WSO Technicals

Question 1

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

Answer 1

Answer:
Income Statement: Net income would increase by $100, leading to higher earnings.
Balance Sheet: Total assets would increase by $100, reflecting the higher book value of assets.
Cash Flow Statement: Operating cash flow would increase by $100 due to the non-cash nature of depreciation.

Question 2

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

Answer 2

Answer:
Income Statement: Focuses on profitability but does not provide insights into the company’s liquidity or solvency.
Balance Sheet: Captures the financial position at a specific point but lacks information on profitability or cash flows.
Cash Flow Statement: Emphasizes cash movements but does not reflect the overall financial health or profitability.

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

Income Statement and Cash Flow Statement: These statements provide insights into a company’s profitability, liquidity, and ability to generate cash flows. Together, they offer a comprehensive view of financial performance.

Question 4

What are common ways of valuing a company and what are their pros and cons?

Answer 4

Answer:
Common Valuation Techniques: Include Comparable Company Analysis (CCA), Precedent Transaction Analysis (PTA), Discounted Cash Flow (DCF), and precedent deal analysis.
Pros and Cons: Each method has strengths and weaknesses. CCA and PTA rely on market comparables, while DCF is based on future cash flows. Precedent deal analysis considers past transactions. The choice depends on the availability of data, the industry, and the stage of the company.

Question 5

In what way is deferred revenue different from accounts receivable?

Answer 5

Deferred Revenue: Represents payments received in advance for goods or services that are yet to be delivered.
Accounts Receivable: Represents amounts owed by customers for goods or services already provided.

Question 6

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

Answer 6

Factors: Differences in growth prospects, risk profiles, market conditions, management quality, industry trends, and perceived synergies can lead to varying valuations.
The future growth of the company’s industry
The company’s competitive position including share, relationships, patents, etc.
The reputation and capabilities of the company’s management team
The quality of the company’s future strategy

Question 7

Why does PE generate higher returns than public markets?

Answer 7

Control and Operational Improvements: Private equity allows for control over portfolio companies, enabling operational improvements and strategic decisions that can enhance returns.

Question 8

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

Answer 8

Leverage Use: Leverage magnifies returns on equity investments. The use of borrowed funds allows PE firms to amplify returns, but it also increases risk.

Question 9

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

Answer 9

Considerations: Exit multiples are often determined by analyzing comparable transactions, industry benchmarks, and the growth prospects of the portfolio company. The chosen multiple should align with the overall exit strategy and market conditions.

Question 10

Walk me through a Discounted Cash Flow (DCF) analysis.

Answer 10

Steps: DCF involves projecting future cash flows, discounting them to present value using a discount rate (WACC), and arriving at a valuation. The formula is DCF = SUm of (CFt) / ((1+r)^t)

Question 11

Walk me through an LBO model at a high level.

Answer 11

High-Level Steps: An LBO model involves projecting the target company’s financials, determining the purchase price, establishing the capital structure, calculating debt repayments, estimating cash flows, and evaluating returns for investors.

Question 12

Walk me through an LBO model at a detailed level.

Answer 12

There are 5 steps to an LBO:
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.).
Determine how that total price will be paid including: equity from the PE sponsor, roll-overequity from existing owners or managers, debt, seller financing, etc.
Project the target’s operating performance over ~5 years and determine how much of thedebt principal used to acquire the target can be paid down using the target’s FCF over that time.
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.
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 13

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 13

Negotiation: The parties can negotiate an earn-out structure or contingent consideration based on future performance. This aligns the interests of both parties and allows for a resolution based on actual outcomes.
Tools to be used:
Earn out: 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 than PE investors are willing to underwrite. 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. 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. If the business under-performs the seller’s expectations then the buyer keeps some or all of the Earn-out money. This type of structure is a common way of bridging valuation gaps between buyers and sellers.
Cash Payments: The most straightforward method is an all-cash transaction, where the buyer pays the entire purchase price upfront. This provides immediate liquidity to the seller.
Stock or Equity Exchange: Instead of or in addition to cash, the buyer may offer the seller shares in the acquiring company. This ties the seller’s future returns to the performance of the combined entity.
Debt Financing: The buyer may use debt financing, such as bank loans or bonds, to fund the acquisition. This allows the buyer to leverage the acquired company’s assets and cash flow.
Seller Financing: In cases where the seller retains an interest in the business, the buyer may arrange for the seller to finance part of the purchase price. This involves the seller receiving payments over time, often with interest.
Contingent Value Rights (CVRs): CVRs are financial instruments that entitle the seller to additional payments based on the achievement of specific milestones or events, similar to earnouts. However, CVRs are typically traded separately from the buyer’s stock.
Preferred Stock: The buyer may issue preferred stock to the seller, which comes with certain rights and preferences, such as priority in receiving dividends or liquidation proceeds.
Royalties: In industries like technology or intellectual property, the seller may receive ongoing royalties based on the revenue generated from the acquired assets.
Warrants: Warrants provide the seller with the right (but not the obligation) to purchase shares of the acquiring company’s stock at a predetermined price. This allows the seller to benefit from any future increase in the buyer’s stock price.
Locked Box Mechanism: In a locked box arrangement, the purchase price is determined based on a historical financial position of the target company, often with a price adjustment mechanism for changes in working capital between signing and closing.
Escrow Accounts: A portion of the purchase price is placed in an escrow account to cover any potential indemnification claims or issues that may arise after the deal is closed.

Question 14

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

Answer 14

Formula: ChangeinNWC=EndingNWC−BeginningNWC.
It includes changes in current assets (excluding cash) and current liabilities.
NWC = Accounts Receivable + Inventory – Accounts Payable

Question 15

What are some common areas of due diligence?

Answer 15

Financial Due Diligence: Analyzing financial statements, tax returns, and accounting practices.
Operational Due Diligence: Assessing the efficiency of operations and potential synergies.
Legal Due Diligence: Reviewing contracts, litigation risks, and compliance.
Commercial Due Diligence: Examining market positioning, competitive landscape, and growth potential.
ESG Due diligence
Tech Due diligence

Question 16

Would you rather achieve a high IRR or a high MoM on a deal? What are the tradeoffs? What factors might influence your answer?

Answer 16

Tradeoffs: High IRR indicates a quick return, while high MoM suggests a large overall return. The choice depends on the fund’s strategy, liquidity preferences, and investment horizon.
Two common reasons to prefer a higher IRR are:
1. IRR is the most important single metric by which many LPs judge the performance of PE firms 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 won’t be impressed with a 2.0x MoM if it take 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, whereas 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 are:
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 terrific 40% IRR, but the GP would earn only ~20% * $40 = $8 in carried interest. On the other hand, 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 you can see, the choice between MoM and IRR can be complicated and involves several considerations. 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 17

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

Answer 17

Highest Values: DCF, as it considers future cash flows.
Lowest Values: Comparable Company Analysis (CCA), as it relies on current market multiples.
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. Of course there are times when this is not the case, especially when a company is under-levered or poorly managed.
o Precedent transactions tend to be on the higher side, especially when the buyer is “strategic” because such buyers frequently pay both a control premium and a synergy premium.
o Public comps / market valuations tend to be roughly in the middle of the pack depending on whether the market is hot or cold.
o DCF analyses are also middle of the pack on average, but there is a wild variability in DCF analyses on both the high side and the low side because DCF analyses are extremely sensitive to input assumptions.

Question 18

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

Answer 18

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.
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, and during cold debt markets it can fall to ~4.0x. This ratio can also be higher or lower based on the nature of the target’s business. Highly cyclical or risky businesses with few tangible assets are on the lower end of the range, while stable business with a lot of tangible assets (which can be liquidated to repay debt holders in the event of 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 / (1.5xblended 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.
Minimum Equity Ratio: Long gone are the days when PE firms could routinely buy targets for 5 – 10% Equity and 90 – 95% debt as a percentage of the total acquisition price. These days lenders demand that about 20 – 30% of the total acquisition price be equity. As such, you could estimate:
Maximum debt = 0.75x (total acquisition price)

Question 19

What constitutes a good LBO target?

Answer 19

Characteristics: Stable cash flows, opportunities for operational improvement, strong market position, and potential for cost synergies.
Price is super important!

Question 20

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

Answer 20

Acquisition/Control Premium: Represents the additional amount paid for acquiring a controlling stake in a company.
Reasons: Paid for the strategic advantages, control, and synergies gained through acquiring a majority stake.
When a PE buyer (or any investor) acquires a majority share of a publicly traded company, it nearly always pays more per share than the company was trading at prior to acquisition. 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 becomed public. For example, if the 30-day VWAP of a stock is $20 on the day an acquisition is announced for $25 per share, then the acquisition premium is $25/$20-1 = 25%. The size of control premiums varies, but they are usually between 10% and 50%.
There are several reasons why investors might be willing to pay acquisition premiums:
o Some buyers, especially strategic buyers, expect to realize synergies with the acquired asset which makes the asset more valuable to the acquirer than to previous shareholders.
o 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 get cash out of their investment.
o 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 management, 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. Thousands or more individuals or entities may be owners of a single stock, and the top ten largest 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 the transaction. Many of these owners own the stock precisely because they think it is undervalued by the market. Such owners would not be willing to sell the stock at its market price. There are of course zero (or nearly zero) owners who would sell 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 21

How would you gauge how attractive an industry is?

Answer 21

The three most important measures of an industry’s attractiveness are its growth rate, stability, and profitability. The most attractive industries are predictable/stable, high growth, and high profitability. However, keep in mind that attractive companies can exist in unattractive industries if they have a strong competitive advantage. For example, the airline industry is low growth, cyclical, and unprofitable, but Southwest Airlines has been successful for many decades due to their differentiated business model. Even unattractive companies in unattractive industries might sometimes make good investments if you can buy them at the right price and/or remedy some of what ails them.
Gauging stability
o The stability and predictability of an industry is usually easy to gauge by determining its growth drivers and examining its performance over a few business cycles.
o If the growth drivers depend on entrenched secular trends (e.g. the healthcare industry in a country with a demographically aging population) then the industry will be more predictable than one which depends on taste/trends/fads (e.g. fashion brands).
o If the products the industry produces are “must haves” for customers (e.g. electricity or food staples), then the industry will be more resistant to recessions than an industry which produces luxuries (e.g. cruise lines or expensive cars). o If the products the industry produces are commoditized, then its fortunes tend to oscillate with the business cycles of its customers (e.g. mining or semiconductors), whereas industries with strong intellectual capital/differentiation tend to be less cyclical (e.g. enterprise software or medical devices).
Gauging growth rate
o Estimate the industry’s historical growth rate from industry reports or from the aggregate revenue growth rates of participant companies.
o Discover the primary drivers of historical growth (e.g. technology improvement, untapped market penetration, growing product/service adoption, price growth, etc.) from industry reports, participant’s public disclosures, or calls with industry experts.
o Discover how growth drivers are trending and project future growth from educated assumptions about the main drivers.
Gauging profitability
o 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:
 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’s suppliers that is a good sign for future profitability. If not, the reverse may be true.
 Bargaining power of customer: Similar logic applies as Suppliers’ Bargaining power. If industry participants are more consolidated than their customers it’s a good sign for profitability.
 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.
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.
 Existing competitive rivalry: It’s 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 22

How would you gauge a company’s competitive position?

Answer 22

Competitive Position: Assessed through market share, brand strength, pricing power, innovation, and comparative advantages over competitors.
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.
- 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.
- Brand perception: Brand awareness can be a very important competitive strength indicator, especially for consumer-facing businesses. Equally important is how customers perceive the brand when they are aware of it. The best signal of competitive strength is high unaided customer awareness, associations with positive attributes customers care about most, and a high willingness to recommend the brand to friends and family.
- 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. For example, a farm equipment manufacturer should probably manufacture not only tractors, but also tillers, harvesters, and many other things a farm equipment wholesaler/retailer is likely to carry. It is equally important, of course, that the products and services a company offers are well designed, well manufactured, and highly regarded by customers.
- Management team quality: A bad management team can ruin the best business. A good management team can sometimes work miracles. Assessing management team strength is highly subjective, but it’s something PE professionals spend a lot of time discussing.
- Other signs of competitive strength:
o Lowest-cost product / service delivery model
o Strong intellectual property (IP) such as patents
o Low levels of customer “churn” (customers rarely stop being customers)
o Excellent physical locations (important for retail companies)
o Diversified customer and supplier base
o Diversified revenue sources
o High levels of recurring revenue

Question 23

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

Answer 23

Operational Improvements: Streamlining processes, cost reductions, and efficiency gains.
Strategic Initiatives: Expanding market reach, entering new segments, and pursuing acquisitions.
Financial Engineering: Optimizing capital structure, refinancing debt, and dividend recapitalizations.Recruit better management and board members
o Provide more aligned management incentives (usually via stock option pool)
o Identify and finance new organic growth opportunities (new geographies, new product lines, adjacent market verticals, etc.)
o Find, finance, and execute add-on acquisitions
o Foster stronger relationships with key customers, suppliers, and Wall Street
o Support investment in better IT systems, financial reporting and control, research & development, etc.

Question 24

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

Answer 24

Types: Financial covenants (e.g., Debt/EBITDA), operational covenants, and change of control covenants.
Use: To protect lenders and ensure the financial health of the borrower.
Debt covenants are contractual agreements between lenders and borrowers (such as companies which have been bought via an LBO) that give lenders certain rights to help protect their investment. Maintenance covenants require the borrower to maintain a certain equity cushion or debt service coverage cushion to maintain their ability to repay its debt. 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. See the section on covenants for details.

Question 25

What is free cash flow, how do you calculate it, and why does it matter in an LBO?

Answer 25

Definition: Represents cash generated by a company available for distribution to investors or debt repayment.
Calculation: Operating Cash Flow - Capital Expenditures.
Importance in LBO: Determines the ability to service debt, fund growth, and generate returns for investors.

Question 26

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

Answer 26

The single most important value determinant for most companies is its free cash flow (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.
If you cannot use FCF I would use EBITDA for private companies (majority inv) and Net income for (minority inv)