Investing and PE Flashcards
What are characteristics of a great business to invest in?
Strong CF generation, recurring revenue streams / sticky customer base, defensible market position, strong management team
Would you prefer to make an investment that yielded a 20% IRR or 30% IRR?
All else equal, 30% is clearly better - However, we must address other factors, including timeframe and variability / risk of return
Timeframe: 20% over 3 years is better than 30% over 2 years. If only 2 years, PE firm needs to re-deploy capital (deal-making risk). If 3 years, may also be worse from a liquidity perspective
Variability / risk of return: Is it much risker or does it have a wider range of outcomes? What is the margin of safety?
Why would a PE firm contribute less money than it is able to in an investment?
- To use more debt to hit a certain return threshold (too large equity contribution may have a low IRR)
- Company doesn’t need that much capital and don’t want to over capitalize (some businesses feel compelled to use all of the cash in sub-optimal ways)
- Leave some money for co-invest (another PE firm or strategic partner), which may improve business management
All else being equal, would you prefer to purchase a company with no debt on its BS or 3x LTM EBITDA of debt on its BS?
Same for a full buyout - PE firm chooses how much debt to put on the BS (initial cap structure is irrelevant and the company’s debt before doesn’t directly impact returns
Caveats: Prepayment penalties, minority investments, tangible evidence of debt support/credit market knowledge and relationships
- Existing debt has a significant amount of prepayment penalties or make-whole premiums (penalty to debtholders to buy it out)
- Minority investments won’t change the capital structure (should be comfortable with prior capital structure)
- Existing debt may be tangible evidence that he company can support debt (positive feature) and has positive debt relationships/understanding of credit markets
Which factors would lead to an industr having heavy amounts of M&A and consolidation?
Product development involving high R&D/CapEx, industry TAM has stagnated/is saturated, potential synergies are prevalent
- Product development R&D: Tech/biotech - Large incumbents acquire proven technologies rather than devote resources to nascent tech
- Saturation: Industries that have reached their natural max size start to run out of organic growth opportunities, so may buy smaller comps and cost-cut (ex: industrial companies lacking runway in typical core competency)
- Potential synergies: Cross-sell (revenue) or redundant costs (cost)
Assume you buy and sell the common equity at the same entry and exit multiple. Assume EBITDA grows 10% annually, but company never generates net CF. Do you think this is likely to be a profitable investment? If so, under what circumstances would it be unprofitable?
Main return drivers are debt paydown (none), multiple expansion (none), EBITDA growth (10% annually)
EBITDA growth is ~60% when compounded, so significant company growth means this would likely be profitable
Unprofitable if:
- Too much debt, so interest payments dwarf growing EBITDA and reduce equity value
- Company dilutes your ownership by issuing more shares of the same class as you (smaller portion of exit)
- Securities ahead of common equity appreciate in value more than the increase in overall equity value (ex: preferred stock PIKs at a 12% rate each year, which outpaces growth in equity value)
Assume that you make a $250M investment in a business. If you receive $50M of CF from the investment at the end of each year for 5 years, what DR will be necessary to make this investment NPV equal to 0?
0
DR at which NPV = 0, meaning sum of all CFs will equal 0 at this DR
$250M investment happens at time zero, so discount the remaining by a DR; sum of PV of those CFs must equal 0
$50M * 5 = $250M, so required DR must be 0%; if >0%, the PV of $250M future CFs would be <$250M; if <0%, NPV > 0
Should tip you off that discounting 5 years is a mathematical annoyance
