Random Flashcards
Sale to strategic VS to PE fund
Strategics can offer higher price because of synergies; often require majority stake - so have to pull along other investors. PE buyers are more sophisticated so can offer shorter time to close but demanding buyers.
Cash Conversion Cycle
Cash conversion cycle shows time it takes a company to convert its investments in inventory to cash. CCC = Days Inventory + Days Sales Outstanding - Days Payables outstanding
Would you rather achieve a high IRR or a high MoM on a deal? What are the tradeoffs? What factors might influence your answer?
Two common reasons to prefer a higher IRR are: 1. IRR is the most important single metric by which many LPs judge the performance of PE firms because LPs such as pension funds and endowments need to hit certain return rate thresholds in order to meet their commitments to their constituents. An LP won’t be impressed with a 2.0x MoM if it take 10 years to materialize, because the IRR on that return would be far below the LPs requirements for the PE portion of its portfolio. Funds which achieve “top quartile” IRRs usually have little trouble raising subsequent funds, whereas funds with low IRRs struggle to raise future funds. Therefore, PE funds are careful not to let IRRs drift below the level their LPs expect. 2. Most PE funds don’t get their carried interest unless their IRR exceeds a certain “hurdle rate”. Hurdle rates and the mechanics of hurdle rate accounting are varied and complicated, but most funds must clear a 6 - 17% IRR in order to receive their full carried interest percentage. Therefore, if a fund’s IRR is below or near its hurdle rate, PE funds are especially financially incentivized to boost IRR. Two common reasons to prefer a higher MoM are: 1. Assuming the hurdle rate has been exceeded, GPs are paid carry dollars based on MoM, not IRR. If a GP buys a company for $100 and sells it for $140 one year later, that translates to a terrific 40% IRR, but the GP would earn only ~20% * $40 = $8 in carried interest. On the other hand, if a GP buys a company for $100 and sells it for $250 after four years, the IRR falls to 25% but the carried interest earned is ~20% * $150 = $30. 2. PE firms (and by proxy their LP investors) incur transaction costs when they buy and sell companies. If a PE firm sells portfolio companies too quickly in order to juice IRR, then it has to spend more money to find and close additional deals. In addition, once a PE firm fully invests its existing fund, it must raise another fund, which also has fundraising costs associated with it. Timing of particular investment and performance of portfolio in general affects this choice.
Marketing regulations
PE fund must raise capital via private placements to qualified investors only (often defined by having a minimum of investable assets or being registered as qualified individuals). Marketing to high-net worth and sophisticated investors is permitted in some jurisdictions, while any general public offering of the fund or marketing to retail investors is usually prohibited.
Mezzanine Debt
Financing below high-yield debt and right before equity (might be referred as financing between secured debt and equity). Hedge and mezz funds are primary investors. Most common financing structures: - Convertible debt, - Bond with warrants, - Convertible preferred stock - Preferred stock with warrants - Unsecured debt with few covenants Pricing components: Target return 10-15% - Cash interest / dividends - PIK interest / dividends - Warrants (“equity kicker”)
How do you account for project under construction?
If a company is constructing a major project such as a building, assembly line, etc., the amounts spent on the project will be debited to a long-term asset account categorized as Construction Work-in-Progress. There is no depreciation of the accumulated costs until the project is completed and the asset is placed into service. When the completed asset is placed into service, the project’s accumulated costs will be removed from the Construction Work-in-Progress account and will be debited to the appropriate plant asset account and start depreciating.
Tax consequences of asset sale VS stock sale
Stock Sale - Avoid a corporate-level tax: Most deals are structured as stock sales because sellers usually face tax on the gain on sale, leading to a second level of tax in an asset sale above the shareholder-level capital gains tax. Favored by sellers. Asset Sale - Gives buyer future tax savings via stepped-up tax basis: In light of the additional tax on seller, you might be wondering why anyone would ever do an asset sale. The most common reason is that the acquirer gets to step up the tax basis of the acquired target assets. That means future tax savings through higher tax-deductible depreciation and amortization in the future. Favored by buyers.
Why IRR decreases with increase in entry/exit multiples? Keeping the debt at the same level
You are investing more sponsor’s equity to get the same cash generation profile so MOIC will be lower for any given period -> lower IRR but it depends on whether the debt stays at the same level
If you were given a CIM and had to write an investment memo within a day, what items would you focus on?
- Industry (Large & Underserved TAM, Growth Trends, Macro Disruptions, Cyclicality, Margins) - Investment Highlights (Strong and Defendable Market Position, Growth Opportunities, Diversified Product Portfolio and Customer Base, Unique Differentiating Factors) - Differentiating Factors of the Business - Opportunities for value creation (alpha generation) - Financials (Projected and Historical Growth and Profitability) - Management Team
Factors to look for in a management team?
- Extensive relevant industry experience and proven operational record of implementing strategic initiatives - Cohesion (i.e. they work well together and have been working together to deliver measurable results for some time) - Hunger for more (not satisfied with where they are at, clear desire to take the company to the next level) - A desire to re-invest in the business as part of the transaction (to get management aligned with the sponsor) - Sophistication to handle PE ownership and increased financial demands (because of the debt load and demands for growth and profitability from the company’s new financial investors)
Potential Sources of Funds
- Management Rollover - Seller Note - Revolver - LT Debt - BS Cash - Potential Sale or Divestiture of Part of the acquired business - Sponsor’s Equity
Contractual mechanisms to achieve control and liquidity
- Board control and veto rights - Registration rights (right to trigger IPO) - Redemption Rights (right to require portfolio company to purchase sponsor’s equity) - Drag-along rights (right to force minority investors to participate in the sale of the portfolio company (or the parent holding company, as applicable) - Tag-along rights (give their holder the right to force another stockholder that is selling its shares to include the other holder’s shares in the sale, on a pro rata basis) - Contractual requirement to have certain % of stockholders to agree to potential move like sale of the company - Requirement to get board agreement or stockholders vote to do some action (like sale of assets or capital investment)
What is vendor / supplier lock-in
vendor lock-in, also known as proprietary lock-in or customer lock-in, makes a customer dependent on a vendor for products and services, unable to use another vendor without substantial switching costs. Lock-in costs that create barriers to market entry may result in antitrust action against a monopoly.
Inter-dependency of commercial and financial risks
The lower commercial risk the higher financial risk can be. If the company has low commercial risk (predictable cash flows) it can take on more financial risk (more debt)
Demand elasticity - what is it
Degree to which demand changes as price changes. High elasticity - if price goes down a little demand goes up a lot. Perfectly inelastic good is when change in price won’t affect demand for the good at all.
Objectives of due diligence
- confirm what you are buying; - identify issues that feed into price negotiations, and hence reduce the risk of paying too much; - de-risk the deal by identifying points against which legal protection should be sought; - define the full potential of the target and it’s commercial prospects and help to define a plan for achieving the maximum value - judge management’s ability against the defined strategy
Approach to operational revision of a company
- Strategic due diligence that would help to define full potential of a company - Developing detailed operational 3-5 years plan (blueprint) with 3-5 core initiatives and define what you are NOT going to do - Accelerating implementation of the blueprint by molding the company around the plan (developing critical to follow and forward looking predictive metrics, match talent with key initiatives, give them powers and make them OWN key initiatives, align generous incentives, make equity sweat and embrace leverage) - Fostering result-focused culture in a company
Make Equity Sweat principles
- Embrace leverage. - Focus on cash generation (to make debt pay). - Aggressively manage: • Working capital – Receivables/payables – Inventory • Capital expenditures • Other balance sheet assets – Unproductive equipment/facilities – Businesses/divisions that are underperforming or worth more to others – Traditionally fixed assets converted as sources of financing Invest capital with discipline: • Think of your new capital investments as important as original investments.
What are risks specific to PE fund investing in developing market?
- Country specific risks (i.e. corruption, absence of rule of law) - Currency risk (get investments in dollars from international LPs but revenues are in local currency) - Higher GDP volatility so target IRRs have to be high enough to absorb this volatility - Lack of liquidity & exit opportunities - Some sectors imply a high degree of government control like commodities (oil & gas etc)
Reasons for M and A
- Industry consolidation (eliminate over-capacity, gain market share, improve prices, achieve economies of scale - Geographic roll-up (geographical expansion) - Product and market extension (extend company’s product line or coverage in existing industry) - M&A as an R&D (acquire IP) - Defensive M&A (acquire potential threat of substitute or competitor) - Industry Convergence (entry new growing industry) - Acquihire (acquire the team)
Why buyers might not like Floating Exchange Ratio?
Because in floating exchange ratio the price for the acquisition stays fixed but exchange ratio can vary based on buyer’s stock price. If the price falls far enough the buyer can end up issuing infinite number of shares. Much more than the buyer originally thought they would like to issue. So the risk is on the buyer.
Scope of due diligence
When defining scope on Due diligence focus on why you are buying the target - if it’s IP focus on IP; if it’s the market focus on the market
Three marketing competition strategies per Porter
- Cost leadership requires aggressive construction of efficient-scale facilities and cost minimization in all areas of the business (including customer selection). Cost leadership often requires a high relative market share to give scale advantage. 2. Differentiation is creating something that is perceived industry wide as being unique. There are many ways of creating a unique offering from product features (waterproof matches) design or brand image (Mercedes) to customer service (UK retailer Marks & Spencer’s no-quibble returns policy). Differentiation usually involves lower market shares and higher costs. 3. Focus involves concentrating on particular buyer groups or segments. These are effectively sub-markets. How well the target serves these groups will determine its competitive position. This could be through lower costs in serving the segment or meeting its needs better (or, these days, both).
Two things to analyze when analyzing a company
- Structural analysis of the industry where the company competes (market size, market growth, cyclicality, penetration of the market (stage the market at - growth, maturity etc), price elasticity, technological and regulatory disruptions, margins and degree of buyer power, switching costs, competition and barriers to entry) 2. Ability of the company to compete (differentiating factors [brand, technology, expertise, some sort of additional value for customers], competitive position, historical performance (financial & historical margin analysis, customer feedback), management)
How companies can create operational value?
+ Capital Structure Optimization
- Working capital optimization (inventory, receivables, payables)
- Fixed asset optimization (capacity, leasing, financing, asset utilization, lease backs, sale of inefficiently used assets)
- Capital expenditure optimization (postpone or avoid investments)
- Surplus cash policies (dividends, share buybacks, debt repayments)
- Restructuring and divestment
- Tax optimization (off-shore, transfer pricing, tax treaties)
+ Bottom Line
- Sourcing (Outsourcing, offshoring, insourcing)
- Procurement (Cost savings and supplier base)
- Logistics ( Order handling, planning and stocks, warehousing and distribution)
- Operation, production and manufacturing efficiencies (specialization)
- Delayering
+ Top Line (Core Business)
- Sales force effectiveness (incentives tied to margin and growth)
- Account management (strategic accounts and end customers)
- Marketing (Promotion effectiveness, brand management)
- Pricing (Strategy, levels and structure of discounts, execution)
- Product line development (continuous improvements to existing products)
- Product bundling and cross-selling
- Channel management (Channel merchandising, sales aspects of logistics)
- Shifting product mix
+ Top line (Expansion)
- Channel strategy (Expansion into new channels)
- Product innovation (New product development)
- M&A
- Brand strategy
- Geographic expansion
- Business model expansion
- Service (Model, organization and processes)
Representations and warranties
Guarantees that the seller gives about the business
Indemnification clauses
Agreement to compensate other party for breach in representations and warranties or loss
Acquisition Chronology
Value Chain Chart
PE Fund Deal Process Stages
Due Diligence 3rd Party Advisors
Stock Sale VS Asset Sale
TSA What is it and when used?
SPA What is it and key segments
LOI Building Blocks
Any regulatory approvals - when take place and what are those
Flow of Funds Schedule
