Top 30 Commonly Asked Technicals

Question 1

How would $100 decrease in depreciation expense on Income Statement impact all three major financial statements?

Answer 1

IS: When depreciation decreases by $100, EBIT and EBT increase by $100. When EBT increases by 100m, net income increases by $60 (assuming a ~40% corporate tax rate which means an extra $40 is paid in taxes)

BS: Since net income increases by $60, shareholder equity also increases by $60. Since an extra $40 is paid in cash taxes, cash decreases by $40. Since depreciation decreased by $100, net PP&E increases by $100. The balance sheet remains in balance since liabilities went up by $60 and assets went up by $60

CFS: Net income increased by $60 which increases cash from operations, but PP&E increased by $100 which decreases cash from operations. The net impact is that cash from operations declines by $40 which happens to match both the only cash expense incurred by the drop in depreciation (taxes) as well as the drop in cash on the balance sheet

Question 2

Tell me why each of the financial statements by itself is inadequate for evaluating a company?

Answer 2

• IS: This alone won’t tell you whether a company generates enough cash to stay afloat or whether it is solvent. You need the BS to tell you whether the company can meet its future liabilities, and you need the CFS to ensure it is generating enough cash to fund its operations and growth
• BS: This alone won’t tell you whether the company is profitable because it is only a snapshot on a particular date. A company with few liabilities and many valuable assets could actually be losing a lot of money every year
• CFS: (1) This won’t tell you whether a company is solvent because it could have massive long-term liabilities which dwarf its cash generating capabilities (2) It won’t tell you whether the company’s ongoing operations are actually profitable because cash flows in any given period could look strong or weak due to timing rather than the underlying strength of the company’s business

Question 3

If you could choose two of the three financial statements in order to evaluate a company, which would you choose and why?

Answer 3

• Choose the IS and BS because if you have them, you can actually build the CFS yourself.
• Remember that CF is basically equal to net income plus/minus non-cash items on the IS, plus rise in liabilities on the BS, minus rise in assets on the BS

Question 4

In what way is deferred revenue different from accounts receivable?

Answer 4

• Deferred revenue is a liability because the company has already collected money from customers for goods or services it has not yet fully delivered
• Accounts receivable is an asset because the company has delivered goods or services for customers and has not yet been paid

Question 5

What might cause two companies with identical financial statements to be valued differently?

Answer 5

• The financial statements do a good job of describing a company’s historical performance, but they do not necessarily tell us everything we need to know about a company’s future performance. Since the value of a company depends primarily on its expected future performance, the financial statements are insufficient
• Some important things financial statements don’t tell us include, but are not limited to:
  
  • The future growth of the company’s industry
  • The company’s competitive position including share, relations, patents, etc.
  • The reputation and capabilities of the company’s management team
  • The quality of the company’s future strategy

Question 6

Why does PE generate higher returns than public markets?

Answer 6

• The short answer is the PE LPs demand higher returns than public market investors which causes PE investors to price their deals to an IRR of 20% or higher. PE LPs demand these high returns for two main reasons:
  
  1. LBOs are highly levered thus making PE investments riskier than public stocks
  2. PE investments are much less liquid than public stocks; it can take up to ten years to realize returns

Question 7

Why does PE use leverage? Or how does leverage increase PE returns?

Answer 7

• The short answer is that PE returns are calculated based on return on their invested equity. Using leverage to do deals allows you to use less equity which means the ultimate returns are larger in comparison to the amount of equity initially invested. Another way to look at it is that the cost of leverage (debt) is lower than the cost of equity
  
  1. This is because equity is priced to an IRR of 20%+, whereas the annual interest expense on debt is usually below 10%
  2. Yet another way to look at it is using a lot of debt makes the return on equity much more volatile and much riskier because the debt must be repaid before the equity gets any return. The high returns on PE equity may be seen as the fair return associated with the extra risk associated with high leverage.

Question 8

How would you determine an appropriate exit multiple on a PE deal?

Answer 8

• Comparable multiples analysis will tell you what multiples similar public companies are trading for on the stock market
• Precedent transactions will tell you what the multiples were on deals involving similar targets
• An LBO analysis (in this case referred to as a Next Financial Buyer analysis) will tell you what multiple a financial sponsor would be willing to pay in the future

Question 9

Walk me through an LBO model at a high level

Answer 9

• At a high level, there are 5 steps to an LBO:
  
  1. Calculate the total acquisition price, including acquisition of the target’s equity, repayment of any outstanding debt, and any transaction fees (such as the fees paid to investment banks and deal lawyers, accountants, consultants, etc.)
  2. Determine how that total price will be paid including: equity from the PE sponsor, roll-over equity from existing owners or managers, debt, seller financing, etc.
  3. Project the target’s operating performance over ~5 years and determine how mcuh of the debt principal used to acquire the target can be paid down using the target’s FCF over that time.
  4. Project how much the target could be sold for after ~5 years in light of its projected operating performance; subtract any remaining net debt from this total to determine projected returns for equity holders
  5. Calculate the projected IRR and MoM return on equity based on the amount of equity originally used to acquire the target and the projected equity returns upon exit

Question 10

How might you still close a deal if you and the seller disagree on the price of the asset due to different projections of its future operating performance?

Answer 10

• The classic PE solution to this common problem is called an “earn-out”
• Sellers are frequently more optimistic about the future performance of a business that PE investors are willing to underwrite
  
  1. In such cases either party may propose that the sellers are paid a portion of the total acquisition price up-front, while a portion is held back (frequently in an escrow account until the business’ actual future performance is determined
  2. If the business performs like the seller expects then the seller is paid the remainder of the purchase price some months or years after the close of the deal
  3. If the business under-performs the seller’s expectations then the buer keeps some or all the earn-out money
• This type of structure is a common way of bridging valuation gaps between buyers and sellers

Question 11

How would you calculate change in Net Working Capital (NWC)?

Answer 11

• Change in NWC is simply the difference between NWC in the current period less NWC during the pervious period
  
  • The classic formula for NWC is current assets (excluding cash) less current liabilities
    
    • For a lot of businesses, it is sufficient to define NWC as: NWC = Accounts Receivable + Inventory - Accounts Payable

Question 12

What are some common areas of due diligence?

Answer 12

1. See section “Common Diligence Topics”
2. If the question is asked broadly, you can describe the high level categories (commercial, valuation, accounting, and legal) and give a few examples from each category
3. If the question is asked about a specific company, you will need to use best judgement to decide which issues from the common diligence topics section are more relevant

Question 13

Would you rather achieve a high IRR or a high MoM (multiple of money invested) on a deal? What are the tradeoffs? What factors might influence your answer?

Answer 13

• While PE firms try to achieve both, sometimes trade off exists
  
  • Example: PE firm bought company for $100 and held on for 3 years: can sell immediately for $180 or wait another year and sell it for $200.
    
    1. If sell at year 3: 22% IRR, 1.8x MoM
    2. If sell at year 4: 19% IRR, 2.0 MoM
  • This tradeoff exists because a longer hold period counts against IRR but does not count against MoM
• Two common reasons to prefer a higher IRR:
  
  • 1.) IRR is the most important single metric by which LPs judge the performance of PE firms
    
    • This is 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 wont be impressed with a 2.0x MoM if it takes 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, while 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:
  
  • 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 40% IRR, but the GP would earn only ~20%*40= $8 in carried interest
      
      • 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
• As a general rule: PE firms prefer to hold on to portfolio companies and grow MoM as long as the annual rate of return the portfolio companies are generating meets or exceeds the rate expected by the PE firm’s LPs.

Question 14

Which valuation techniques usually produces the highest vs. lowest values? Why?

Answer 14

• Generally, it is difficult to predict which techniques will yield higher or lower valuations.
  
  • The cost of PE equity is higher than nearly any other form of capital, so in an efficient market, PE-backed LBO valuations should tend to be on the lower side on average. There are times when this is not the case, especially when a company is under-levered or poorly managed
  • Precedent transactions tend to be on the higher side, esp when the buyer is “strategic” because such buyers frequently pay both a control premium and a synergy premium
  • Public comps/market valuations tend to be roughly in the middle of the pack depending on whether the market is hot or cold
  • DCF analyses are also middle of the pack on average, but there is variability in DCF analyses on both the high and low side because DCF analyses are extremely sensitive to input assumptions

Question 15

How would you estimate roughly how much debt capacity is available for an LBO?

Answer 15

• Debt capacity for an LBO is typically constrained by three primary ratios: total leverage ratio, interest coverage ratio, and minimum equity ratio
  
  • Any one of these ratios could be the governing constraint for a particular deal
  • To estimate debt capacity for an LBO, you could estimate debt capacity under each of those ratios and take the lowest of the three
    
    • See the Debt coverage and Leverage Ratios section for further detail
• Total Leverage Ratio: the most common method for estimating this ratio is Total Debt / LTM EBITDA
  
  • During normal times, Maximum Debt = ~5.0x(LTM EBITDA).
  • During hot debt markets, this ratio can go up to ~6.0x, during cold times it can fall to ~4.0x
  • This ratio can also be higher or lower based on the nature of the target’s business
    
    1. Highly cyclical or risky businesses with few tangible assets are on the lower end of the range, while stable businesses with a lot of tangible assets (which can be liquated if needed to repay debt in event of a default) are on the higher end of the range
• Interest Coverage Ratio: the most common method for estimating this ratio is LTM EBIT / Annual Interest Expense
  
  • The floor for this ratio is usually around 1.5x. Therefore, the maximum debt this ratio will allow is roughly:
    
    • Maximum Debt = LTM EBIT / 1.5(Blended Interest Rate)
      
      • The blended interest rate depends on prevailing interest rates and how the overall LBO debt package is structured, but roughly 8-9% is a safe assumption

1. Minimum Equity Ratio: These days lenders demand that about 20-30% of the total acquisition price be equity. As such, you could estimate:
   
   1. Maximum Debt = 0.75(Total Acquisition Price)

Question 16

What constitutes a good LBO target>

Answer 16

• Target that performs to par on diligence sections (commercial, valuation, accounting, and legal)
• The key is price: Almost any target would make a good buyout candidate at a low enough price
  
  • Is there any company you wouldn’t buy for a dollar?
  • Deals which check all the boxes are usually very expensive… all problems may be overcome with price

Question 17

What is an acquisition / control premium and why is it paid?

Answer 17

• What is an acquisition / control premium and why is it paid?
  
  • The percentage by which the acquisition price per share exceeds the pre-acquisition trading price per share is called a control premium (aka acquisition premium)
    
    • The trading price per share prior to acquisition is commonly calculated as a 30 to 90 day trailing Volume Weighted Average Price (VWAP) prior to the day news of the pending acquisition became public
      
      • Example: if the 30-day VWAP of a stock is $20 on the day an acquisition is announced for $20 per share, then the acquisition premium is 25/20-1=25%. The size od control premiums varies, but they are usually between 10% and 50%
  • There are several reasons why investors may be willing to pay acquisition premiums
    
    1. Some buyers, esp strategic buyers, expect to realize synergies with the acquired asset
    2. Majority control of a company allows the new owners to choose how to spend the company’s capital, including how and when to take dividends or exit the investment. Unlike public shareholders, PE owners have a great deal of influence over how and when they will cash out their investment
    3. Buyers of public assets frequently believe that the company will be worth more under their control than its public valuation. They believe they can add value by getting better mgmt, setting a better strategic direction, fixing operating problems, etc. majority control is what gives buyers the power to execute such plans
  • Another way to look at control premiums is from the perspective of the sellers
    
    • A public stock has a very fragmented ownership base–> top 10 owners frequently own less than 50% of outstanding shares. In order to consummate an LBO, the buyer has to convince at least a majority of shareholders to approve of the transaction. Many of these owners own the stock precisely because they think It is undervalued by the market. Such owners would no be willing to seel the stock below its trading price
      
      • Therefore, by virtue of pure math, a new buyer will need to pay more than the trading price to acquire a majority of shares

Question 18

How would you gauge how attractive an industry is?

Answer 18

• Three most important measures of an industry’s attractiveness are its growth rate, stability, and profitability. Attractive companies can exist in unattractive industries if they have competitive advantage. Even unattractive companies in unattractive industries might make good investments if you can buy them at te right price and/or remedy some of what ails them
• Gauging stability:
  
  • Determining its growth drivers and examining its performance over a few business cycles
    
    1. If the growth drivers depend on entrenched secular trends (eg healthcare industry in a country with aging population) then the industry will be more predictable than one which depends on taste/trends/fads (eg fashion brands)
    2. If the products the industry produces are “must haves” for customers (eg electricity or food staples), then the industry will be more resistant to recessions than one that produces luxuries (eg cruise lines or expensive cars)
    3. If the products the industry produces are commoditized, then its fortunes tend to oscillate with the business cycles of its customers (eg mining or semiconductors), whereas industries with strong intellectual capital/differentiation tend to be less cyclical (e.g. enterprise software or medical devices).
• Gauging profitability:
  
  • Discover the historical profit margins of industry participants and then utilize the 5-forces framework to gauge whether industry-wide profit margins are likely to shrink, grow, or remain steady. The 5-forces framework is as follows:
    
    1. Bargaining power of suppliers: the relative level of consolidation between industry participants and the industry’s suppliers frequently determines which side is likely to capture most of the profits. If industry participants are more consolidated than the industry suppliers that us a good sign for future profitability. If not the reverse may be true
    2. Bargaining power of customer: if industry participants are more consolidated than their customers, it’s a good sign for profitability.
    3. Threat from new entrants: how strong are the industry’s Barriers to Entry (BTEs)? Strong BTEs include essential/exclusive intellectual property, high fixed capital investment requirements, high minimum efficient scale thresholds and high value placed on brand and existing relationships. Highly profitable industries with low BTEs are likely to lose profitability over time as new competitors pile in.
    4. Threat from substitute products: a good signal is when the industry’s products or services meet essential customer needs which cannot be met other different ways
    5. Existing competitive rivalry: it is a good sign if the existing competitors have established a pattern of competing on factors other than price and on focusing on growing the industry rather than taking market share from each other

Question 19

Which industry would you invest in and why?

Answer 19

• Trick to this question is not just simply identifying a good industry, but rather an industry that is improving
  
  • Investing is about buying undervalued assets rather than simply good assets
• Look for industries which are experiencing some of the following:
  
  1. Acceleration in long-term growth: driven by new tech, an inflection point in adoption, changing consumer preferences, etc
  2. A shift in competitive rivalry: e.g. competitors are beginning to compete on brand, quality, service, technology, etc. instead of price. E.g. a major competitor is exiting the industry
  3. A shift in supply chain dynamics: e.g. the industry is consolidating. This could lead to both add-on acquisition opportunities as well as between bargaining power relative to suppliers and customers
  4. Barriers to entry increasing: e.g. patents, proprietary tech, brand, min efficient scale etc. are becoming more important
  5. Threat from substitutes declining: e.g. the products and services the industry provides are becoming more unique and essential to customers

Question 20

How would you gauge a company’s competitive position

Answer 20

1. Market share: high market share relative to competitors is usually a sign of competitive strength. Firms with higher market share are more likely to enjoy brand awareness, close relationships with key customers/suppliers, economies of scale, etc. recent share trends also matter. Companies which are gaining share tend to be better positioned competitively.
2. Profit margins: high profit margins (such as Gross Margin, EBIT Margin, Net Income %, etc) are frequently a sign of competitive strength. Companies with higher margins are usually more cost efficient and/or able to charge premium prices due to a superior product offering. Recent expansion of margins is also frequently a positive signal
3. Brand perception: brand awareness can be a very important competitive strength indicator, especially for consumer-facing businesses.
4. Product breadth and quality: in many industries it is important for competitors to carry a full line-up of products that can meet all or most of customers’ needs.
5. Management team quality: a bad management team can ruin the best business. A good mgmt team can sometimes work miracles. Assessing mgmt team strength is highly subjective, but its something PE professionals spend a lot of time discussing

• Other signs of competitive strength:
  
  1. Lowest-cost product / service delivery model
  2. Strong intellectual property (IP) such as patents
  3. Low levels of customer “churn” (customers rarely stop being customers)
  4. Excellent physical locations (important for retail companies)
  5. Diversified customer and supplier base
  6. Diversified revenue sources
  7. High levels of recurring revenue

Question 21

What are some common ways PE firms increase portfolio company value?

Answer 21

• How much value PE firms actually add is an open question, but the following methods are frequently mentioned:
  
  1. Recruit better mgmt and board members
  2. Provide more aligned mgmt incentives (usually via stock option pool)
  3. Identify and finance new organic growth opportunities (new geographies, new product lines, adjacent market verticals, etc.)
  4. Find, finance, and execute add-on acquisitions
  5. Foster stronger relations with key customers, suppliers and wall street
  6. Support investment in better IT systems, financial reporting and control, R&D, etc.

Question 22

What company would be a good LBO candidate today and why?

Answer 22

• You always want to have one or two good pitches in your back pocket. Before selecting a candidate, refer back to the sections on the common attributes of LBO candidates and how PE firms make money. Try to find candidates which fit at least some of the following criteria:
  
  1. Has a lot of stable and predictable FCF to paydown debt relative to how much you would have to pay to acquire it. A free cash flow yield (FCF / purchase price) of 10+% is a solid benchmark
  2. Could benefit from a strategic overhaul which would be difficult to execute as a public company
  3. Is having significant operational difficulties which would require much time, patience, and capital to address
  4. Has a bad mgmt team or governance structure which a PE firm could improve
  5. Has a lot of room to grow either organically or via acquisition if backed with enough patient long-term capital

Question 23

If I gave you $X, how would you invest it?

Answer 23

• There is no right answer but a good answer demonstrates your passion for investing, understanding risk vs reward, and understanding of investment time horizons. Answer by following these steps:
  
  1. Discuss a few of the investment options available to you
  2. State what your investment goal, risk appetite, and time horizon is
  3. Compare and contrast the risks, rewards, and time horizons of these options
  4. Pick the investment options which best fits these criteria
     

Question 24

What are some different types of debt covenants and what are they used for?

Answer 24

• Debt covenants are contractual agreements between lenders and borrowers (such as companies which have been bought via an LBO) that given lenders certain rights to help protect their investment
  
  1. Maintenance covenants require the borrower to maintain a certain equity cushion or debt service coverage cushion to maintain their ability to repay its debt
  2. Incurrence covenants prevent the borrower from taking certain actions which could be detrimental to existing lenders such as taking on more debt or paying out cash dividends to equity holders. Strict covenants can make an investment much riskier to a PE investor because a default on a covenant can result in the loss of the entire equity investment even if the portfolio company remains solvent.
  3. See section on covenants for details

Question 25

If you had to value a company based on a single number from its financial statements, what would that number be?

Answer 25

• The single most important value determinant for most companies is its FCF because FCF is how owners pay themselves dividends and pay down debt. If you could know a second fact about the company before estimating its value, you would want to know how quickly its FCF is growing.