Private Equity Interview - Technicals Flashcards
How would a $100 decrease in depreciation expense on the income statement impact all
three major financial statements?
Income statement - net income up by $60
Cash flow statement - net income up by $60, depreciation down by $100 so cash down by $40
Balance sheet - Assets: Cash down by $40, assets up by $100 so up $60
Balance Sheet - L/E: Retained earnings up by $60
By itself, why is the income statement inadequate for evaluating a company?
- Doesn’t tell you whether a company generates enough cash to stay afloat
- You require balance sheet to see if company can meet future liabilities
- You require cash flow statement to ensure there is enough cash to fund operations
By itself, why is the balance sheet inadequate for evaluating a company?
- Doesn’t tell you whether the company is profitable
- A company with few liabilities and valuable assets could still be losing money if ROIC is poor
By itself, why is the cash flow statement inadequate for evaluating a company?
- Doesn’t state whether a company is solvent because there may be long-term liabilities which hinders cash generative abilities
- Doesn’t tell us whether the company is profitable
If you could choose two of the three financial statements, which would you choose and why?
IS and BS, because can build CFS from tehm
How do you build cash flow statement from income statement and balance sheet?
Net Income - from Income statement
D&A - income statement/ balance sheet
Operating working capital - balance sheet
Capex - balance sheet
etc
What are common ways of valuing a company and what are their pros / cons?
LBO - financial sponsors perspective to meet minimum IRR. Typically gives lowest valuation as needs highest return on investment
DCF - very sensitive to inputs, but is intrinsic valuation so most company specific
Public Comps - Market valuation that is up to date, but no two companies are the same so can be hard to find accurate comp set
Precedent Transactions - can be out of date quite quickly and no two companies the same
In what way is deferred revenue different from accounts receivable?
Deferred revenue is a liability as the company has collected cash but not yet delivered the product/service
Accounts receivable is an asset because the company has already made a sale but has not yet received the cash
What might cause two companies with identical financial statements to be valued differently?
Give a good picture of historical performance, but not on future performance
One company may have greater future growth, be better positioned in terms of market share and relationships, and may have a better future strategy
Why does PE generate higher returns than public markets?
PE LPs demand higher returns due to illiqudiity, which causes PE investors to price their deals to an IRR of 20% or higher
Why do PE LPs demand high returns?
- LBOs are highly levered thus riskier than public stocks
- PE investments are much less liquid than public stocks
Why does PE use leverage?
PE returns calculated based on return on their invested equity. Using leverage allows you to use less equity, which means that returns are significant if you can pay down debt over the lifetime of the deal.
In a PE deal, how does the cost of equity compare to the cost of debt?
Cost of equity is priced to IRR of 20%+, which should be a lot higher than the cost of debt at around 10%
How would you determine an appropriate exit multiple on a PE deal?
- Can use comps and work out approximate percentile based on operating metrics
- Can use precedents to see the multiple paid by sponsors or strategics
- An LBO analysis (in this case, a next financial buyer analysis), will tell you what multiple a financial sponsor would be willing to pay in the future.
Walk me through a DCF?
Project income statement for 5-10 years.
Calculate Unlevered Free Cash Flow, moving from:
EBIT
- Taxes
= Unlevered Net Income
+ D&A
- Capex
- Increase in NWC
= Unlevered Free Cash Flow
You then want to discount these cash flows back to present value, before calculating a terminal value using either the multiple method or using the perpetuity growth rate method.
Walk me through an LBO model at a high level?
- Transaction assumptions, including purchase price and transaction fees
- Determine the sources and uses of the financing structure of the LBO; what funding sources are there, and what will they be being used to do
- Project the company’s operating performance over the next 5 years, including income statement and some cash flow items such as capex, as well as the debt schedule
- Project the exit assumptions such as exit multiple and calculate ending equity value
- Calculate projected IRR and MoM return based on the amount of equity originally used to acquire the target and the projected equity returns upon exit; utilise sensitivity tables to see how returns change based on inputs
