PE competencies Flashcards
How do private equity firms exit their investment?
- Sale to a Strategic Buyer → The sale to a strategic buyer tends to be the most convenient while fetching higher valuations as strategics are willing to pay a premium for the potential synergies.
- Secondary Buyout (aka Sponsor-to-Sponsor Deal) → Another option is the sale to another financial buyer – but this is a less-than-ideal exit as financial buyers cannot pay a premium for synergies.
- Initial Public Offering (IPO) → The third method for a private equity firm to monetize its profits is for the portfolio company to undergo an IPO and sell its shares in the public market – however, this is an option exclusive to firms of larger size (i.e. mega-funds) or club deals.
What is a leveraged buyout (LBO)?
An LBO is the acquisition of a company, either privately held or publicly traded, where a significant amount of the purchase price is funded using debt. The remaining portion is funded with equity contributed by the financial sponsor and in some cases, equity rolled over by the company’s existing management team.
Once the transaction closes, the acquired company will have undergone a recapitalization and transformed into a highly leveraged financial structure.
The sponsor will typically hold onto the investment for between 5 to 7 years. Throughout the holding period, the acquired company will use the cash flows that it generates from its operations to service the required interest payments and pay down some of the debt principal.
The financial sponsor will usually target an IRR of approximately ~20-25%+ when considering an investment.
What are some positive levers to increase the IRR on an LBO?
- Earlier Receival of Proceeds → Dividend Recapitalization, Sooner than Anticipated Exit, Opted for Cash Interest (as opposed to PIK Interest), Annual Sponsor Consulting Fees
- Increased FCFs Generation → Achieved through Revenue and EBITDA Growth, Improved Margin Profile
- Multiple Expansion → Exiting at a Higher Multiple than the Purchase Multiple (i.e. “Buy Low, Sell High”)
If an LBO target had no existing debt on its closing balance sheet, would this increase the returns to the financial buyer?
Upon the completion of an LBO, the firm essentially wiped out the existing capital structure and recapitalized it using the sources of funds that were raised. When calculating the IRR and cash-on-cash returns, the companies’ debt balance pre-investment does NOT have a direct impact on returns.
What are the limitations of a DCF model?
While discounted cash flow analysis is the best method available for assessing the intrinsic value of a business, it has several limitations. One issue is that the terminal value represents a disproportionately large amount of the value of the total business, and the assumptions used to calculate the terminal value (perpetual growth or exit multiple) are very sensitive.
Another issue is that the discount rate used to calculate net present value is very sensitive to changes in assumptions about the beta, risk premium, etc. Finally, the entire forecast for the business is based on operating assumptions that are nearly impossible to accurately predict.
What indicators would quickly tell you if an M&A deal is accretive or dilutive?
The quickest way to tell if a deal between two public companies would be accretive is to compare their P/E multiples. The company with a higher P/E multiple can acquire lesser valued companies on an accretive basis (assuming the takeover premium is not too high). Another important factor is the form of consideration and mix of cash vs. share
Given two companies (A and B), how would you determine which one to invest in?
This is one of the most common private equity interview questions. Deciding between company A and B requires a comprehensive analysis of both quantitative and qualitative factors. Assuming they are in the same industry, you could start to compare the businesses based on:
* Business model – how they generate money, how the company works
* Market share/Size of the market – how defensible is it, opportunities for growth
* Margins & cost structure – fixed vs. variable costs, operating leverage, and future opportunity
* Capital requirements – sustaining vs. growth CapEx, additional funding required
* Operating efficiency – analyzing ratios such as inventory turnover, working capital management, etc.
* Risk – assessing the riskiness of the business across as many variables as possible
* Customer satisfaction – understanding how customers regard the business
* Management team – how good is the team at leading people, managing the business, etc.
* Culture – how healthy is the culture and how conducive it is to success
All of the above criteria need to be assessed in three ways: how they are in (1) the past, (2) the near-term future, and (3) the long-term future. This will be the basis of a DCF model (which will have multiple operating scenarios), and the risk-adjusted NPVfor each business can be compared against the price the business might be purchased at.
What is enterprise value versus equity value?
Enterprise value is the overall current value of the company while equity value is the value of the company’s shares and loans, which can give an idea of the company’s current and future value.
EV = Market Cap + Total Debt – Cash
- What are the main factors that cause a need for mergers and acquisitions?
The major factors that lead to a merger and acquisition include:
* Saving money
* Improving financial health and overall metrics
* Eliminating competition from the market
* Gaining more power over pricing by buying-out a distributor or supplier
* Diversifying or specializing — expanding the company’s product or finding ways to make it more niche for a specific market
* Expansion of technological abilities, or absorbing new technologies from acquired companies
When should a company issue debt instead of equity?
Since the cost of debt is generally cheaper than the cost of equity, there are quite a few situations where issuing debt makes more sense than issuing equity. Issuing debt instead of equity makes sense if:
* The company can get tax shields from issuing debt.
* The company has stable cash flows and can make interest payments.
* It results in a lower WACC.
* The company can get a better return on investments with more financial leverage.
What is net working capital?
Net working capital (NWC) is essentially how much money a company has if it paid off all current short-term debts.
NWC = Current Assets – Current Liabilities
Current assets include items found on a balance sheet, such as accounts receivable, inventory, and prepaid expenses, while current liabilities are short-term debts like accrued expenses, deferred revenue, and accounts payable.
If a company has a positive NWC, it means the company is able to cover all short-term liabilities with their current assets. A negative NWC would mean the company cannot cover these liabilities, though, and indicates that the company either needs to increase cash reserves or seek more financing.
