Guides - Drive

Question 1

What is a good PE investment

Answer 1

• Stable and defensible cash flows
• Low capital investment and working capital needs
• Operational Levers to pull (volume, prices increases, cut costs, etc.)
• Can bolt on companies
• Divestable / monetizable assets
• Cheap price
• Attractive industry. Growth.
• Clean balance sheet with credit support capability
• MGT team
• Exit strategy

Question 2

What are some due diligence questions?

Answer 2

Industry Questions

• Porter’s 5 (Supplier, Customer, Substitute, Competitive Rivalry, Entrants)
• How are products differentiated in terms of price, brand, and service
• The concentration of customers / suppliers

Company Specific - Operational

• Competitive positioning
• Growth disaggregated in terms of price and volume (room to increase volume via market growth or market share growth (think WSO model) or increase prices)
• How does the company and MGT respond during downturns? Cyclical business? Tied to commodity prices?
• Cost structure (operating leverage)
• ROIC / how well do they utilize assets
• what is their capex like (growth vs. maintenance, future capex needs)
• how is working capital managed?

Company Specific - Financial

• Cash, debt, off balance sheet liabilities
• Projected financials? Capexs?

Company Specific - Strategic

• Any non-core business lines?
• Room for improvement or rationalization?

Company Specific - Management

• MGT trackrecord during downturns
• MGT performance at prior companies - were they able to increase margins?

Company Specific - External
- Regulatory or legal risks?

Exit Strategy

• Is industry consolidating and sale is an option?
• State of industry in equity and credit markets

Question 3

“Good business” case studies

Answer 3

What are the key bullet points you need to know if something is a good business?

• MGT
• Margins
• Cash flow positive
• Loyal customers, brand
• MGT alignment

If I was talking with the CEO and could ask three questions, what would I ask?

Question 4

Paper LBO - Things to Know

Answer 4

• Cap structure
• Duration of investment
• Projected EBITDA for FCF and exit value
• D&A
• Interest / cost of debt
• Tax rate
• Capex
• NWC
• Exit multiple

Question 5

Why EV/EBITDA over P/E?

Answer 5

• Value of company available to all capital holders. We’re going to put our own capital structure on the business after close
• On that, EBITDA a better approximation of unlevered operating cash flow
• Accounting manipulations to NI such as accelerated depreciation
• Value firms that have negative NI

Question 6

What are ways a firm can spend FCF?

Answer 6

Invest in the company (Capex)
Enter new markets or product lines (organic growth, R&D)
M&A (Expand, take out competition, synergies)
Financing decisions –> retiring debt and stock; issue dividends

Question 7

Given no multiple expansion and flat EBITDA, how to create value

Answer 7

Increase FCF to paydown debt

• refinance with lower cost paper
• lower capex, quicker cash conversion cycle
• lower taxes

More leverage

Pay yourself a dividend
Management fees if below the line

Question 8

LBO Model Drivers?

Answer 8

EBITDA growth (comes from revenue growth and ebitda margin expansion)

Multiple expansion (cheap price, good exit)

Debt Paydown

Leverage at close

Question 9

If you have company with P/E of 10x and cost of debt of 5%, which is cheaper?

Answer 9

Cost of earnings here is 1/10 = 10%

Debt is cheaper

Question 10

NCI problems

Answer 10

Revenues and expenses are reported on a consolidated basis assuming 100% ownership.
Only at the end of the income statement do you back out earnings attributable to NCI.
So you ADD back NCI to your EV calc so you get apples to apples on your EV/EBITDA
Or you can take ownership % of EBITDA

Question 11

Asset

• Carrying Amount > Tax Basis =
• Carrying Amount < Tax Basis =

Liabilitiy

• Carrying Amount > Tax Basis =
• Carrying Amount < Tax Basis =

Answer 11

Asset

• Carrying Amount > Tax Basis = DTL
• Carrying Amount < Tax Basis = DTA

Liabilitiy

• Carrying Amount > Tax Basis = DTA
• Carrying Amount < Tax Basis = DTL

Question 12

Income Tax on IS =

Answer 12

Cash taxes payable + increase in DTL - increase in DTA

DTAs essentiallyt the plug between cash taxes payable and income tax expense on IS

Question 13

Captial Leases vs Operating Leases

Answer 13

Capital leases - payments separated into interest and operating expenses

Operating leases - payments in operating expenses only

Question 14

Beta levered formula

Answer 14

Beta Unlevered * (1+(1-T)* D/E)

Question 15

How do NOLs flow through the 3 statements?

$200 NOL BoP; $100 pretax income; 40% tax rate

Answer 15

First you have an NOL balance that is kept off the balance sheet that represents prior negative years’ taxable income.

Your DTA balance = NOL * tax rate
Change in balance = Nol * (NOL created less NOL used)
Tax expenses on the IS do not change
Taxes payable reduced by this NOL amount

Ex
DTA on BS = 200*.4=80
1. Calculate NOL used. = $100
100*.4=40 decrease in DTA
2. IS doesn't change. Tax expense of 100*.4=40; NI of $60
2. CF statement = decrease in DTA increases cash
60+40=100
3. BS
Cash up 100, DTA down 40, RE up 60

Question 16

Now what if you have a $100 loss?

BoP $200 NOL BoP; $100 pretax loss; 40% tax rate

Answer 16

1. DTA on BS is 200*.4=80
2. NOL = 200+100=300
   2a. IS tax shield of 40, 60 loss in NI
3. Increase in DTA = 100*.4=40, which is a decrease in cash flow. Cash down 100
4. Cash down 100
   DTA up 40
   RE down 60

Question 17

Now what if you have $250 income?

BoP $200 NOL BoP; $1250 pretax gain; 40% tax rate

Answer 17

Use up all of $200 NOL. New pretax income is $50 * .4 = 20 in actual taxes paid

IS = Tax expense = 250*.4=100
CF = NI of $150 plus decrease in NOL (200*.4)= 80 - Cash of 230
BS = cash up 230, DTA down 80, NI up 150

Question 18

How do Fx impact the financials?

Answer 18

When a company’s functional currency differs from its reporting currency, it will report gains / losses from Fx impacts.

Temporal method = when sub’s functional currency =/= local currency. Not very independent. Use historical exchange rates to bring over assets and liabs

Current rate method = foreign sub is independent, bring everything over at current rate (not reflected n P&L, but AOCI)

Question 19

IPO Exits: Pros and Cons

Answer 19

Pros: method of exit when a sale is not available due to no M&A appetite. Put a price to your position. Can use for M&A and incentivize employees.

Cons: No clean exit; may take awhile to unload shares. Uncertainty with share price. Regulatory costs and now in the public sphere

EV less net debt = equity
equity * percentage of position sold = CFs in year 1

Question 20

Dividend recaps

Answer 20

Capacity for extra debt?
Breakage costs?
Covenants allow for the dividend?
Not a clean exit
State of the credit markets

Good to take money off the table and recover some of your basis

Question 21

NAV Modeling

Answer 21

Present value of reserves assuming no additoinal exploration capex. Cashflow will go to zero when you are out of reserves

1. Forecast pricing based on current strip, realized prices (calc differentials), or futuers
2. Forecast production (current rate of production, account for type curve)
   (IP rate = current production per day today. IP-30=initial production 30)
   IP * 365 * decline rate
   Can look at comps in similar basins to find decline curves
3. Expenses and CF items: look at fixed costs and production/transportation costs per Barrel to get to FCF

Question 22

3 reasons a company would enter a div recap transaction

Answer 22

1. Excess debt capacity; boost returns (business has performed better than expected, credit markets opened up)
2. Can refinance at a lower rate or wipe restrictive covenants
3. Signal to investors strong performance when fundraising
4. Reduce exposure
5. Can’t find an immediate exit

Question 23

Sources and uses of a div recap

Answer 23

Sources: new debt issuances, RCF draw, cash on hand

Uses: debt paydown, breakage costs, other fees, dividend to equity holders

Question 24

Investment Framework

• due diligence questions

Answer 24

1. Industry Attractiveness
   - Market Size; Underlying market growth
   - Barriers to entry / change in market share over time
   - Key trends
   - Porters 5, stage of business cycle, concentration
   - Cyclicality
2. Competitive Positioning –> okay we like the market
   - Target’s performance relative to industry
   - Strategy (Cost leadership? Differentiation?)
   - Growth trajectory - organic / inorganic?
   - Profitability (margins, growth)
   - Strengths / weaknesses (economic moat? Sustainabile value creation?)
3. Strength and Stability of Target –> okay we like the market and the target is taking / holding market share. Is the business model sustainable?
   - Current Customer concentration, relationships
   - True drivers of profit and performance (product, customer and technology) (Does it vary by product, customer, end market?)
   - Target executing? (MGT any good?)
4. Opportunities / Business Plan and Risk of Target –> Okay we really like this investment. Do the financials / MGT forecast back the story?
   - Financial plan –> is it realistic?
   - Margins (room for expansion, operational improvement? Margin cushion? FC vs VC)
   
   • Stability of earnings
   • Growth?
     - Consider the downside
   • Leverage off trough EBITDA
   • Stable cash flows? Clean BS? Capex and NWC needs? Hard assets?
5. Exit strategy –> okay great investment but how do we get out?
   - IPO? Strategic or financial buyer? Sale to a LP?

Other

• Financing? Debt capacity, type etc
• Risk adjusted returns compared to other alternatives (i.e. stocks, bonds, treasuries)
• Potential for value creation (revenue growth, margin expansion, debt paydown, multiple expansion –> make a larger company)
• Potential for bolt-ons
• Opp Cost of replicating ourselves vs. more accretive to acquire?
• Risks (idiosyncratic risk and are they getting paid for it? Look into ROIC and ROE. Should you diversify?)
  
  • (Market risk? Not diversifiable.)
  • (Price risk? Risk that will drive returns)

Question 25

4 reasons to pursue M&A

Answer 25

Stratetic: complementary assets; target has tech that the buyer cannot or will not build Financial: accretive acquisition Ego / size Growth Defensive: target taking away share

Question 26

Stock vs Asset Purchases - Which does a seller prefer? Buyer?

Answer 26

Seller: prefers a stock deal. By acquiring stock in the new entity, you do not pay taxes immediately. Asset deals are subject to double taxation (corporate level and individual level when you receive proceeds) Buyer: asset deal: pick and choose assets which lowers amount of diligence required. Can also step up assets and depreciate = tax shield. (Stock = can only write up for book purposes - DTLs only for stock deals)

Question 27

Walk me through an accretion / dilution analysis

Answer 27

1. What is it? Measuring the feasibility of an acquisition by comparing the pro format EPS of combinedco to the buyer's standalone EPS. 2. Project both companies' financials and combine, making transaction assumptions along the way (synergies, interest income if cash used, interest expense if debt issued / assumed, and amortization from write ups) 3. Fix the denominator only if you issue shares (acquirer's shares + shares issued) 4. Pro Forma EPS - Look over the next 2 years

Question 28

11. Company A has assets of $100 million versus Company B which has $10 million. Both have the same dollar earnings. Which company is better?

Answer 28

Company B has a higher return on assets (“ROA”) given that both company had the same earnings but Company B was able to generate it with fewer assets and is, thus, more efficient. Something to think more about is if Company A was entirely debt financed whereas Company B was entirely equity financed. From a return on equity or investment (“ROE” & “ROI”) perspective, Company A might be a better company but it would be riskier from a bankruptcy perspective so the “better” company would be less black and white in this situation. The interviewer is probably looking for the simple answer, though; that Company B is better because it is more efficient with its assets.

Question 29

What is LIBOR? How is it often used?

Answer 29

London Interbank Offered Rate the daily interest rates at which banks borrow unsecured funds from banks in the London wholesale money market, and is roughly comparable to the Fed Funds rate. LIBOR is used as a reference rate for several financial instruments, such as interest rate swaps or forward rate agreements, and they provide the basis for some of the world’s most liquid and active interest rate markets.

Question 30

What is a PIPE?

Answer 30

With the cost of credit rising, private investments in public equity, (“PIPEs”), have become more popular. This is an alternative way for companies to raise capital; PIPEs are made by qualified investors (HF, PE, mutual funds, etc.) who purchase stock in a company at a discount to the current market value. The financing structure became prevalent due to the relative cheapness and efficiency in time versus a traditional secondary offering. There are less regulatory requirements as there is no need for an expensive roadshow. The most visible PIPE transaction of 2008: Bank of America’s $2 billion investment in convertible preferreds of mortgage lender Countrywide Financial.

Question 31

You have a company with $100 million in sales. Which makes the biggest impact? A) Volume increases by 20 percent B) price increases by 20 percent C) expenses decrease by $15 million.

Answer 31

The answer is B) price by 20 percent. Think about how EBITDA is affected by all three scenarios. It’s not C because EBITDA will only increase by $15 million. Volume will increase the revenue to $120 million but variable costs will increase proportionally. By increasing price, you will capture the entire $20 million impact.

Question 32

If a company's revenue grows by 10 percent, would its EBITDA grow by more than, less than or the same percent?

Answer 32

If any fixed costs, EBITDA will grow more. This is because fixed costs will stay the same, so total costs will not increase as much as revenue. Note this is similar to the previous question, but now looking at it in terms of percentage.

Question 33

Why would you use options outstanding over options exercisable to calculate transaction price in an M&A transaction?

Answer 33

Options outstanding represent the total amount of options issued. Options exercisable are options that have vested and can actually be exercised at the strike price. During a potential M&A transaction however, all of the target’s outstanding options will vest immediately and thus the acquirer must buy out all option holders.

Question 34

What’s the difference between IRR, NPV and payback?

Answer 34

IRR measures the return per year on a given project and is the discount rate that makes NPV equal to zero. - Annualized rate of return that considers timing of the cash flows NPV measures whether or not a project can add additional or equal value to the firm based on its associated costs. - Helps project managers consider the relative size of a project Payback measures the amount of time it takes for a firm to recoup the initial costs of a project without taking into account the time value of money.

Question 35

You have a company with $500 million of senior debt and $500 million of junior debt. The senior debt has an interest rate of L+ 500 and, in default, would recover 70 percent; the junior debt would recover 30 percent in default. What should the interest rate be on the junior debt?

Answer 35

Loss on default * Probability of default = incremental interest that needs to be paid. So 70 percent loss * 5 percent probability (an assumption you have to make) = 350 basis points over the senior debt or L + 850.

Question 36

In an inflationary environment, how would a firm's cash flow change if we switch from FIFO to LIFO? How would the DCF value change?

Answer 36

a. Ignoring the effect of taxes: i. In an inflationary environment (cost of inventory increases), LIFO would be more expensive than FIFO ii. This would cause COGS to increase iii. But, NWC would decrease by a proportionate amount due to larger decreases in inventory iv. Cash flow wouldn't change, so there is no change in value b. BUT if we include the effect of taxes: i. Higher expenses with LIFO will allow the company to save on taxes, so cash flow will be slightly higher for the LIFO company (note: FIFO/LIFO is simply an accounting tool, the only thing that actually changes in hard cash flow is taxes you are paying) ii. Thus, a LIFO company would have higher cash flow and a higher valuation

Question 37

If I were to perform a DCF on a coal mine, would I use a growth rate or multiple to value its terminal value?

Answer 37

Neither - multiple is a perpetuity function. Growth rate assumes it grows forever and a coal mine is an exhaustible resource. That's why NAV analysis is helpful for natural resource companies

Question 38

What are main drivers of an LBO?

Answer 38

1. Entry/Exit Multiple 2. Debt level 3. Holding period 4. Cash flows c. Initial investment

Question 39

Company A is at 12x P/E and Company B is at 8x P/E with NI of 100. Company A purchases Company B for 1,000 with all debt at 10% interest. Is this deal accretive or dilutive?

Answer 39

It is accretive. The net income of Company B is $100 and the cost of the acquisition is $60, assuming a 40% tax rate.

Question 40

You have $100MM, would you rather buy back debt at 5%, buy back stock at 15x, or acquire a company at 12x

Answer 40

a. Debt is 4% after tax, which is a multiple of 25x b. Stock is 15x, or costs 6.6% (1/15) c. Acquisition is 12x, or costs 8.3% (1/12) d. ACQUISITION IS MOST ACCRETIVE BC LOWEST MULTIPLE / HIGHEST YIELD

Question 41

Buy a company with which option? a. Option 1 - All stock with PE of 16x b. Option 2 - 100% debt at 6% interest c. Option 3 - 33% cash at 3% interest and 66% debt at 6% interest

Answer 41

a. Option 1 - All stock with PE of 16x --- Translates to cost of 6.66% b. Option 2 - 100% debt at 6% interest ----Translates to multiple of 16.67x (1/6) c. Option 3 - 33% cash at 3% interest and 66% debt at 6% interest i. 33% cash at 33x (1/3) ii. 66% debt at 16.67x (1/g) iii. 33x(1/3)+16.67x(2/3) = about 22x iv. Translates to rate of 4.5% d. OPTION 3 IS LOWEST COST. EITHER CONVERT ALL TO MULTIPLES, AND HIGHEST IS CHEAPEST, OR CONVERT TO % COST, AND LOWEST IS CHEAPEST.

Question 42

Would you rather have $2,000 in cash now or $100 every year in perpetuity?

Answer 42

a. Depends on what the discount rate is (low == better) b. The value of a cash flow in perpetuity is V = CF/discount rate c. If you have a discount rate <5%, you would rather have $100 in perpetuity d. If you have a discount rate >5%, you would rather have $2,000 now

Question 43

What is the P/E of cash?

Answer 43

a. Assume interest on cash of 1% b. Price of cash is how much cash you're looking at (use $100 as an example) c. On that $100, you are earning $1 in interest d. Thus, your P/E = $100/$1 = 100 e. P/E of cash is 100 f. This can be applied to any asset - look at how much it costs vs. how much it is earning you and you can find its "P/E"

Question 44

What happens when tax depreciation is greater than book depreciation

Answer 44

a. Asset is worth more for tax, less for book b. Pay less taxes due to higher dep expense c. Creates a DTL d. DTL created any time something is listed as less in book than for tax purposes - -->Pay less in taxes up front, have DTL e. DTA created any time something is listed as more in book than for tax purposes - --->Pay more in taxes up front, have DTA

Question 45

Compensation expense increases by $10, tax rate or 40%. Paid 50% in cash and 50% in stock. Walk through 3 statements

Answer 45

a. IS: Comp ex. Increases (10), so after taxes NI (6) b. CF: NI (6), Add back $5 in CFF, Cash (1) c. BS: Cash (1), NI (6) and APIC +5 so RE (1)

Question 46

What happens to NI for a steel manufacturer if steel prices fall 5%

Answer 46

Revenue falls 5%, COGS falls 5%, SGA stays about the same, so NI falls by more than 5%

Question 47

Advantages of PE style investing

Answer 47

- Private (no public market pressures, SEC / regulatory costs, focus on more long-term projects) - Sponsor's network - More permanent capital - Align MGT incentives with equity stakes - Focus on FCF and sense of urgency to create value - Put up less equity capital as a sponsro

Question 48

Considerations of PE investing

Answer 48

- financial leverage - illiquid investments - may underinvest in the company - pressure to monetize after 3-5 years - hands on ownership (sometimes)

Question 49

Given that there is no multiple expansion and flat EBITDA, how can you still generate a return?

Answer 49

FCF accumulation - D&A tax shield - Tax rate - Interest expense - Lower Capex - WC needs - Unwinding of a DTA - Dividend

Question 50

Which is lower valuation, DCF or LBO?

Answer 50

LBO because it is discounted at a higher cost of equity Why? PE investors have a fixed fund; opportunity costs; illiquidity premium

Question 51

If you have a company with a P/E of 10x and cost of debt of 5 percent, which is cheaper for an acquisition?

Answer 51

Cost of equity = inverse of PE = 10% Cost of debt = 5% Debt is cheaper

Question 52

A company runs two operating subsidiaries. One sells coffee and one sells doughnuts. You own 100 percent of the coffee subsidiary. You own 80 percent of the doughnut subsidiary. The coffee subsidiary generates $100 million of EBITDA. The doughnut subsidiary generates $200 million of EBITDA. Doughnut companies are worth 5.0x EBITDA. The parent share price is $10 and there are 100 million shares. The company has cash of debt of $500 million and cash of $200 million. What’s the enterprise value to EBITDA multiple for this company?

Answer 52

The enterprise value is market capitalization plus net debt plus minority interest. Market cap is easily to calculate, shares * share price, so $10*100 million = $1,000 million. Net debt is debt less cash so $500 million - $200 million = $300 million. The question has given you the approximate market value of the minority interest in the doughnut company which is 5.0x EBITDA, so $200 * 5.0x * (1 - 80%) = $200 million. As a side note, when calculating enterprise value for comps, you might take the minority value from the balance sheet. This fine to do in such cases. However, a finance professional always chooses market value over book value, so this question gives you enough information to calculate the market value of the minority interest. Back to the answer: you total this all up for EV, which comes to $1,500 million = $1,000 million + $300 million + $200 million. The total EBITDA is $300 million = $100 million + $200 million. Therefore, the EV/EBITDA multiple is $1,500/$300 = 5.0x.

Question 53

In an LBO, if cost of debt is 10 percent, what is the minimum return required to break even?

Answer 53

Since interest is tax deductible, the break-even return is the after-tax cost of debt. Assuming tax rate of 40 percent, the break-even return is 6 percent.

Question 54

You have a company with 3x senior leverage and 5x junior leverage, what happens when you sell a business for 9x EBITDA?

Answer 54

It’s a de-leveraging transaction because pro-forma the company will have a lower total debt to EBITDA ratio. - Assumes you use all proceeds to retire debt at face value

Question 55

To a distressed PE investor, what are the pillars?

Answer 55

1. Cheap relative to comps 2. Multiple compression or expansion at exit 3. FCF Profile (Stable, defensible) 4. How are you buying it? (Competiive, proprietary, through debt?) 5. Industry as a whole vs. recessionary trends 6. MGT 7. What cycle are we in now 8. Working capital (huge) - easy to take out of business 9. SG&A cost out - benchmark business costs relative to competitors (opp. to run it better?) 10. M&A activity - consolidated or fragmented? Can you become a leader buying up businesses? 11. Creativity (Trump administration, election, etc.)

Question 56

Carve-Out | Advantages and Considerations

Answer 56

Structure: as asset sale or spin-out (old SH retain equity) Pros 1) Underappreciated by conglomerate / current company - Sales: improve volume by identifying niches and pathways to market, marketing campaign, paying sales team better commissions. Better growth prospects and MGT not taking advantage? - Room for price increases - Expenses: Labor, production (similar product lines, process, automation), finance Consequence: standalone EBITDA =/= run-rate EBITDA 2) MGT Equity = incentive to focus on FCF generation 3) Underappreciated by market 4) At exit, risk of integration will be subdued and can sell as a self-sustaining entity, commanding a higher multiple Considerations 1) Costs to achieve cost savings (severance, IT systems, legal and professional fees) 2) Transition services agreement - services that the parent provides to ensure a smooth de-merger 3) Duplicative expenses as you roll off the TSA to a self-sustaining entity 4) Feasibility - Activists doing this job Valuation - Enterprise Value - effective purchase price greater than current S&U (PV of costs) - Run-rate EBITDA > current EBITDA > EBITDA impacted by expenses

Question 57

PE Buy-Out Strategies

Answer 57

1) Take-Private 2) Carve-out 3) Distressed-for-control 4) Regular auction 5) Proprietary 6) Buy and Build Value creation - Industry expertise (helps diligence process) - Operational PE

Question 58

Take-Private

Answer 58

1) Mispricing in the market - Toe-In: Accumulate shares in the open market and will realize some return if someone beats you to it - Can sell shares if you're wrong 2) Give more equity to MGMT - Focus on long-term projects (no qtr to qtr earnings and share price fluctuation) 3) Costs - SEC compliance costs - Cut costs without public scrutiny

Question 59

Distressed-for-Control

Answer 59

Methods: debt for equity swap in or out of Bk; sale process; 363 / plan sponsor Pros: 1) Forced seller as it tries to raise liquidity 2) cheap cheap cheap 3) Strategics don't want to touch / stigma / complex 4) Not as competitive

Question 60

Buy and Build

Answer 60

- Platform + Add-On 1) Effective Entry Multiple: blended down 2) Larger company: economies of scale (supplier bargaining power, marginal costs, distro channels) 3) Synergies (similar product lines) 4) good for fragmented industries ripe for consolidation 5) Use platform CFs and unencumbered assets as credit support for financing 6) already have the MGMT team in place 7) Valuation (from econ of scale and other; - Become end-to-end solution provider)