100 units at $10 each. The company manufactures each unit for $5. The company incurs fixed costs of $300. What is the EBITDA margin of the company? How many more units does Company ABC need to sell in order to double its EBITDA margin? How much does Company ABC need to reduce its fixed costs by to double its EBITDA margin (from the original question)?

1. Insurance Businesses, Mature SaaS Businesses 2. Long term contracts, high value products customers always need to buy. Infrastructure Assets, Compliance PRoducts, Sticky Software (Microsoft Office)

1. Give 3 examples of companies that will typically have strong CFS Generation? 2. Give 3 examples of companies will typically show Recurring Revenue/Sticky Customers

1. On top of D&A or below, added back similarly 2. With the other interest expenses below EBIT and above EBT, added back on CFS 3. Not on income statement. If DTL negative on cash flow. If DTA positive on cash flow.

1. Where does incremental D&A from writeup go in an LBO? 2. Where does the amortization of financing fees go? 3. Is the amortization of DTL reflected on the income statement? Where is it?

3 Drivers of Return here: Multiple Arbitrage, EBITDA Expansion, Debt Paydown. A. Multiple Arbitrage and EBITDA Expansion 1. Entered 5x 100 EBITDA = 500 AV 2. Exited 6x 120 EBITDA = 720 AV + 220 Value Created B. Debt Paydown $25 per year over 5 years = 125 + 125 Value Created = 345 Total Returns to Equity = 95 Total Incrase to Enterprise Value (220-125 due to the less debt meaning less Enterprise Value)

A company has $100mm in EBITDA in Year 1, which grows to $120mm in Year 5. Assume that you are able to pay down $25M in debt each year. Also assume that the company was purchased at a 5.0x Year 1 EBITDA multiple and exited after 5 years at a 6.0x Year 5 EBITDA multiple. How much equity value was created through the transaction? How much enterprise value was created?

So receiving $50M every year for 5 years will get me $250MM at the end, which is what I put in. So therefore the discount rate would have to be zero-- If any higher than zero, then the NPV of the investment is below the capital I put in. If any lower than zero, then the NPV of the cash flows I receive would be more valuable than that 250

Assume you make a $250mm investment into a business. If you receive $50mm of cash flow from the investment at the end of each for 5 years, what discount rate will be necessary to make the NPV of thei nvestment equal to zero?

• The exhibit below lays out the build to get to EBITDA under these assumptions. We derive revenue of $1,000 by multiplying 100 units sold by $10 price per unit. We derive variable costs by multiplying 100 units by $5 cost per unit. We then deduct $300 in fixed costs to arrive at $800 in total costs. • This implies an EBITDA of $200 ($1,000 less $800) and an EBITDA margin of 20%. • It is worth noting that the breakeven of the business is the point in which the number of units sold clears the fixed costs of the company. $300 in fixed costs divided by the profit per unit of $5 implies that the business needs to sell 60 units to break even.

Company ABC sells 100 units at $10 each. The company manufactures each unit for $5. The company incurs fixed costs of $300. What is the EBITDA margin of the company?

Formula: Inventory / COGS * 365 Days Conceptual Understanding: Measures the time from when inventory is purchased from supplier to sold to customer. Example of Low DIO: A fruit stand would have a low DIO, as they try to buy and sell all of their inventory within a matter of days. Example of High DIO: On the other hand, a jewelry retailer may have a very high DIO, as they are unperishable items with longer sales lead times.

Give the formula and conceptual understanding of Days Inventory Outstanding; as well as an example of low and high DIO.

Formula: Accounts Payable / COGS * 365 Days Conceptual Understanding: Measures the time you have before having to repay your supplier for the inventory. What does it measure? Oftentimes, this measures the power you have with your supplier and the terms you are able to win. What companies have high DPO? Large companies with robust supplier networks such as Walmart, Amazon and Apple tend to be able to negotiate longer payment cycles and a well-positioned buyer could manage DPOs of 60-90+ days.

Give the formula and conceptual understanding of Days Payable Outstanding. What does it measure? What companies have high DPO?

Formula: Accounts Receivable / Revenue* 365 Days Conceptual Understanding: Measures the time from when a sale is made to when cash is actually received. What does it measure? Oftentimes, this measures the credit collection ability of the company and the selling power it has with its customers. Example of No DSO: A family business that demands cash payment would not have any accounts receivable or DSO. Typical credit card and supplier terms are in the range of 30-60 days.

Give the formula and conceptual understanding of Days Sales Outstanding; Conceptually, what is it an indicator of? What is an example of no DSO? what is the typical range of DSO?

A capital lease is an agreement that allows a company to purchase an asset in exchange for payments over time. The capital lease entitles the purchaser to own the asset at the end of the lease. This is a common way for companies to finance their equipment. Mechanically, you can envision it like the lease on a car - you pay a monthly / annual fee to have the car instead of buying it out right. • Balance Sheet: Assets are increased by the amount of the PP&E. Liabilities are increased by the capital lease, which is equal to the PV of the principal payments you must pay. The capital lease is a liability because you owe future payments. • Income Statement: Interest expense is higher because capital lease payments are treated as interest. • Cash Flow Statement: Unaffected

How would taking on a capital lease impact the three statements?

Both metrics measure different types of value-- One is an enterprise value metric other is equity value metric. Equity v.s. Enterprise Value potential differences 1. The companies could have dramatically different net debt amounts or different subsidiary investments Since P/E is net income driven, then the line items between Net Income and EBITDA will drive differences EBITDA driven differences (above/below), e.g. 1. difference in D&A (e.g. accounting policy, value of assets on the books) 2. Interest could be different due to treatment / relationship from banks, credit rating, different geographies leading to different market risk. 3. Taxes could be different due to different geographies, 4. one-time events 5. existing DTAs / DTLs.

If two companies have identical EV/EBITDA multiples and business models, why might their P/E multiples be different?

All else being equal, revenue will go down. 110% price x 90% of units = 99%, which is less than 100%, so revenue will go down.

If you raise prices by 10% and reduce units sold by 10%, what will the impact be to revenue?

Lower amount, because it is both impacted by variable costs, as well as tax affected. In most cases the company's EBITDA will grow by less than $10 here.

If a company's revenue grows by $10, would the company's EBITDA grow by a higher, lower, or the same amount?

Lower/Less This is because it will also have an increase in associated variable costs and the flowthrough to EBITDA will not be 100%. In most cases, the company's EBITDA would grow by less than $10 here. The only situation in which EBITDA were to grow by $10 would be if the revenue grew due to a price increase. There is no situation in which EBITDA can grow by more than $10 unless there is an accompanying decrease in costs.

If a company's revenue grows by $10, would the company's EBITDA grow by a higher, lower, or the same amount? What is the only exception?

This transaction would likely have a negative IRR. This is because of the likely interest expense on the debt and the transaction expenses associated with buying and selling a company.

If there were no multiple expansion, no EBITDA growth, and no debt paydown, would an acquisition have positive IRR, neutral IRR, or negative IRR? Why?

So value creation in an LBO comes from (1) Debt Paydown (2) EBITDA Growth (3) Multiple Expansion 1. We've eliminated 2 of the 3, but it seems there's still EBITDA growth at 10%. EBITDA growing at 10% compounded over 5 years equals a 60% increase. The investment will likely still be profitable as the underlying company will have grown significantly 2. However, it could remain unprofitable in 2 situations (A) If company has a significant amount of debt, interest payments could dwarf the growing EBITDA and still inevitably reduce the equity value of the copmany. The question mentions no cash flow generated-- could be due to heavy interest expense (B) You're a common equity holder with other instruments ahead of you increasing in value more than the overall equity value (e.g. EBITDA growing 10% but PIK growing 12%) (C) The Company raises more equity with the same rights as you and it dilutes your stake. The company may have grown, but now you receive a smaller portion of the exit.

Imagine that you buy and sell the common equity of a company at the same entry and exit multiple. Assume that the EBITDA of the company grows at 10% annually, but that the company never generates any net cash flow. (1) Do you think this is likely to be a profitable investment? (2) If so, under what circumstances would this be an unprofitable investment?

- It depends on the particular kind of transaction. 100% vanilla takeover:, then yes, you should wipe out all of shareholders' equity. You will reset that account (as well as the share price). • If there was another tranche of preferred equity, then that amount would remain on the balance sheet. Structured investment or minority investment: you wouldn't wipe out all of equity.

In an LBO model, do you wipe out the entire book value of equity?

• Neither: The true cost of buying a company is best described as the total "Uses" in a model. This is the total amount of cash that must be paid to complete the transaction, i.e. pay down all the shares, pay transaction advisors, etc. You'll find that the Uses total actually does not equal either the enterprise value or the equity value completely. • The Uses will be much closer to enterprise value, but will still be off because of cash required to be on the balance sheet, underwriting fees, and transaction expenses.

In an LBO model, is the "true cost" of buying a company equivalent to the enterprise value or the equity value?

(1) Strong Cash Flow Generation - CFS important to pay down debt. Higher CFS indicates lower capex and good unit economics/well managed cost structure. (2) Recurring Revenue Streams / Sticky Customer Base - Implies Less Risky Cash Flow Streams. (3) Moat/Defensible Market Position (4) Strong Management Team

What are characteristics of a great business to invest in? (5)

Cash from operations 1. Add back D&A (Incl. any incremental amort of intangibles or depreciation of PPE) 2. Subtract unwind of DTL (Add unwind of DTA) 3. Add back amort of capfinfees 4. Add back PIK 5. Subtract Change in NWC Cash from investing 6. Subtract Capex simple version Net income + D&A minus change in NWC - capex

Name all the common Addbacks you would expect to see from net income to get to LFCF Cash

The 3-statement model consists of the income statement, balance sheet, and cash flow statement. 1. On the Income Statement, we are trying to calculate Net Income to ensure that all of the company's revenue and expenses are included. 2. Then we want to get a more accurate picture of what cash flow is, which we do by adding back non-cash expenses (D&A) and deducting any capital uses (capex, capitalized software, change in net working capital). 3. Lastly, we use the cash flow to determine how much debt on the balance sheet we can pay down. 4. Key 3-Statement Model Items: Income Statement + Revenue (-) COGS = Gross Profit (-) Operating Expenses (except D&A) = EBITDA (-) D&A = Earnings Before Interest and Tax (-) Interest (-) Tax = Net Income Cash Flow Statement Net Income (+) D&A (-) Capex & Capitalized Software (-) Change in Net Working Capital (+) Any non-cash expenses like capitalized financing fees or PIK interest = CFADS (-) Mandatory Paydown (-) Accelerated Paydown = LFCF After Debt Paydown Balance Sheet - Cash - Debt (Revolver, Term, Sub, Mezz) - Net Working Capital (AR, Inv, AP)

Walk me through a 3-statement model. How does it flow through to an LBO?

An LBO or "leveraged buyout" model is used to analyze the returns of a potential investment in private equity. 1. Entry Analysis: We start by making various assumptions on the company's valuation, investment structure, and exit 2. Mechanically, one forecasts out the financial profile of the business for several years into the future 3. We would build a 3-statement model in order to determine debt pay-down at the balance sheet level and cash flows received by the investor 4. We use the cash flows received by the investor to calculate what the IRR (internal rate of return) of the investment is. It is common to then perform a variety of sensitivities of key variables

Walk me through an LBO (keep it SIMPULLL)

Outsourcing certain business functions can make fixed costs more variable in nature (e.g. outsourcing customer service, which would prevent you from having to set up a call center). Automating certain business functions can make variable costs more fixed in nature (e.g. investing in software or machinery to replicate the output of labor). 1FG Example: We pay venues $500 to use venue; and sell tickets where we control price and volume. If nobody comes, huge risk, but if 1000 people come and paid $50, we earned outsized returns. It was always a threshold-- if a venue charges $500, we would much rather do high operating leverage; if $5000, much rather have lower operating leverage by splitting tickets WMG Example: Historically, Meta pays record label flat fee to use music. Meta was thus able to maintain low operating leverage and gain outsized returns on its user growth. We negotiated deal that switched payment structure to variable fee economics, Meta had to pay us for every incremental user on the platform accessing music. This greatly decreased Meta's operating leverage, while increasing our returns.

What are strategies in which a company can change its operating leverage? 1FG Example; WMG example

1. Multiple Expansion - Enter 5x Exit 10x 2. EBITDA Growth - If you buy a company and multiples stay the same, no debt paydown, you can still create value by increasing ebitda 3. Debt Paydown - If you buy a company and sell at the same ebitda, same multiple, but you paid down debt during the holding period using the company's cash flows, you can still generate returns. For example a very stable franchise business that functions like an annuity.

What are the main drivers of return in an LBO? Debt paydown is an analog for how much ______ was generated during the holding period

• Change depreciation policy (increase useful lives of assets to decrease depreciation expense in a given year). • Compensate employees with options instead of cash. • Recognize revenue more aggressively (e.g. booking contracts before fully signed). • Switching from LIFO to FIFO during period of rising costs. • Sell large assets or recognize one-time item expenses. • Reclassify certain expenses as capital expenditures (e.g. moving software R&D to capitalized software costs).

What are ways that a company could inflate or manipulate its GAAP earnings?

1. Product Development involves High R&D / Capex: A. Industries such as technology and biotechnology tend to have a lot of M&A because large incumbent companies tend to acquire companies with proven technologies rather than devote significant resources to nascent technologies (emerging technologies such as autonomous vehicles, artificial intelligence, and cybersecurity come to mind). 2. Ceiling has been hit on Industry Total Addressable Market ("TAM") has been hit (Stagnation). When there's no more room to grow organically, companies seek organic growth. A. Industries that have reached their natural maximum size tend to exhibit greater M&A, as companies start to run out of organic growth opportunities. B. In an effort to continue growing, larger competitors may spend money to buy smaller competitors and then begin focus on cost-cutting. C. Turning to M&A is common among legacy industrial companies that lack runway in areas of their typical core competency. 3. Potential Synergies are Prevalent: Presence of Cross-selling opportunities (revenue) and redundant costs e.g.SGA (cost) 4. PE Activity 5. Lax Regulatory Environment

What factors would lead to an industry having heavy amounts of M&A and consolidation? (3) (RDC, TAM, Syn)

1. The internal rate of return ("IRR") is expressed as a percentage and measures the potential profitability of an investment or project. 2. This is also the rate at which the net present value of all future cash flows is equal to zero. IRR is To Calculate IRR you need 2 things 1. The size of Cash flows 2. The timing of cash flows All investments will begin with an initial cash outflow or payment made by the investor - we define the timing at which this investment is made as "Time Zero" or "T = 0". The IRR is then calculated based on what cash flows are received and when. Ordinarily in an LBO context, cash inflows will come in the form of dividends or an eventual sale of your investment.

What is IRR? What 2 pieces of information do you need to calculate it in an LBO? All investments will begin with an initial _____ __________ made by the investor - we define the timing at which this investment is made as "______ ________" or "____ = __". The IRR is then calculated based on what cash flows are received and when. Ordinarily in an LBO context, cash inflows will come in the form of ____________ or an eventual _____ of your investment.

1. Multiple of Money ("MoM") is a return metric that assesses the sheer magnitude of cash that an investment could yield. 2. MoM is expressed as a multiple and is calculated by summing the total cash received by the cash invested into the business (i.e. inflows divided by outflows). 3. MoM is not complete in its own right as it does not consider the time value of money. It treats a dollar received a month after the investment the same as a dollar received 5 years later. 4. The solution is to calculate both IRR and MoM and provide snsitivites for both

What is What is Multiple of Money / Multiple of Invested Capital (MOIC) / Money on Money? 1. What does it assess? 2. How is it calculated? 3. Is it a complete metric? 4. So what's the solution?

An earn-out is an incentive instrument that entitles management to receive a payout under a certain circumstance. The earn-out gives management higher potential upside after the deal is closed. For example, an earn-out could be based on reaching a certain revenue or EBITDA target. This is a way to minimize pure common equity dilution and still incentivize management. This is typically used in scenarios where buyers and seller cannot agree on a specific valuation, or a specific projection. Earn-out if achieved, not harm no foul if not.

What is an earn-out?

Operating leverage is a company's ratio of fixed costs to variable costs. (High SG&A low COGS = High Operating Leverage) (e.g. software, telecom, large upfront investments. Operating leverage is not a definitively good or bad thing, depends on business. A. Businesses with low operating leverage can more easily earn profit, but they don't have the ability to easily earn outsized profits due to variable costs. from strong sales performance. B. Business with high operating leverage and predictable sales volume would be the best investment.

What is operating leverage? Is it better for a business to have more or less operating leverage? Which is a better investment

1. The cash conversion cycle measures the amount of time that it takes for a company to convert inventory to cash. 2. It is calculated as: (DIO + DSO - DPO) which tracks the amount of time to go from purchasing a unit of inventory to actually receiving cash from the customer. 3. Days Inventory Outstanding ("DIO", calculated as Inventory / COGS * 365 Days) Measures the time from when inventory is purchased from supplier to sold to customer. A fruit stand would have a low DIO, as they try to buy and sell all of their inventory within a matter of days. On the other hand, a jewelry retailer may have a very high DIO, as they are unperishable items with longer sales lead times. 4. o Days Sales Outstanding ("DSO, calculated as Accounts Receivable / Revenue * 365 Days) Measures the time from when a sale is made to when cash is actually received. Oftentimes, this measures the credit collection ability of the company and the selling power it has with its customers. A family business that demands cash payment would not have any accounts receivable or DSO. Typical credit card and supplier terms are in the range of 30-60 days. 5. o Days Payable Outstanding Measures the time you have before having to repay your supplier for the inventory. Oftentimes, this measures the power you have with your supplier and the terms you are able to win. Large companies with robust supplier networks such as Walmart, Amazon and Apple tend to be able to negotiate longer payment cycles and a well-positioned buyer could manage DPOs of 60-90+ days. 6. • You may not need to memorize this formula for an interview context, but we like to reference this concept of the cash conversion cycle because it highlights the importance of managing a company's working capital and explains the drivers behind actual cash flow generation. It is a framework to assess how efficiently a company can make money. It is generally better to have a lower cash conversion cycle, where you can generate and collect cash in a shorter period of time. • Companies with good (lower) cash conversion cycles tend to include businesses with strong negotiating power over suppliers in industries with fast or predictable sales cycles. This can include large players in retail, consumer goods, or natural resources (where goods are distributed immediately), e.g. Walmart, Amazon, eBay, and many oil & gas companies. • Companies with negative cash conversion cycles can finance their operations essentially by borrowing from suppliers. They can sell goods and receive payment from their customers before having to pay back their suppliers.

What is the cash conversion cycle? What is the formula? What are businesses with a good cash conversion cycle?

- When calculating the sources and uses of an LBO, we are looking for the face/fair value of debt, which is what we will have to pay in a transaction. - The book value on the balance sheet may not reflect what we'd actually have to pay as it could include some amortization deduction or incorporate other accounting treatments. - When scraping a filing for debt inputs, you want to look at the 'Debt' section of the filing if possible, as opposed to taking information directly from the balance sheet.

What is the difference between book value and fair value for a debt instrument? Which value should we use from the 10k when calculating a takeout situation?

1. All costs that a business incurs are either fixed or variable in nature - this is a binary categorization. 2. A variable cost varies with the amount of output produced, while a fixed cost remains the same regardless of output. 3. Variable costs vary with how many items you produce. This generally includes costs like raw materials, labor costs, utilities, and commissions. The more cars you produce, the more steel you use and the more man hours you have to pay for. • Fixed costs do not vary with the volume of production, even if no goods or services are produced. This includes costs like rent, utilities, and insurance - items you must pay regardless. • As you think about per unit costs, recognize that a variable unit cost will remain the same if you make 1 item or 1 million. However, fixed costs get distributed over a greater number of units and so per unit fixed costs decline with increased production.

What is the difference between fixed and variable costs? How do both vary with the amout of units produced?

In order to incorporate a margin of safety into the analysis, it is commonplace to sensitize the key variables along a wide range of assumptions. The objective is to pick model variables that will produce a wide span of outcomes (i.e. we generally only want to sensitize the most important drivers). Common sensitized factors include 1. Entry multiple 2. Exit multiple 3. Leverage multiple for transaction 4. EBITDA CAGR 5. EBITDA Margin 6. Revenue Growth

What is the point of conducting return sensitivities? What are some key variables you would want to sensitize? (6)

1. The Revolver Commitment Fee is charged based on the revolver amount that is not being used (i.e. Fee % x [Total Revolver - Revolver Used]). 2. It is a way for banks to make money by simply extending their capital. 3. They impose this fee so they are guaranteed to at least make some money off of the revolver.

What is the revolver commitment fee?

Companies with strong negotiating power over suppliers in industries with fast or predictable sales cycles. This can include large players in retail, consumer goods, or natural resources (where goods are distributed immediately), e.g. Walmart, Amazon, eBay, and many oil & gas companies.

What type of cash conversion cycle is good- Lower is higher? What type of companies fall in this bracket

Historically (1) mature, (2) room to grow, at a moderate or high rate (3) non-cyclical. Manufacutring, Healthcare, Food and Beverage, Industrials The companies found in these types of industries are more likely to generate predictable revenue with fewer disruption risks from technological advancements or new entrants due to having high barriers to entry.

What types of industries attract the most LBO deal flow?

1. Improvement in market conditions 2. Different buyer : sponsor vs strategic 3. Improvement in quality of the business Most money managers will agree that the two factors that drive valuation multiples are 1. growth 2. return on capital / profitability. 3. future expectations thereof All of the different pros and cons of a business can be distilled into the business' ability to grow and the ability generate profits as a proxy for future cash flows. Investors look at forward-looking multiples (based on future performance), meaning that multiples are also essentially driven by expectations. Unprofitable earlystage technology or biotechnology companies may have very high multiples without the proven ability to generate revenues or cash flows, due to the expectations about future performance

What would cause multiples to increase? (3, macro, deal, micro) What 2 factors drive multiples? Multiples are a heuristic for investors' expectation of a company's ability to... Are multiples forward or backward looking? why? Can an unprofitable company be high multiple? why?

However, a firm may not want to use the maximum leverage available if: o The Sponsor believes the target will not be able to support the prposed amount of debt from bankers. o The private equity firm forecasts interest rates to decrease or debt markets to improve. (e.g. get deal done during worse credit markets without max debt knowing you can recap in 2 years in improved markets at better terms) o PE Firm wants to hit target equity investment size ("equity check") in line with its strategy. This may reduce IRR but increase the absolute amount of $ the firm generates. o The company may want to avoid excessive leverage to appease rating agencies or appeal to certain groups of investors. Companies closely monitor their relationships and the guidance put out by rating agencies in order to optimize certain credit ratings. Most rating agencies follow, at least in part, a rubric which assigns credit ratings based on factors like total leverage and interest coverage. Good credit ratings can lead to lower interest rates and more support from institutional investors, some of whom have restrictions on the leverage of the companies they can invest in.

When completing a transaction, why might a private equity firm only lever a business to 4x LTM EBITDA if it was able to secure 5x LTM EBITDA of debt financing?

• Deferred taxes arise when there is a difference between book taxes (what is calculated under GAAP) and cash taxes (what is paid to the IRS). Book taxes decrease net income while cash taxes decrease cash. • Deferred Tax Liability arises when book taxes > cash taxes (you owe more cash taxes in the future) • Deferred Tax Asset when book taxes < cash taxes (you owe less cash taxes in the future) • Asset write-ups lead to DTLs because you save on taxes now (you write an asset up, which increase depreciation / amortization, which decreases taxes under GAAP accounting)

When do deferred taxes arise? Why do deferred tax liabilities get created in the event of an asset write-ups / acquisition?

1. Free cash flow is always going to be neutral to accounting methods. Accounting is merely the rules we choose to bookkeep and should not impact free cash flow. So free cash flow is the same under both circumstances here. 2. During a period of rising costs, FIFO is going to result in higher net income. This is because you are calculating COGS with cheaper inventory. However, this is offset when you calculate the change in net working capital in the cash flow statement. 3. During a period of rising costs under LIFO, the inventory you are purchasing will be calculated as more expensive. This will make the increase in inventory line larger. Increase in inventory is a cash outflow and it will offset any improvements in the COGS margin.

Which accounting method results in greater free cash flow during a period of rising costs? LIFO or FIFO?

During a period of rising costs, FIFO is going to result in higher margins, because you are treating the older, cheaper, inventory as COGS first. Revenue is the same in both situations, but COGS will differ. • LIFO: During period of rising costs, LIFO leads to higher costs, lower margins, lower net income and lower balance sheet (which minimizes taxes). • FIFO: During period of rising costs, FIFO leads to lower costs, higher margins, higher net income and a higher balance sheet.

Which accounting method results in higher profits during a period of rising costs? LIFO or FIFO?

1. The most beneficial to valuation would be a decrease in capital expenditures, because it is a direct use of cash. Directly impacts cash flows without a tax shield 2. Second is expenses: it is tax affected, so no 1 to 1 impact (flows through IS). Decrease of $10 to expenses would increase cash flows by a value of $10 * (1 - Tax Rate). 3. The least most beneficial to valuation would be an increase in revenue. This is because generating additional revenue will generally be associated with increased variable cost. Unless revenue increase is solely a factor of increased price, then it would flow straight through. In this way, increasing revenue by $10 will increase cash flows by $10 * (Margin %) * (1 - Tax Rate)

Which of the following 3 actions would increase the enterprise value the most?: 1) a $10 decrease in capital expenditures. By how much? 2) a $10 decrease in expenses. By how much would it increase AV? 3) a $10 increase in revenues? Assume that each change happens in isolation. By how much would it increase AV?

No. (1) Leverage amplifies returns - Most common reason is because they'd want to use less equity and more debt to hit a certain return threshold. -More leverage improves returns and if you have too large of an equity contribution, your IRR might be too low. (2) Not needed - Another possible reason could be that the company does not need that much capital and you don't want to over capitalize the business. Some businesses feel compelled to use all of the cash raised in sub-optimal ways. (3) Co-invest • Another possible reason is if you are trying to leave some money for a co-invest situation (i.e. bringing in another strategic partner or private equity firm). Having other helpful partners with skin in the game could be a way to improve the management of the business.

Will a PE fund always contribute all of the equity it can? Why would a private equity firm contribute less money than it is able to in an investment? (3) (L,N,Co)

- All else being equal, a 30% IRR is clearly better than 20%, - But need to consider other factors such as timeframe and variability / risk of the return. • Timeframe: is important as a 20% IRR over 3 years is better than a 30% IRR over 2 years from a MoM basis. - Redeployment: If an investment only lasts 2 years, it would require the private equity firm to do another deal in order to re-deploy the capital, which introduces deal-making risk. Liquidity: You could also argue the opposite direction, saying that having your capital locked up for 3 years is worse from a liquidity perspective. • Asking about the variability or risk of the return is also an important factor. Is the 30% IRR deal much riskier or have a wider range of outcomes than the 20% IRR deal? What is the margin of safety of the different deals?

Would you prefer to make an investment that yielded a 20% IRR or a 30% IRR? What 2 questions do you need to ask to answer this? Why do they matter?