PE Interview Prep Flashcards
(44 cards)
Walk me through the income statement.
- Income Statement: shows revenues and expenses over a period of time; used to assess profitability
Revenue
Less: Cost of Goods Sold (COGS)
= Gross Profit
Less: Sales, General, & Administrative (SG&A)
Less: Research & Development (R&D)
= EBIT
Less: Interest Expense
Earnings Before Taxes (EBT)
Less: Income Tax
= Net Income
Net Income if first line on CF Statement
Walk me through the balance sheet.
Assets: The resources with positive economic value that can be exchanged for money or bring positive monetary benefits in the future.
Liabilities: The outside sources of capital that have helped fund the company’s assets. These represent unsettled financial obligations to other parties.
Equity: The internal sources of capital that have helped fund the company’s assets, this represents the capital that has been invested into the company.
Walk me through the cash flow statement.
The cash flow statement summarizes a company’s cash inflows and outflows over a period of time.
The CFS starts with net income, and then then accounts for cash flows from operations, investing, and financing to arrive at the net change in cash.
Operating Activities: Cash flow from company’s core business operations, including sales revenue and expenses
ex: Increase in accounts receivable → Subtract bc more sales on credit, reducing cash collected
Investing Activities: Cash flows related to CapEx and the purchase and sale of long-term assets like property, equipment, and investments.
Cash Flow from Financing Activities: Cash flows related to a company’s capital structure, including issuing or repaying debt, issuing or repurchasing stock, and paying dividends.
What is the purpose of each financial statement?
Income Statement: Profitability - measures the revenue and expenses
Balance Sheet: Financial position (what the biz owns and owes) - measures the assets, liabilities, and equity
Cash Flow Statement: Cash movements - measures inflows and outflows of cash
How are the three financial statements connected?
Income Statement ↔ Cash Flow Statement
Net income on the income statement flows in as the starting line item on the cash flow statement.
Non-cash expenses such as D&A from the income statement are added back to the cash flow from operations section.
Cash Flow Statement ↔ Balance Sheet
The changes in net working capital on the balance sheet are reflected in cash flow from operations.
CapEx is reflected in the cash flow statement, which impacts PP&E on the balance sheet.
The impacts of debt or equity issuances are reflected in the cash flows from financing section.
The ending cash on the cash flow statement flows into the cash line item on the current period balance sheet.
Balance Sheet ↔ Income Statement
Net income flows into retained earnings in the shareholders’ equity section of the balance sheet.
Interest expense on the balance sheet is calculated based on the difference between the beginning and ending debt balances on the balance sheet.
PP&E on the balance sheet is impacted by the depreciation expense on the balance sheet, and intangible assets are impacted by the amortization expense.
Changes in common stock and treasury stock (i.e. share repurchases) impact EPS on the income statement.
Walk me through a DCF
Discounted cash flow (DCF) analysis is a valuation technique to derive the intrinsic value of a company based on projected future cash flows
Forecast a company’s likely future cash flows and then discount them back to present value
- Forecast EBIT
- Calculate EBIAT, then (Add Depr,
Less CapEx, Less Change in NWC) to get to FCF - Calculate the Discount Rate
- Calculate the Terminal Value (Ex. TV in 2017 = FCF 2017 * (1+g) / (r-g))
- Calculate NPV (Enterprise Value) and IRR
- Pursue project if NPV > 0, IRR > Discount Rate
Walk me through an LBO.
- Determine Entry Valuation.
Entry Valuation = LTM EBITDA * Entry Multiple
Entry Multiple is based on
- Market Comparables: Look at the valuation multiples of similar companies (e.g., public comps or recent M&A transactions in the same sector).
- Target-Specific Factors: Adjust for the target company’s growth prospects, profitability, risk profile, or market position.
- Economic Conditions: Consider broader market dynamics, like whether the market is in a bullish or bearish cycle, which impacts multiples.
- Create Sources and Uses of Funds Table: Determine the cost of purchasing the company, and the amount of debt and equity financing required to complete the acquisition.
Uses Side ➝ The total amount of capital required to complete the acquisition
Purchase Enterprise Value (TEV)
+ Transaction Costs
+ Financing Fees
Sources Side ➝ The specific details on how the firm plans to come up with the required funding
Existing Cash
+ Debt
+ Equity (i.e. the equity investment to “plug” the remaining funds required)
- Financial Forecast and Debt Schedule: Create a 3-statement financial model for 5 years along with a debt schedule.
- LBO Exit Returns and Debt Paydown Schedule
(a) Exit Valuation:
Exit Enterprise Value (TEV) = Exit EBITDA * Exit EBITDA Multiple
(b) Debt Paydown: Initial Debt - Cumulative FCF
- Exit Equity Value: Exit Enterprise Value (TEV)–Net Debt
Once we determine the exit equity value, we can estimate the key LBO return metrics, IRR) and MOIC
- MOIC (Multiple on Invested Capital), the ratio of the proceeds of an investment vs. how much you initially invested
= Exit Equity Value÷Initial Sponsor Equity
Ex: MOIC of 2.0x means the investor doubled their money. Higher EBITDA growth and delevering (reducing net debt) boost MOIC.
IRR = MOIC^ (1÷t) –1
IRR is the annualized yield on an investment
- Sensitivity Table
Walk me through a project finance deal.
Project finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of its sponsors.
Construction Phase:
- Identify Uses of Capital (Construction, Financing Fees, etc.)
- Identify Sources of Capital (Debt & Equity)
Operations Phase:
- Project Revenue
- Project Opex (Labor, Overhead) and Capex (Construction Costs)
- Schedule Repayment of Debt
- Schedule Interest Payments on Debt
- Schedule Tax Payments
- Calculate CFADS (Cash Flows Available for Debt Service) which is
= Revenue - Expenses - CapEx - Taxes + Change in NWC - Calculate DSCR (Debt Service Coverage Ratio) which is CFADS / Debt Service (aka Interest + Principal)
- Calculate LLCR (Loan Life Coverage Ratio) which is = NPV of CFADS / Debt Balance. This answers the question, at the beginning of the debt paydown period, how many times can the cash flows cover the debt balance over the life of the loan?
CFADS is discounted at cost of debt (interest rate)
RETURNS METRICS
- Evaluate the Equity IRR
Target 15% IRR; the cash flow after paying the debt holders - Evaluate the Project IRR
Target ~10% project return; compares the project’s return to the WACC. If Project IRR > WACC, the project creates value. - Negotiations and Optimizations
Walk me through a PPA / Brookfield wind farm deal.
- ERCOT 2.5-Yr PPA for 200 MW West Texas wind farm
Context:
Negative Covariance Risk: With West Texas being a renewable energy hub, this plant was constantly plagued by negative energy prices due to high supply and low demand
Solution: Fixed-Price PPA
Node-Hub Basis Risk:
Solution: Permitting curtailment when basis is wider than a certain threshold, so long as the hub is below a certain level
Avoiding situations in which hub prices are extremely high and the off-taker has to buy into the market
Client: electric utility with retail load in Texas
- New England 2-Yr PPA for 26 MW wind farm in Maine
Extension of existing contract
- Unfavorable extension clause
- Solution: reduce uncertainty by relationship building, creative deal structures
Replaces 10% of the university’s energy with renewable power
What is enterprise value vs equity value?
Enterprise value is what an entire company is worth and would be how much money is needed to purchase a whole company
Enterprise value = equity value + debt - cash
(In order to buy a whole company, you need to purchase all of its equity, plus any debt, minus cash bc you can use the company’s cash to pay down debt)
Equity value is the value of a company that is owed to equity investors
Equity value = enterprise value - debt
Why is it better to finance with debt vs. equity?
The logic behind why it is beneficial for sponsors to contribute minimal equity is due to debt has a lower cost of capital than equity. One of the reasons the cost of debt is lower is because debt is higher up on the capital structure – as well as the interest expense associated with the debt being tax-deductible, which creates an advantageous “tax shield”. Thus, the increased leverage enables the firm to reach its returns threshold easier.
What are the key drivers and primary levers in an LBO that drive returns?
Key Drivers of Success:
1. Enter at a Low Price
2. Lever with Cheap Debt
3. Improve the Business (Grow EBITDA)
4. Exit at a High Multiple
Key Levers:
1. Deleveraging: Through the process of deleveraging, the value of the equity owned by the private equity firm grows over time as more debt principal is paid down using the cash flows generated by the acquired company.
With less debt and the same total company value, the remaining equity represents a larger portion of ownership.
Equity Value Growth (EquityValue=EnterpriseValue−NetDebt)
- EBITDA Growth: Growth in EBITDA can be achieved by making operational improvements to the business’s margin profile (e.g. cost-cutting, raising prices), implementing new growth strategies to increase revenue, and making accretive add-on acquisitions.
- Multiple Expansion: Ideally, a financial sponsor hopes to acquire a company at a low entry multiple (“getting in cheap”) and then exit at a higher multiple. The exit multiple can increase from improved investor sentiment in the relevant industry, better economic conditions, and favorable transaction dynamics (e.g. competitive sale process led by strategic buyers). However, most LBO models conservatively assume the firm will exit at the same EV/EBITDA multiple it was purchased at. The reason is that the deal environment in the future is unpredictable and having to rely on multiple expansion to meet the return threshold is considered to be risky.
General target returns for infra investing and investment horizon.
12% for Existing Project Finance, 20% for Greenfield
20%, 5-7 yr horizon for LBOs
How do LBO sponors monetize their returns?
Sponsors Hope to Monetize Their Returns by:
- Selling to a strategic acquirer or another PE firm (90%)
- IPO
- Dividend Recapitalization (Sponsor gives themselves a dividend finances by new borrowing; low interest rate environment)
What do Investors Look for in a Good LBO?
- Steady cash flow with little cyclicality
- Minimal ongoing CapEx and working capital needs
- Suboptimal capital structure (low leverage so value from tax savings is not fully realized)
- Business is deemed undervalued in the market / low multiple / company has fallen out of favor
- Strong management teams unchained from public demands (investor pressure)
- If there are subsidiaries that can be sold to pay down debt
Explain Production and Investment Tax Credits, and monetization.
PTC: A tax credit based on the actual electricity produced by a renewable energy project; a fixed dollar amount ($/MWh) of energy generated; available for 10 years after project commissioning.
Rewards production efficiency: Higher output = More tax credits.
Inflation-adjusted annually
Typical for wind projects
ITC: Upfront CapEx-Based Incentive
A tax credit based on a percentage of CapEx (typically 30% of Capex). but can increase under the IRA
One-time benefit, applied in year one after project completion.
Typical for solar projects
Monetization:
Renewable developers often lack enough tax liability to fully use PTCs/ITCs.
They partner with tax equity investors (e.g., banks, institutional investors) who provide upfront capital in exchange for the tax benefits.
Common Monetization Structures:
Transferability → Developers can sell the ITC directly to third parties.
Partnership Flip → Investor owns majority of the project at first, then “flips” ownership to developer after tax benefits expire.
Sale-Leaseback → Developer sells the project to an investor, then leases it back.
What is a GP and LP?
PE firm = General Partner (GP)
LPs (Limited Partners) provide equity to the PE firm to deploy (pension funds, insurance companies, universities, high net worth individuals)
LPs commit capital and the GP (PE firm) charges them an annual management fee of ~2%
20% of the fund’s returns are kept by the GP (“Carry”); remaining 80% given back to LP
Common IRR Approximations
2x Initial Investment in 3 Yrs
2x Initial Investment in 5 Yrs
2.5x Initial Investment in 3 Yrs
2.5x Initial Investment in 5 Yrs
3x Initial Investment in 3 Yrs
3x Initial Investment in 5 Yrs
2x Initial Investment in 3 Yrs = 25% IRR
2x Initial Investment in 5 Yrs = 15% IRR
2.5x Initial Investment in 3 Yrs = 35% IRR
2.5x Initial Investment in 5 Yrs = 20% IRR
3x Initial Investment in 3 Yrs = 45% IRR
3x Initial Investment in 5 Yrs = 25% IRR
If you had to choose two variables to sensitize in an LBO model, which ones would you pick?
The entry and exit multiples would have the most significant impact on the returns in an LBO.
The ideal scenario for a financial sponsor is to purchase the target at a lower multiple and then exit at a higher multiple, as this results in the most profitable returns.
While the revenue growth, profit margins, and other operational improvements will all have an impact on the returns, it is to a much lesser degree than the purchase and exit assumptions.
What does the “tax shield” refer to?
The “tax shield” refers to the reduction in taxable income from the highly levered capital structure.
As interest payments on debt are tax-deductible, the tax savings provides an additional incentive for private equity firms to maximize the amount of leverage they can obtain for their transactions.
Because of the tax benefits attributable to debt financing, private equity firms can be incentivized to not repay the debt before the date of maturity assuming the prepayment is optional (i.e. “cash sweep”).
How is risk mitigated in Project Finance?
- Ring-fenced cash flow through SPV
- Highly contracted
- Gearing (leverage) constraints
What are the key metrics in Project Finance?
- CFADS (Cash Flow Available for Debt Service): the cash flows that senior lenders have claim to
CFADS = Revenue - Expenses - CapEx - Taxes + Change in Net Working Capital
Project finance is raised based off the strength of the project cash-flows. The CFADS expected during a project is the key contributor for determining the debt capacity of the project (“debt sculpting”)
- DSCR = Debt Service Coverage Ratio = CFADS / Debt Service = measure the ability of the project to service its debt through its cash flows
Lenders want project to demonstrate a cash cushion (ability to repay debt and beyond)
Higher revenue risk = higher DSCR - Cash Flow Available for Equity: CFADS - Debt Service
- LLCR: Loan Life Coverage Ratio: # of times that future projected cash flows can repay the outstanding debt balance
LLCR = NPV of Remaining CFADS / Debt Balance
NPV is discounted by Cost of Debt
1x means there’s exactly enough
Total Revenue
- Total Expenses
=Cash Flow Available for Debt Service
Debt Service
Debt Service Coverage Ratio
Cash Flow Available for Equity
What does a typical Project Finance waterfall look like?
In a typical project finance waterfall, the starting line is CFADS, from which debt service is paid out, with the cash-flows remaining split in the hierarchy to other cash uses, for example:
Debt Service Reserve Account (DSRA): = rainy day account. The project relies on its cashflows to repay debt (usually covers 6 months of CFs)
Major Maintenance Reserve Account (MMRA)
Mezzanine or subordinated debt
Lastly, other equity sources including equity investors and shareholder loans
Common types of Project Finance risk
Construction Risk: Cost overruns, planning/consents
Operations Risk: Raw material costs, Operating performance, maintenance cost/timing
Financing Risk: interest rates, commodities markets, FX exposure
Volume Risk: output volume, output price
