PE Flashcards
(184 cards)
1
Q
Definition of an LBO
A
An LBO is the acquisition of a company where the buyer contributes some of its own money (equity) along with a lot of borrowed money (“debt” or “leverage”) to fund the purchase. Debt makes up 50–80% of the purchase price of a typical LBO. The buyer uses the cash flow of the target company to make interest payments on the debt and pay down the principal over time
2
Q
Why do PE firms use leverage?
A
By using debt to fund the acquisition, the PE firm risks only a fraction of the purchase price and increases the return on its equity.
3
Q
income statement
A
presents a company’s sales over a period of time (usually a fiscal year or quarter) along with the expenses which were incurred to generate these sales.
4
Q
What is the purpose of the income statement?
A
is to match sales up with their associated expenses as closely as possible in order to show how profitable the company is during a particular period
5
Q
capital structure
A
refers to how the company is financed, who has an ownership claim on the company and its assets, and the seniority of those claims.
6
Q
Why PE?
A
because I see myself as an investor in the long-term, and want to learn all the aspects in the process. How to evaluate whether a company can deliver solid returns YI want to learn how businesses work. My interest in private equity began when I read some of Peter Lynch’s books
7
Q
EBITDA
A
earnings before interest, tax, depreciation and amortization. It is a measure of the company’s operating performance
8
Q
How do PE firms measure return?
A
using IRR or MoM
9
Q
IRR
A
the non-discounted, annualized rate of return on invested equity over the lifetime of a deal.
10
Q
Private equity and venture capital
A
is an industry which primarily buys pieces (equity) of companies with the goal of selling this equity 3–7 years later at a profit
11
Q
LP
A
limited partners, partners that provide funding to buy equity. When the investments make a profit, 80% is returned to the LPs plus the LPs original investment, and the private equity keeps the remainder
12
Q
Carried interest/Carry
A
commission for the PE firm. after PE sells investment at a profit, and pay 80% to LPs + their original investment, they keep the remainder
13
Q
LPs annual management fee
A
LPs pay a 2% of total assets under management to PE
14
Q
Largest LBO of all time
A
1989 with KKR’s $31 billion LBO of RJR Nabisco, the largest LBO of all time for 17 years and inspired the book Barbarians at the Gate
15
Q
Why did the industry hit a major speed bump during the early 1990s?
A
- reckless use of leverage in the mid-late 80s took a toll as several high profile LBOs went bankrupt including Federated Department Stores and Walter Industries
- high yield debt market collapsed in 1989 as Michael Milken was charged with stock manipulationand Drexel Burnham Lambert went bankrupt, drastically increasing the cost of leverage and makingsome refinancing impossible
16
Q
What caused the boom in the 2000s, “the golden era”
A
- mid 2000s witnessed a huge swell in securitization by investment banks through instrumentssuch as Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs)
17
Q
Some facts about the “golden era”
A
in 2006, PE firms completed $696 worth of deals
13 of the 15 largest deals of all time happened between 2005 and 2008
For the first time ever, PE companies began to go public themselves, with IPOs by the Blackstone Group and KKR
18
Q
What does securitization do?
A
creates liquidity by allowing smaller investors to purchase shares in a larger asset pool
19
Q
Example of securitization
A
mortgage-backed security
20
Q
Mortgage-backed security
A
is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment market participants. When an investor invests in a mortgage-backed security, he is essentially lending money to a home buyer or business.
21
Q
Deal types of start-up (Early stage)
A
- Seed Capital
2. Venture Capital
22
Q
Seed Capital Deal type
A
- earliest dollars into the company besides the founding members
- normally a minority stake 5-10% taken as preferred equity and/or warrants
23
Q
Biggest drivers of returns for seed capital deal types
A
- large emphasis on revenue or customer growth
- achieving profitability or at least demonstrating the ability to provide profitability
24
Q
Venture Capital deal type
A
- normally the first institutional money, to help the unprofitable high-growth start up grow
- normally minority stake of 5-10% taken as preferred equity or warrants
25
Deal types of growth stage (mid-stage)
1. Growth Equity (GE)
| 2. Growth Buyout (GB)
26
Growth Equity (GE)
- capital to help a young, profitable, high grow business to grow faster
- normally minority stake (10-30%) common.preferred equity or warrants
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Growth Buyout (GB)
- same as growth equity, except a majority stake
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Deal types of mature (late stage)
1. Private Investment in Public Equity (PIPE)
2. Carve-out/Divestiture
3. Leverage Buyout (LBO)
4. Distressed Investment
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Private Investment in Public Equity (PIPE)
Purchase of a large common or preferred equity stake (5-20%) in the stock of a publicly traded company
30
Biggest drives of returns for PIPE deal types
Growth of target’s stock price which appreciates in part due to the target’s utilization of cash from the PIPE
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Leverage buyout (LBO) deal description
- majority control takeover of the equity of a profitable, mature, usually lower growth public or private business
- frequently using a high debt/equity ratio to fund the takeover
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LBO biggest drivers of returns
- use of target's free cash flow to pay down debt (sometimes this is the top driver of LBO returns)
- revenue and profit margin growth
- exit multiple expansion
33
Distressed investment deal description
- purchase, at a discount, of the debt or equity of a company at risk of default
- corporate restructuring, bankruptcies, and financial covenant breaches are typical sources of distressed investment opportunities
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Distressed investment drivers of returns
- helping it to turn around its operations and achieve solvency
35
Example of why its good for a PE firm to do LBO deal
if the company's purchase price is $100 million, and the PE firm is able to raise $80 million in debt then the firm only has to pay $20 million. Allowing them to earn more returns since they did not invest $100 million in the company, and in consequence increases the carry
36
Difference between GE and LBO
GE refers to investments in a mid-stage company, usually with proven products/ideas that are generating significant revenue and are expected to grow their business. LBOs on the other hand target mature companies that are already generating significant cash flow
37
What is the exit strategy in PE?
To make money, the PE firm must be able to exit the investments, either through IPO or M&A.
38
Why companies become distressed?
- expenses out of control
- facing a dangerous competitor
- capital structure is completely unsound
39
Type of investment Fortress Investments does?
distressed investments, they take a control-oriented approach acquires a large position in the debt securities of a distressed company in order to secure a control position in bankruptcy proceedings. After obtaining the control position, the PE firms will take an active role in the restructuring by changing around the operations and management team of the firm
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Type of investment Fortress Investments does?
distressed investments, they take a control-oriented approach acquires a large position in the debt securities of a distressed company in order to secure a control position in bankruptcy proceedings. After obtaining the control position, the PE firms will take an active role in the restructuring by changing around the operations and management team of the firm
41
Formula for IRR for a single cash flow
(cash returned/cash invested)^(1/#years before return realized) - 1
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Why is IRR important for PE?
1. because LPs usually demand cumulative rates return of 20% or better
2. PE also have to exceed an IRR threshold called the Hurdle rate between 7 to 10% before receiving any carried interest
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What does IRR depend on?
- how much total profit a deal generates
| - how long it takes to realise these profits
44
MoM
multiple of money return.
Add up all of the net projected equity returns generated by a deal and divide it by how much equity the PE firm has to invest to originally win the deal:
MoM = sum of all net returns / cash invested
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Why is MoM important?
- because total carried interest is paid based on total MoM rather than IRR, as long as the IRR hurdle rate is met
46
Income statement
presents a company's sales over a period of time along with the expenses that were incurred to generate these sales
47
What is the purpose of the income statement?
is to match sales up with their associated expenses as closely as possible in order to show how profitable the company is during a particular period
48
What is the purpose of the income statement?
is to match sales up with their associated expenses as closely as possible in order to show how profitable the company is during a particular period
49
When are sales recognized in the income statement?
when they are earned and realised, but no cash necessarily needs to exchange hands
50
Gross profit equation
sales - COGS
51
OPEX
operating expenses a company incurs during production period but are not directly incurred in the production and/or delivery of specific good or services
52
Why PE firms must generate high returns?
1. investment are illiquid, LPs cannot early get their money out like in stock market when they need it. PE firms usually hold investments for over 5 years
2. PE firms have the reputation for being risky because it uses a large amount of leverage which increases the chances that portfolio companies will default and take out the invested equity
3. timing is not predictable, when LPs commit to a PE their capital may be called for a new investment at any time over the next several years, little predictability to when new investments will happen or how large they will be
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What are the common methods PE firms use to achieve these high returns?
1. Buying Cheap
54
What are the reasons and situations where a PE firm is able to buy assets for less than other potential buyers?
1. Better understanding of asset value
2. Relationship with management and sellers
3. Absence of other natural buyers
4. Access to investment cash during downturns
5. Faster deal closing
6. More certain deal closing
55
Why are residential REITs attractive?
Since 2013, rents have increased 3% each year, bigger rents make homeownership more attractive but also make it harder for tenants to save up for down payment. So REITs that invest in real estate are positioned for significant growth in 2019 and beyond
56
REITs
real estate investment trust, is a company that owns, operates or finances income-producing real estate. Modeled after mutual funds, REITs historically have provided investors of all types regular income streams, diversification and long-term capital appreciation
57
Why invest in REITs?
1. historically provide competitive total returns, over the last 25 years total returns have been above S&P 500 and have higher returns than corporate bonds
2. provide high, steady dividend
3. provide long-term capital appreciation
4. not similar to other other assets, making it a good portfolio diversifier
5. an investment in real, tangible assets
58
Mortgage REITs (mREITs)
provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments
59
How do Mortgage REITs make money?
through their investments in mortgages and mortgage-backed security
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How do Mortgage REITs work?
take shareholders money and usually use leverage to lend that money to companies, individuals that want to buy real estate, receive interest money on their loans and administrative fees they may charge
61
Gross Profit
sales - cost of goods sold
62
EBIT
EBITDA - D&A
- focuses on the company's ability to generate earnings from operations, excluding the burdens from taxes and capital structure
- if there was a recent tax cut in the company, the company's income would increase. EBIT allows investors to look at the company's profitability without the effects of taxes
63
Net interest
Companies pay interest on their debts to others and receive interest payments on their loans to others. Net interest is simply the sum of interest payments and receipts. Interest is not counted as an operating expense (and therefore isn’t taken out of EBIT) because it typically depends on how a business is capitalized rather than how inherently profitable it is. Net interest can be positive or negative, but is almost always negative for companies which become highly levered via an LBO.
64
Diluted Shares Outstanding (DSO)
refers to the number of shares, or pieces, a company’s total equity is broken up into if all outstanding equity-granting instruments (like options, stock grants, warrants, etc.) were exercised
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EPS
earnings per share
| Net income/DSO
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impact on cash when assets in the B/S increase
decrease cash, buying inventory
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impact on cash when assets in the B/S decrease
increase cash, inventory is sold
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impact on cash when liabilities in the B/S increase
increase cash, borrowing from bank
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impact on cash when liabilities in the B/S decrease
decrease cash, liabilities are paid down
70
What happens to the B/S and C/F/S when a company issues debt?
issuing debt means borrowing money from the bank.debt liabilities go up in the balance sheet and cash from Financing activities goes up.hen a company repays its outstanding debt principal, its debt liabilities go down, and its cash from Financing Activities also goes down since the repayment is made in cash
71
What happens to the B/S and C/F/S when a company issues equity?
When a company issues new equity (shares), its shareholder equity on the balance sheet goes up and cash from Financing Activities goes up from the equity issuance proceeds. Shareholder equity decreases when a company buys back its shares with cash, while cash from Financing Activities decreases
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What happens to the C/F/S when a company pays dividends?
cash from financing activities decreases
73
What are the links between the I/S and B/S?
1. Depreciation reduces Net PP&E and amortization reduces non tangible assets. More of these assets on the balance sheet usually leads to more D&A on the income statement
2. Current and long-term debt in the B/S is what generates interest expense. More debt on the balance sheet usually leads to higher net interest on the Income Statement.
3. Net Income from the income statement is added directly to Shareholder Equity in the B/S
74
What are the links between the I/S and C/F/S?
1. Net Income and the D&A portions of the Cash from Operating Activities come from the income statement
2. The rest of the connections between the income statement and the C/F/S go through thebalance sheet.
75
What are the links between the B/S and C/F/S?
1. b/s cash is beginning cash in one CFS period and ending cash in another CFS period
2. D&A decreases PP&E, non-tangible assets, and goodwill; capex and some other investing activitiesincreases PP&E, non-tangible assets, and goodwill
3. Increases in these assets (Accounts receivable, inventory) on the balance sheet decreases cash from operating activities; decreases in theseassets increase cash from operating activities
4. Increases in these liabilities (accounts payable, deferred taxes, deferred or (unearned)) revenue on the balance sheet increase cash from operating activities; decreases in these liabilities decrease cash from operating activities.
5. Increases in debt increase cash from debt, and decreases in debt reduce cash from debt; increases in cashfrom equity increase shareholder equity, and decreases in cash from equity reduce shareholder equity; shareholderdividends reduce shareholder equity
76
How can a company be financed?
1. equity
| 2. debt
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Equity holders
are investors who have provided the company with cash financing in exchange for a direct ownership stake in the company.
are the direct beneficiaries of a company’s net income profits. Equity holders can decide whether the company pays its net income out to them via dividends/share repurchases or re-invests its net income to grow the business and generate more net income in the future
78
Debt holders
investors who provide the company with cash financing in exchange for a contractual promise to be repaid over a set period of time with a set amount of interest (yield)
debt is more senior than equity in the capital structure.
Since debt is less risky than equity, the interest rate (yield) that debt holders receive is lower than the rate of return equity holders expect.
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Comparable multiples
type of valuation, its the ratio of the value of the company relative to some quantitative measure of its performance
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Total Enterprise Value
most famous multiple in PE
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Example of total enterprise value
For example, a 7.0x EBITDA multiple for a company which generated $100 million of EBITDA over the past twelve months implies that the Total Enterprise Value of that company is 7x * $100 million = $700 million
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When are investors willing to pay higher multiples?
investors are willing to pay higher multiples for companies with higher competitive advantages and exposed to some attractive industries because these companies are likely tp become larger and more profitable in the future
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comparables
when you use multiples to compare a company with a group of companies (comparables) which have similar characteristics
frequently competitors or companies in the same industry, companies that perform similar functions, or companies that have similar profiles as the target.
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Calculating Enterprise value
Enterprise Value = (market capitalization) + (value of debt) + (minority interest) + (preferred shares) - (cash and cash equivalents)
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What does a high total enterprise value indicate?
company might be overvalued
86
Total enterprise multiple calculate
Enterprise value/ EBITDA
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Total enterprise multiple
ratio tells investors how many times EBITDA they have to pay, were they to acquire the entire business
used to determine whether a company is undervalued or overvalued
88
P/E ratio
price to earnings ratio
- way of valuing a company that measures the price per share relative to its earnings per share
- used to determine the relative value of a company's shares in an apples-to-apples comparison
- used to compare with other companies in the same industry to know if its undervalued or overvalued or benchmark it against S&P 500
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Examples of comparable multiples used for valuing a company
EV/EBITDA
EV/EBIT
P/E
EV/Revenue
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Pros of multiples
1. multiples are a quick way of valuing companies of different sizes
2. less volatile and fewer assumptions than DCF
91
TTM
trailing 12 months, is the term for data from the past 12 consecutive months used for reporting financial figures
represents a company's financial performance in the last 12 months
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Cons of multiples
Choice of multiples sometimes subjective
Difficult to find comparables with identical, or at least similar, revenue drivers
Assumption that market accurately values the peer group
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Market value
for company's that are publicly traded, market cap of a company is the market's estimate of the value of its equity
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Pros of market value
1. Market value is always up-to-date and is instantly available for public companies
2. Market value is determined by the individual decisions of many investors so it reflects the collective work and judgment of many people
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Net debt
Market value is always up-to-date and is instantly available for public companies.•Market value is determined by the individual decisions of many investors so it reflects the collectivework and judgment of many people
96
What Does Net Debt Tell You?
an indication of a business's ability to pay off all of its debts if they became due simultaneously on the date of calculation, using only its available cash and highly liquid assets called cash equivalents
97
What does a negative net debt imply?
that the company possesses more cash and cash equivalents than its financial obligations, and hence is more financially stable
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What does a company with a positive net debt mean?
a company with a positive net debt means it has more debt on its balance sheet than liquid assets. However, since it's common for companies to have more debt than cash, investors must compare the net debt of a company with other companies in the same industry
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What is the market’s valuation of the target’s TEV?
market capitalization + net debt
100
Pros of LBO Modelling
1. do not depend on the information in the public market which may be wrong
2. can capture the value of optimizing a company's capital structure, by using more debt than the public market is used to
3. can capture the value of improvements made in the company that private owners could make that could be difficult for a public company to do
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Cons of LBO Modelling
1. requires making many uncertain assumptions about a company's operating and financial performance at least 3-5 years in the future
2. required more data and more work than valuations based on multiples, precedent transactions or market value
102
Two assumptions of the DCF model
1. financial value of any company depends on cash profits it can provide or dividends it can pay, hence assuming that companies that have the same amount of dividends must have the same financial value
2. time value of money cash today is worth more than cash in the future, because cash today you can invest and have more in the future. so expected future cash flows must be discounted
103
How would a $100 decrease in depreciation expense on the income statement impact the income statement?
I/S
1. depreciation decreasing by $100, increases EBIT and EBT by $100
2. When EBT increases by $100m, net income increases taking into account corporate tax rate
104
How would a $100 decrease in depreciation expense on the income statement impact the balance sheet?
1. since net income increases by 60 in I/S, SE increases by 60
2. since taxes are paid, cash decreases by 40
3. Since depreciation decreased by 100, net PP&E increased by $100
4. liabilities go up by 60 and assets were up by 60, so balance sheet in balance
105
How would a $100 decrease in depreciation expense on the income statement impact the cash flow statement?
1. Net income increased by 60 which increases cash from operations, but PP&E increased by 100 which decreases cash from operations
106
Stock dilution
is the decrease in existing shareholders' ownership of a company as a result of the company issuing new equity. New equity increases the total shares outstanding which has a dilutive effect on the ownership percentage of existing shareholders
107
Why is the I/S by itself inadequate for valuing a company?
The income statement alone won’t tell you whether a company generates enough cash to stayafloat 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
108
Why is the B/S by itself inadequate for valuing a company?
the B/S by itself won't tell you if the company is profitable because it is only a snapshot on a particular date. A company with a lot of assets and few liabilities could be losing a lot of money every year
109
Why is the C/F/S by itself inadequate for valuing a company?
1. the cash flow statement won't tell you whether a company is solvent because it could have massive long-term liabilities which affect its cash generating abilities
2. 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 stronger or weak due to timing rather than the underlying strength of the company's business
110
If you could choose two of the three financial statements in order to evaluate a company which one would you choose and why?
Choose the income statement and the balance sheet because if you have them, you can actuallybuild the CFS yourself. Cash flow is basically equal to Net Income, plus/minus non-cash items on the income statement, plus rise in liabilities on the balance sheet, minus rise in assets on the balance sheet.
111
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 but has not yet been paid
112
What might cause two companies with identical financial statements to be valued differently?
Financial statements give us an accurate picture of the 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 things financial statements do not tell us:
1. the future growth of the company's industry
2. the company's competitive position including she,relationships, patents
3. the quality of the company's future strategy
113
Why does PE generate higher returns than public markets?
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 higher returns for two main reasons
1. LBOs are highly leveraged making PE investments riskier than public stocks
2. PE investments are much less liquid than public stocks; it can take up to ten years to realize returns
114
Why does PE use leverage?
because 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.
115
How could you determine an appropriate exit multiple on a PE deal?
1. Comparable multiples analysis will tell you what multiples similar public companies are trading for on the stock market
2. Precedent transactions will tell you what the multiples were on deals involving similar targets
3. LBO analysis, will tell you what multiple a financial sponsor would be willing to pay in the future
116
What is an acquisition/control premium ?
When a PE buyer 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 prior acquisition trading price per share is called a control premium (acquisition premium)
117
VWAP
volume weighted average price
- when a PE acquires a publicly traded company, the trading price per share prior to acquisition is normally calculated as a 30 to 80 day trailing volume weighted average price prior to the day news of the acquisition becomes public
118
What would be the acquisition premium if the 30-day VWAP of a stock is $20 on the day an acquisition is announced for $25 per share?
25/20 - 1 = 25%
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Why is acquisition premium paid?
1. buyers expect to realise synergies with the acquired asset which makes the asset more valuable to the acquirer than to previous shareholders
2. 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 an investment
3. 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, better strategic direction, fixing operating problems
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How would you measure how attractive an industry is?
looking at its
1. growth rate
2. stability
3. profitability
- but attractive companies can exist in unattractive industries if they have a strong competitive advantage
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What are the elements of the most attractive industries?
1. predictable/stable
2. high growth
3. high profitability
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How do you measure a company's stability?
- measured by looking at its growth drivers and examining its performance over a few business cycles
- if the growth drivers depend on secular trends than it will be more predictable than the ones that depend on taste/trends, fads
- if the products the industry produces are must haves for customers then the industry will be more resistant to recessions than an industry that produces luxuries
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How do you measure growth rate?
1. estimate the industry's historical growth rate from industry reports
2. find out what were the main drivers of historical growth from industry reports, disclosures
3. find out how growth drivers are trending and project future growth from educated assumptions about main drivers
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How do you measure profitability?
1. find out the historical profit margins of industry participants and then utilize the 5 forces framework to measure whether industry-wide profit margins are likely to shrink, growth, or remain the same
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What are the 5 forces framework?
1. Bargaining power of supplies
2. Bargaining power of customer
3. Threat from new entrants
4. Threat from substitute products
5. Existing competitive rivalry
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Bargaining power of supplies
refers to the pressure suppliers can put on companies by raising their prices, lowering their quality, or reducing the availability of their products. The bargaining power of the supplier in an industry affects the competitive environment and profit potential of the buyers. The buyers are the companies and the suppliers are those who supply the companies. Lower supplier power makes the industry more attractive
127
Bargaining power of customer
refers to the pressure that customers/consumers can put on businesses to get them to provide higher quality products, better customer service, and/or lower prices.
the seller is the company. High buyer power diminishes the industry profitability and lowers the attractiveness of an industry
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Threat of new entrants
refers to how strong are the industry's barriers to entry, strong BTEs include essential/exclusive intellectual property, etc. high profitable industry with low BTEs are likely to lose profitability over time as new competitors come in
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Threat from substitute products
a good sign is when industry's products or services meet essential customer needs that cannot be met in a different way
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Existing competitive rivalry
good if competitors focus on competing on other factors besides price and focus on growing the industry rather than taking market share from one another
131
What factors would you look at when looking for an industry to invest in?
1. acceleration in long-term growth : driven by new technology
2. a shift in competitive rivalry : competitors are competing on brand, quality, service, technology instead of price
3. barriers to entry increasing: patents, unique technology, brand
4. threat from substitutes declining: products and services the industry provides are become more unique and essential to customers
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How would you measure a company's competitive position?
1. Market share : high market share relative to competitor shows competitive strength. Firms with larger market share have more brand awareness, close relationships with customers/suppliers
2. Profit margin: high profit margin are a sign of strength. Companies with higher margins are usually more cost efficient and/or able to charge premium prices due to a superior product offering.
3. brand perception: how customers see the brand =, best signal is high unaided customer awareness
4. Product breadth and quality: how product meets customers need.
5. Management team quality: a bad management can ruin the best business, good management can work miracles
133
What are some common ways PE firms increase portfolio company value?
1. recruit better management and board members
2. provide more aligned management incentives ( like via stock option pool)
3. identify and finance new organic growth opportunities (new geographies, new product lines, adjacent market verticals)
4. find, finance, and execute add-on acquisitions
5. foster stronger relationships with key customers, suppliers, and wall street
6. support investment in better IT systems, financial reporting and control, R&D
134
What are debt convenants ?
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 investments
135
What are some different types of debt convenants?
1. Maintenance convenants: require the borrower to maintain a certain equity cushion or debt service coverage cushion to maintain their ability to repay its debt
2. Incurrence convenants: 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
136
If you had to value a company based on a single number from its financial statement, what would that number be?
FCF Free cash flow, 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
137
How do PE firms generate revenue?
Management fees and carried interest
138
What is Private Equity?
an alternative investment class that consists of capital that is not listed on a public exchange. Private equity is composed of investors that directly invest in private companies, or that buy public companies with the goal of selling it years later at a profit
139
Management fee
meant to cover PE's operating budget
based on number of assets under management
LPs have to pay management fee regardless if the PE firm makes a profit
140
Carried Interest
a share of profits that GPs of PE receive
motivates GPs to work towards improving the investment's performance
around 20% of the fund's annual profit
only created when the fund generates profits that exceed the hurdle rate
GPs use LPs money to make investments and keep a percentage of the profits after returning the principal
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Relationship between carried interest and hurdle rate
PE only receives the carry if they achieve the hurdle rate, normally of 7-8%
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Hurdle rate
minimum rate of return (7-8%) on an investment required so that the PE firm receives the carry,
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What are some of the smaller revenue sources of PE?
deal fee and monitoring fee
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Deal fees
When a PE firm closes a deal, it frequently charges the target a deal fee calculated as asmall % of the total deal size. These fees are often shared with LPs
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Monitoring fees
Portfolio companies frequently pay management fees to their PE owners a compensation for the owners’ ongoing monitoring and managerial assistance
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How is the deal sourced?
normally from an investment bank, with a few pages representing the target company. if the company is being sold at an auction by the investment bank, then the PE fund if they are interested in the company they sign an NDA to receive the CIM
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CIM
confidential information memorandum is a document that investment banks prepare with companies in a sell-side M&A process.The packet of information gives buyers information about the business, management and financials, and the market. The CIM can be more than 50+ pages long
containing information about the target’sbusiness, industry, strategy, historical financials, projected financials, etc
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When making the decision to sign the NDA, the PE firm considers several factors:
Does the proposed investment fit its investment criteria at a high level?
Does the firm have any conflicts which prevent it from pursuing the deal?
Is there much to learn from further participation in the process?
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What does the analyst do with the CIM?
builds a simple LBO model based on management's financial projections to estimate how much the PE firm could pay for the target company while achieving its IRR, then puts the information gathered for the model in a summary and presents it to the MDs. If the MDs like the deal profile they send a non-binding bid with a range of how much the firm expects to be able to pay for the asset
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IOI
indication of interest, part of the deal process where the MD sends the non binding price for the asset
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What are some of the characteristics that make deals attractive?
1. strong competitive position
2. predictable cash flow
3. long-term market tailwinds
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What is one of the most important determinants of a fund's returns?
Price they paid to acquire the business
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four types of diligence
commercial, valuation, accounting and legal
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Commercial Diligence
projecting the target's operational and financial performance
investigating market growth, historical performance, the target's competitive position, business model, key performance drivers, supply chain analysis
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Valuation Diligence
determining the current fair market price for the asset and the multiple it could be sold for at exit, to make sure they are paying a fair current price and to forecast its profits at exit
- looking at comparables and what they are trading at, comparables average trading multiples
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Accounting diligence
focuses on confirming that the target's reported financials accurately represent the fundamentals of the business
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Legal Diligence
focuses on confirming that the target is not subject to any material unreported legal liabilities
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How could you determine an appropriate exit multiple on a PE deal?
1. Comparable multiples analysis will tell you what multiples similar public companies are trading for on the stock market
2. Precedent transactions will tell you what the multiples were on deals involving similar targets
3. LBO analysis, will tell you what multiple a financial sponsor would be willing to pay in the future
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What is Total enterprise Multiple?
Tells you how many times EBITDA you would have to pay if you were to acquire the company
7xEBITDA multiple, means that if the company generated $100 million EBITDA in the last 12 months than the total enterprise value of the company would be $700 million
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Steps in DCF model
Step 1: Project company’s FCF 5 years forward
Step 2: Calculate an appropriate discount rate for the profits projected in the first step
- Weighted Average Cost of Capital (WACC) to calculate an appropriate discount rate
Step 3: Project the target’s Terminal Value (TV) after the last year of projected FCF
Step 4: Apply the following formula to discount the value of all future cash flows back to the present day
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What is Total Enterprise Value (TEV)?
Measure of the financial value of a company
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Equation for TEV
TEV = Value of Equity + Value of Debt – Excess Cash
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Why is excess cash subtracted in the TEV calculation?
Excess cash is cash on the balance sheet that is not needed for ongoing operation, it is subtracted from TEV because in the event of an LBO the seller usually keeps the excess cash. Excess cash doesn’t reflect the value of business operations
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Why is FCF important for PE?
FCF very important for PE firms because it tells you how much debt the company can pay which then determines how much leverage an LBO can use
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FCF equation
FCF = Ebit (1- Tax Rate ) + D&A – Capex – Change in WC
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Weighted Average Cost of Capital (WACC)
- WACC is a measure of riskiness of investing in a business
| - used as a discount rate in DCF
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Relationship between WACC and TEV
- TEV of every company is made of some percentage equity and some percentage debt
- WACC is the sum of cost of equity and the sum of cost of debt, each weighted by the percentage of TEV they constitute
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Capital Asset Pricing Model (CAPM)
- Model that describes the relationship between the riskiness of assets and the rate of return investors should expect in order to bear those risks
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What is Net Working Capital?
How much cash a company needs to fund its daily operations
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Change in NWC
Difference between the current period NWC and the previous period NWC
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If change in NWC is positive
it means that the company spent additional cash to fund its daily operations over the current period
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What does positive NWC mean for FCF?
Companies that always have positive NWC consistently need more and more cash to fund its operations as they grow, which decreases FCF and debt capacity
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What does negative NWC mean for FCF?
Companies with consistent negative NWC, generate more and more cash from NWC as they grow, which increases FCF and it means the company can increase its debt capacity
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Why should you care about change in Net Working Capital?
PE firms calculate returns based on cash or on the anticipation of future cash flows. If a company requires more and more working capital as it grows then the amount of cash and the return to the PE firm will be lower (all other things being equal)
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Terminal Value (TV)
- Represent all future cash flows in the DCF
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Deal Selection: Characteristics to look for when choosing deals
1. Strong Competitive Position
2. Predictable Cash Flow
3. Long-term market tailwinds
4. Concrete Improvement Opportunities
5. Favorable deal dynamics
6. Strong Management Team
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4 Main Sections of the teaser
1. Transaction Overview
2. Key Financial Metrics
3. Investment Highlights
4. Industry Overview
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What is the section Transaction Overview in the teaser?
overview of the opportunity, short overview of transaction, industry
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What is the section Key financial metrics in the teaser?
high level info, includes EBITDA, revenue, gross profit, EBITDA margins
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What is the section Investment Highlights in the teaser?
key considerations when making your potential investment. Market position, product offering, customer overview, expertise of management team
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What is the section Industry Overview in the teaser?
overview of key trends that might be happening in the space
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How PE firms make money?
Method #1 : Buy cheap
Method #2: Financial Engineering
Method #3: Improve Operations
Method #4: Exit Right
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How are PE firms able to buy cheap?
1. Better understanding of asset value
2. Relationship with management and sellers
3. Absence of other natural buyers
4. Access to investment cash during downturn
5. Faster deal closing
6. More certain deal closing
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How can Financial Engineering drive returns?
1. Better Balance Sheet Management
2. Interest tax shield
3. Debt pay-down
