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I received this PE interview question awhile back and I was wondering how one would answer this?

If I wanted to evaluate an investment opportunity for PE and I can only ask for three things, what would I ask for and why?

No details are provided about the company (not what it does, not what industry it's in, so on...)

Can any of you veteran or PE-based monkeys help me out? I'd like to know how to approach something like this in the future.

Comments (68)

  • monkeysama's picture

    Well.....I'm an idiot but here's what I would want to know;

    P/E
    Insider Trading (who sold shares or bought shares that works at the company - this is an actual metric BTW)
    What Industry the company is in.

  • In reply to monkeysama
    Ben Shalom Bernanke's picture

    monkeysama:
    Well.....I'm an idiot but here's what I would want to know;

    P/E
    Insider Trading (who sold shares or bought shares that works at the company - this is an actual metric BTW)
    What Industry the company is in.

    I would pass on insider buying/selling. I would like to see some sort of earnings growth number. PE doesn't always tell the whole story.

  • HFFBALLfan123's picture

    1.) FCF- Most important in the case of an LBO because you will need to be able to cover your increased interest expense and have some left over to pay down principle

    2.) Capital Structure- don't want to buy in with a shitload of share classes ahead of you with liquidity preferences

    3.) Management's Experience- inexperienced mngmt. is always a red flag.

  • alexpasch's picture

    EBITDA, Revenue, Industry

    By Industry I mean specific (i.e. what it does, ideally as specific as possible), so not just "healthcare" but rather "hospital company" or "medical device company"...something that will at least give you enough to get a good idea of a good comp group

    With these three things, you could put it in a comps and get a good idea as to valuation and company efficiency (i.e. multiples relative to peers, EBITDA margins, etc.). You could then compare valuation to industry fundamentals and see if you think that's reasonable. I used to work in PE, that's how I would answer the question.

    Ideally you want historical, current and projected revenue and EBITDA, but that could be violating the spirit of the question (i.e. you could just ask for all of the financials as one of the three things, lol)

    I would not answer insider trading, even if I were interviewing for a big megafund that did a lot of public to private. For most companies it is insignificant, and not one of the top three things I would ask for (granted it can be important sometimes, but the question is more what are the three absolute most important things for a quick go-no go investment). EV/EBITDA is better than P/E ratio. P/E can vary depending on leverage and in PE capital structure often changes after the investment is made.

    Consultant to a Fortune 50 Company

  • In reply to alexpasch
    monkeysama's picture

    alexpasch:
    EBITDA, Revenue, Industry

    By Industry I mean specific (i.e. what it does, ideally as specific as possible), so not just "healthcare" but rather "hospital company" or "medical device company"...something that will at least give you enough to get a good idea of a good comp group

    With these three things, you could put it in a comps and get a good idea as to valuation and company efficiency (i.e. multiples relative to peers, EBITDA margins, etc.). You could then compare valuation to industry fundamentals and see if you think that's reasonable. I used to work in PE, that's how I would answer the question.

    Ideally you want historical, current and projected revenue and EBITDA, but that could be violating the spirit of the question (i.e. you could just ask for all of the financials as one of the three things, lol)

    I would not answer insider trading, even if I were interviewing for a big megafund that did a lot of public to private. For most companies it is insignificant, and not one of the top three things I would ask for (granted it can be important sometimes, but the question is more what are the three absolute most important things for a quick go-no go investment). EV/EBITDA is better than P/E ratio. P/E can vary depending on leverage and in PE capital structure often changes after the investment is made.

    Good answer. Also want to add that it may be important once you have earnings and revenues to see how much the company relies on high revs to get earnings or do a simple earnings/revenues ratio. Depending on industry this might tell you a lot. Ideally the fourth thing I would ask would be "how experienced is management" or "is management selling shares".

  • In reply to HFFBALLfan123
    alexpasch's picture

    HFFBALLfan123:
    1.) FCF- Most important in the case of an LBO because you will need to be able to cover your increased interest expense and have some left over to pay down principle

    2.) Capital Structure- don't want to buy in with a shitload of share classes ahead of you with liquidity preferences

    3.) Management's Experience- inexperienced mngmt. is always a red flag.

    FCF is a great answer, but you have to be careful. FCF can be divided into overall FCF (i.e. operating cash flow minus cap ex plus interest expense) or the more common FCFE (i.e. operating cash flow minus cap ex). Many people will say FCF and refer to FCFE. This hides the interest expense component which makes comparisons difficult across companies, and also difficult to gauge how much debt you can add. EBITDA by definition excludes interest expense and is better/easier for building a comp set. (Granted, if you were to say free cash flows to equity AND debt, and explain the difference between the two types of FCF and also how they relate to EBITDA, and why the full FCF is actually better than EBITDA if you can get it for all companies in the comps (in practice, you probably won't), I'd say you're gonna get the job offer.

    Capital Structure is very important, don't know if I would put it as top three. I think industry and valuation are more important. I've seen deals structured with great protective covenants still do poorly because the company doesn't grow much. Bad capital structure will definitely kill a deal, but no one does a deal solely for capital structure.

    Management is very important, but unless you're looking at a lot of seeding deals, management will almost certainly have a minimum level of competence. People always mention management as the most important qualitative element, but I think industry is a much, much better answer. You can always fire management, can't usually change the industry/product of the company. Plus haven't there been studies that say (in the public markets at least), something like 60% of the equity returns can be explained by industry alone?

    Consultant to a Fortune 50 Company

  • CaptK's picture

    Agree with AlexPasch - EBITDA, Revenue, and Industry are the biggies. From there you can understand the market they play in, the size of the company, and their margins. You also need EBITDA to make an intelligent bid as a multiple. It's actually pretty amazing how at the end of the day, many PE investments actually come down to those 3 factors nearly entirely (the rest is just minutiae).

    Also, monkeysama - both P/E and insider trading are irrelevant for private companies (which are 90%+ of PE buyouts), so definitely don't say that if you get this question in an interview.

    - Capt K -
    "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham

  • alexpasch's picture

    Yeah it really is funny how often those are like the only three things that really matter. So many people on this board (particularly those still in school) worry way too much about stuff like Excel and modeling. There was a time when those things didn't exist, and it was all about industry, and basic financials analysis. Thing is, it still is only about those things. At the end of the day, a model is not going to make or break a deal and that is why analysts and associates, despite doing all the "work", get paid the least. They're just not doing the real value add. Being a rainmaker (buy-side or sell-side) is much more about social skills, network, negotiating, sourcing, etc as well as having a good sense for good businesses, industries, economic trends, etc. Get good at THOSE things, and you'll go a lot farther than the "star" modeler.

    Consultant to a Fortune 50 Company

  • Kanon's picture

    I can't remember what I answered now... but I think I said FCF, revenue and EBITDA, but I should have asked for industry (I got too focused on what are some major items I would look at in a model instead of the big picture).

    Thanks guys - very educational!

  • s2tn6at's picture

    1. What's the business model? (how does the company generate cash flows?, is there a strong customer value proposition?, where does the company stand in its industry?)
    2. What are the growth opportunities over the next 5 years?
    3. Management team

  • Marcus_Halberstram's picture

    I disagree.

    You have to understand what they're trying to determine with this question. And my view is they're trying to determine if you understand private equity investing, how/why it works and how to analyze an investment. While knowing the industry is important in making an investment decision where you've got all sorts of detailed information... if you're given the choice of 3 pieces of info, the industry should not be one of them.

    I'd ask for 5 year Revenue CAGR(%), LTM EBITDA($) and cash conversion(%).

    From there you can ball park an IRR in about 5 minutes in Excel.

    While you need to know about the management team and industry outlook etc... for this type of quick "should we spend any time on this" type analysis, you're not going to dig into the industry and management team. You're not going to build out a big elaborate model and make all these assumptions based on the industry you're given.

    After you answer this question, the interviewer will give you your 3 asks, and you'll have to give him an answer without any follow-up questions.

    The problem interviewers get into is they get intimidated by these sort of questions and tend to give very broad and general answers, which doesn't work for a "should I invest in this company"-type question. You need to get specific in your answer as to what data you would need, so that you get specific answers from the interview. From there you have to be able to say YES I would invest or NO i would not.

    If you get your 3 asks... can you give him an investment answer? Lets take a shot at it...

    Someone said FCF, Cap structure and management experience.
    - Company will generate $450 million over the next 5 years
    - the industry is healthcare/pharma (they manufacture pharmaceuticals for race horses)
    - the CEO has 25 years of experience in pharmaceutical manufacturing, he has an undergrad degree in biochem and an MBA, CFO has 20 year experience at a big pharma company, COO similar background
    Should you invest in this company? Almost all members of an executive teams will each have 15-30 years experience, some sort of higher education degree etc... they'll all be "impressive" on paper.

    Business Model, 5 yr growth opportunities, management team
    - company manufactures pharmaceuticals for race horses; they develop, design, manufacturer, market and distribute their products throughout the world to elite race horse trainers; raw materials are typical medicinal ingredients, not high volatility in pricing. Seek to differentiate themselves by working closely with trainers to identify bespoke products for particular breeds of horses.
    - 5 year growth opportunities lie in developing new products to sell to existing customers and increasing market share in the industry. If you had asked for a specific qualitative figure you would have gotten something more concrete.
    - the CEO has 25 years of experience in pharmaceutical manufacturing, he has an undergrad degree in biochem and an MBA, CFO has 20 year experience at a big pharma company, COO similar background
    Should you invest in this company?

    If you had asked for 5 yr revenue CAGR, LTM EBITDA and cash conversion you'd have gotten the following to work with:
    - 5 yr rev cagr is 5%
    - LTM EBITDA is $70 million
    - Cash conversion is 50% (unlevered)
    ---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR)
    ---- can ball park FCF generation over the next 5 years by applying cash conversion % to EBITDA and growth that FCF by CAGR each year
    ---- slap a boilerplate cap stucture on it, come up with an IRR and you know if its in the realm of do-able or not

    If its showing a 11% IRR do I give to shits if the CEO and CFO are the smartest guys in the world? Do I care which industry they are in?

    I would ask for those 3 things and explain how I would use them to ball park an IRR. Then I can gauge if I should spend more time on this or not. If the IRR is in an attractive range I'd want to dig in more. Understand the business model, the industry outlook, where comps are trading at, any potential fatal flaws (i.e. material litigation, environmental liability issues, etc...). The only reason you care about revenue is because it drives your EBITDA, if you can get to EBITDA you don't care about revenue. The only reason you care about EBITDA is because it drives FCF and because it drives valuation. Capital structure is meaningless. You want to keep your answers as simple as possible, why would you voluntarily propose some convoluted share structure? You want assumptions to be as simple as possible, you purchase the company outright, no breakage costs, etc...

  • Kanon's picture

    Marcus - thanks for the great advice as always. Much appreciated!

    "---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR)"

    I think I missed something, how do you determine a purchase multiple from this exactly?

  • In reply to Kanon
    Marcus_Halberstram's picture

    Kanon:
    Marcus - thanks for the great advice as always. Much appreciated!

    "---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR)"

    I think I missed something, how do you determine a purchase multiple from this exactly?

    Well you'll notice that industries trade in a given multiple range. That industry range is largest driven by the industry's growth outlooks. So aircraft component manufacturers may trade at a 5-7x range from their growth profile of 3-4%-ish. Obviously very rudimentary estimates, but if you talk through this in your interview you establish that you know what drives the value of a firm and that the CAGR can get you in the ball park.

  • TheKing's picture

    Damn, Marcus came in here and dropped a nuclear bomb. Game ovah.

  • In reply to Marcus_Halberstram
    Kanon's picture

    Marcus_Halberstram:
    Kanon:
    Marcus - thanks for the great advice as always. Much appreciated!

    "---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR)"

    I think I missed something, how do you determine a purchase multiple from this exactly?

    Well you'll notice that industries trade in a given multiple range. That industry range is largest driven by the industry's growth outlooks. So aircraft component manufacturers may trade at a 5-7x range from their growth profile of 3-4%-ish. Obviously very rudimentary estimates, but if you talk through this in your interview you establish that you know what drives the value of a firm and that the CAGR can get you in the ball park.

    I see - when I went into that interview, the hypothetical company's industry or sector is not known, and therefore I would not know what range of multiples to apply. So for this question I posted to WSO, I was going by that same assumption (which may be another reason why some of the above posters mentioned the need to know which industry - as one of the needed asks).

    But given that CAGR is asked for, I guess you can also make a very high level guess as to what purchase multiple to assume... (re: a 3-4% yoy growth company is probably going to be around 5-7x...)

  • alexpasch's picture

    Marcus

    You can't just look at quantitative measures. A revenue CAGR is not guaranteed going forward. You can't assume EBITDA margins stay constant, etc. This is why industry is so important; so you can place the numbers in a context. I don't care if the financials are horrendous if the industry explains why that is so and I have a plausible reason for predicting a rebound.

    People who focus so much on quantitative factors are the ones who do stuff like sell CDS or buy MBS because their entire due diligence into industry consists solely of "housing never goes down". They get burned. I don't care if a company's financials are great if I believe their industry sucks and is not going to do well. An IRR does not tell me anything about risk, industry does. What if the IRR is 30% but the company is very risky? It might not be an attractive risk/reward proposition. Also, your IRR is based purely on financial theory, which ignores reality and market fundamentals. From my three numbers, I can get actual comps and get a much better picture of what the company is worth, and based on the EBITDA multiple of comps and projected growth rates in the industry, I can back into an IRR as determined by current market prices (not what I think a multiple should be, but what I'm going to have to pay). You could do your analysis based off your three questions, and say go, and the market could be using a multiple on cash flows much lower than what you're assuming (i.e. you are overpaying).

    I read the question as you can only ask for three things, period (i.e. you are not doing a quick financial screen, you get three pieces of info and have to make a decision solely from that).

    Again, if you don't have industry, you have no way of putting your numbers in context. It's saying you ask for three pieces of info, it does not say you have to give an answer in 2 mins after receiving that info. With your info, I can't do much other than the 2 min long IRR analysis you did in your post. If you know industry, you can do a lot more due diligence and build a more complete picture of the investment.

    There is not a single situation I can think of where you give me the three bits of info I ask for and I can't give you a basic go, no-go answer. I don't care what numbers you give me for your three metrics, I can't come to a conclusion because I have nothing qualitative to go on.

    From my experience, when that question gets asked (and I've asked/received similar questions multiple times), what people want to see is that you get the big picture; i.e. you are an investor, not a financial engineer. Not mentioning a single qualitative element is a big no-no in my opinion. One of my fav interview questions is "what is the most important thing when deciding whether to invest in a company"? then ask them the second thing, third thing, etc. (with their answers in between, and basically no comment from me, so they don't know if I like their answers). See how many quantitative things they say before they say something qualitative and vice versa. Who would you hire? Someone that said "FCF/EBITDA" and then said "Industry" for their second item? Or someone that says "Rev. CAGR", "EBITDA", "Cash conversion %", "P/E", "FCF" one after the other? I've heard a whole myriad of answers and IMO it really weeds out the financial engineers (and the consultants, who don't know finance) from the very top, balanced candidates, who are the best investors.

    P.S. - My favorite interview question is "What is the best investment someone could make right now and why?" I know whether I want to hire someone solely based off their answer to that.

    Consultant to a Fortune 50 Company

  • In reply to Marcus_Halberstram
    alexpasch's picture

    Marcus_Halberstram:
    Kanon:
    Marcus - thanks for the great advice as always. Much appreciated!

    "---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR)"

    I think I missed something, how do you determine a purchase multiple from this exactly?

    Well you'll notice that industries trade in a given multiple range. That industry range is largest driven by the industry's growth outlooks. So aircraft component manufacturers may trade at a 5-7x range from their growth profile of 3-4%-ish. Obviously very rudimentary estimates, but if you talk through this in your interview you establish that you know what drives the value of a firm and that the CAGR can get you in the ball park.

    Haha meanwhile I am short some aircraft component manufacturers in my fund (seriously). You're taking an extremely theoretical approach that is detached from reality. You're assuming market efficiency (i.e. multiples are derived from growth expectations, etc.) and only seldom is the market right.

    Consultant to a Fortune 50 Company

  • Kanon's picture

    alexpasch:

    I wish I could clarify whether the 3 asks mean: Do I get these 3 items of info and can do your analysis on that or if it's for a quick-and-dirty analysis (what Marcus provided). Unfortunately I didn't ask the interviewer to clarify the limits of his question (rookie mistake), and I just assumed his question meant that I get 3 items, and I'm not allowed to do anything else (re: look up industry comps, etc.)

    From Marcus' perspective it's - do a quick and dirty analysis with just these 3 items. If it has a decent enough of an IRR, it at least passes a smell test to dive deeper into looking at its performance relative to other industry players and the like. So the question is then "is this an investment worth further investigation" and not necessarily "do we want to do this investment, yes or no".

  • Marcus_Halberstram's picture

    ^^---- I wouldn't say its theoretical. Its pretty pragmatic. When you look at an industry in aggregate, the noise is dampened and the general valuation trend (especially relative to other industries/growth outlooks) is more clearly defined. Its not meant to be a precision analysis.

    If you disagree, go to Cerberus tell them you're looking to sell them an OEM auto component manufacturer at 11x EBITDA... they won't even have to look at any of the metrics I mentioned above or anything else for that matter before telling you they're not interested.

  • Marcus_Halberstram's picture

    alexpacsh-

    Are you seriously that dumb?

    Its an interview question. What 3 things do you need to know to do an investment analysis. Analysis is by definition quantitative. I didn't say those are the ONLY 3 pieces of information anyone needs in order to make an invest / don't invest decision. It's the answer to an interview question. Knowing all possible quantitative/qualitative specifics are important in the practical world. Knowing all those things in an interview room when you're given 3 asks, is stupid. You're given the option to get 3 pieces of information. If you're answer to that interview question is to ask for a full blown diligence process. In an interview, the person asks you that question and you give them the 3 pieces of info you would request and then they give you specific answers to your 3 asks and tell you do walk them through how you'd come to a conclusion.

    The question was not "what type of diligence needs to be done before making an investment decision?" The question was "I went to an interview and was asked this question, how should I have answered it?"

    PE investors have a variety of strategies. I don't think you're shooting yourself in the foot by coming off as a financial engineer oriented PE investor. Financial engineer and investor are not mutually exclusive FYI.

  • In reply to Kanon
    alexpasch's picture

    Kanon:
    alexpasch:

    I wish I could clarify whether the 3 asks mean: Do I get these 3 items of info and can do your analysis on that or if it's for a quick-and-dirty analysis (what Marcus provided). Unfortunately I didn't ask the interviewer to clarify the limits of his question (rookie mistake), and I just assumed his question meant that I get 3 items and I'm not allowed to do anything else (re: look up industry comps, etc.).

    I agree, clarification is necessary. Everything that Marcus said is right, but I read the question as, you get three items of info, and then you can do whatever you want (i.e. comps, dcf, research, etc.) to tell me whether you should invest or not. From my experience, when interviewers ask questions like that, they are looking to distinguish the finance-heavy kids from the kids who take a more well-rounded approach to investing. Certain firms will have different preferences with regard to that (or even within a firm, preferences will vary, based on what the person is being hired for).

    I'm just saying to be careful, and you should definitely clarify. Even financial questions can be disguised as qualitative in nature. One of the partners at the PE firm I used to work for liked to ask people a question along the lines of "I have an analysis that is giving me an IRR of 40%, should I invest?", to see if people understood the concept of risk/return. If you answered "yes, that is a good return" without mentioning execution risk, market risk, etc. (i.e. qualitative stuff), you would probably get a very low score from him. Haha once he got this kid that was like "what's the catch, there has to be a catch?" and he replied "I have a crystal ball that guarantees me the numbers in the model will come true" and the kid was like "oh, then yes, definitely invest" and he replied "the company is in Zimbabwe, and inflation is 100%, how does the IRR look now?" (I felt bad for the kid, but he actually didn't get that bad a score cuz at least it seemed sketchy to him originally) The best interview questions are those that tell you something about a candidate without having to directly ask him.

    Consultant to a Fortune 50 Company

  • In reply to Marcus_Halberstram
    alexpasch's picture

    Marcus_Halberstram:
    alexpacsh-

    Are you seriously that dumb?

    Its an interview question. What 3 things do you need to know to do an investment analysis. Analysis is by definition quantitative. I didn't say those are the ONLY 3 pieces of information anyone needs in order to make an invest / don't invest decision. It's the answer to an interview question. Knowing all possible quantitative/qualitative specifics are important in the practical world. Knowing all those things in an interview room when you're given 3 asks, is stupid. You're given the option to get 3 pieces of information. If you're answer to that interview question is to ask for a full blown diligence process. In an interview, the person asks you that question and you give them the 3 pieces of info you would request and then they give you specific answers to your 3 asks and tell you do walk them through how you'd come to a conclusion.

    The question was not "what type of diligence needs to be done before making an investment decision?" The question was "I went to an interview and was asked this question, how should I have answered it?"

    PE investors have a variety of strategies. I don't think you're shooting yourself in the foot by coming off as a financial engineer oriented PE investor. Financial engineer and investor are not mutually exclusive FYI.

    I have not insulted you so I don't see why you feel the need to insult me. I have learned not to insult people or get into dick measuring contests...you should follow my advice, you never know who you're talking to...

    The question said you get three pieces of info to make a PE investment decision. It could be read both ways. It didn't specify time frame or level of due diligence conducted after receiving the three items and it didn't specify whether it was solely quantitative in nature. I did not make any assumptions, I answered the question literally, you made assumptions. I don't see anything in the question as written by the original poster that says I should be making those assumptions. I have asked similar questions in interviews and I do not expect a solely quantitative answer. I think the very essence of the question is to get an idea of the type of diligence the candidate thinks needs to be done before making an investment decision. If you answered as you did, I would say "well what about the qualitative aspects"? And then you'd be stuck looking bad, lecturing me (the interviewer) on why qualitative elements don't matter. If I say Industry, Revenue and EBITDA, I can't get burned, because if they say well why not just 3 quantitative (i.e. your three things), I can give a rebuttal similar to my rebuttal in the post above. My answer is both correct AND safer. You use your three items to basically derive a theoretical IRR. I use my three items to derive an IRR (from the market, i.e. using a market price, not a theoretical price) and I get some qualitative info to boot.

    Now, if the question specified purely quantitative and that I only had five minutes, I would go with your answer. The question as written, however, does not make those assumptions. My guess is that you are an extremely quantitative individual and you feel the need to show that off, which is great and many firms value that very highly. But, in my opinion, that is not what the question is about. If an interviewer wanted to roast someone with financial brain teasers, they sure as hell would pick something harder than this. The very nature of the vagueness of the question to me suggests a qualitative element.

    Consultant to a Fortune 50 Company

  • CaptK's picture

    In my opinion, Alex and Marcus are both right. Alex takes more more qualitative approach (which I also tend to agree with), while Marcus focuses more on the financial metrics of the deal. Both are important, and if you were working at a PE firm and considering an investment, both would get equal weight, but may be looked at in a different order depending on the type of firm you're working at.

    I think it also depends a lot on an individual firm's investing strategy and philosophy. If I had to hazard a guess, I'd say Alex comes from a MM fund, while Marcus is speaking more from a megafund perspective.

    When dealing with MM buyouts, the qualitative factors become much more important because you're looking at deals that may not be as widely shopped, and also may not be as well managed (ie - leaving room for turnaround) - thus a lot of the value is created by how the business grows after you acquire it. Thus, more of a focus on industry factors, comps, and qualitative trajectory.

    In larger buyouts, targets are usually professionally managed, widely shopped, and add-ons are harder to execute, so pricing on the original deal is very important to returns. Though it will become a private security, big LBOs are much more like investing in the public equity markets. Thus more of a focus on financial engineering.

    Both approaches are right, and both are complementary. Just depends what school you come from.

    - Capt K -
    "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham

  • Marcus_Halberstram's picture

    Coming back to the real world, outside of an interview question, I view the quantitative aspect as a litmus test, as in "do I spend any more time/effort on this deal"

    You can run the numbers on a potential deal in a relatively short time frame and that will tell you if you need to proceeds further or not. Qualitative diligence, IMO, is more time consuming and bespoke, for lack of a better word.

    I'm a believer that the investment analysis utility curve is very steep at first and flattens out considerably thereafter. You get the most utility per minute of effort expended at the initial period of reviewing an investment. The later stages are absolutely necessary, but there's no need to get to the later stages if the investment thesis falls flat on its face at the outset. Its in the later stages that you'll identify a potential pitfall or fatal flaw, but again, you don't need to dig into a chemical company's environmental liabilities the deal's returns are lackluster.

  • In reply to CaptK
    alexpasch's picture

    CaptK:
    In my opinion, Alex and Marcus are both right. Alex takes more more qualitative approach (which I also tend to agree with), while Marcus focuses more on the financial metrics of the deal. Both are important, and if you were working at a PE firm and considering an investment, both would get equal weight, but may be looked at in a different order depending on the type of firm you're working at.

    I think it also depends a lot on an individual firm's investing strategy and philosophy. If I had to hazard a guess, I'd say Alex comes from a MM fund, while Marcus is speaking more from a megafund perspective.

    When dealing with MM buyouts, the qualitative factors become much more important because you're looking at deals that may not be as widely shopped, and also may not be as well managed (ie - leaving room for turnaround) - thus a lot of the value is created by how the business grows after you acquire it. Thus, more of a focus on industry factors, comps, and qualitative trajectory.

    In larger buyouts, targets are usually professionally managed, widely shopped, and add-ons are harder to execute, so pricing on the original deal is very important to returns. Though it will become a private security, big LBOs are much more like investing in the public equity markets. Thus more of a focus on financial engineering.

    Both approaches are right, and both are complementary. Just depends what school you come from.

    Well said, I did work for a MM PE shop and I agree approaches are different across PE.

    Personally, I think finance (as a whole) has become intoxicated by modeling and financial due diligence to such an insane degree that it's actually adversely impacting returns. I have a friend who works at Bain Capital, and I remember asking him "why did you guys invest in X, that industry's input costs could skyrocket", "well financials told us Y, and we actually did an analysis on those input costs and this is the sensitivities we got", "umm, those sensitivities don't sound right, did you guys consider [this aspect, which you would glance over unless you really knew the industry, which in this case I did] of it?" (silence) "oh well who cares, I don't get carry and we'll probably be out of it by then".

    I used to think modeling was the be all and end all until one time several years ago when I was at an interview for a MM PE shop (not the one I worked for) and I was meeting with one of the Partners and he asked me something like "why should I hire you", and like the first thing I said was something along the lines of like "I'm smart and I can build really sophisticated financial models, etc."; he like stopped me and said something like "modeling is useless, i can teach anyone to model, I don't see why you think that's valuable". Needless to say I didn't get an offer from them...

    Consultant to a Fortune 50 Company

  • wamartinu's picture

    Marcus, what you said about about correlation between sales cagr and purchase multiple seems intuitively right to me. But I was looking at this recent PE deal (hydraulic cylinders market leader) in Europe and here's the stats:

    6 year sales cagr: 20%
    Ebitda margin: 12.5%
    Purchase Multiple EV/EBITDA: 8.8x

    according to what you're saying the purchase multiple should be around 20x or more, but its less than half that.
    So what could explain this possible deviation?

  • In reply to wamartinu
    anonymous_analyst's picture

    wamartinu:
    Marcus, what you said about about correlation between sales cagr and purchase multiple seems intuitively right to me. But I was looking at this recent PE deal (hydraulic cylinders market leader) in Europe and here's the stats:

    6 year sales cagr: 20%
    Ebitda margin: 12.5%
    Purchase Multiple EV/EBITDA: 8.8x

    according to what you're saying the purchase multiple should be around 20x or more, but its less than half that.
    So what could explain this possible deviation?

    low margin business, potentially cyclical industrials company, you'd be crazy to pay 20x.

    the 'correlation' between multiple and sales cagr should have a 3'rd dimension - the ebitda margin.

    don't be too pedantic about how to value a company... correlations / multiples / etc will only get you so far.

  • anonymous_analyst's picture

    upon further reflection you'd actually be crazy to pay 10 times.... would need to be 'strategic' / have a big view on synergies.

  • In reply to Marcus_Halberstram
    alexpasch's picture

    Marcus_Halberstram:
    Coming back to the real world, outside of an interview question, I view the quantitative aspect as a litmus test, as in "do I spend any more time/effort on this deal"

    You can run the numbers on a potential deal in a relatively short time frame and that will tell you if you need to proceeds further or not. Qualitative diligence, IMO, is more time consuming and bespoke, for lack of a better word.

    I'm a believer that the investment analysis utility curve is very steep at first and flattens out considerably thereafter. You get the most utility per minute of effort expended at the initial period of reviewing an investment. The later stages are absolutely necessary, but there's no need to get to the later stages if the investment thesis falls flat on its face at the outset. Its in the later stages that you'll identify a potential pitfall or fatal flaw, but again, you don't need to dig into a chemical company's environmental liabilities the deal's returns are lackluster.

    I agree with the utility curve bit. I actually look at qualitative first, that's actually quicker for me. I am extremely knowledgeable about one industry, but have a pretty good knowledge of most industries. If it's an industry I don't know, I don't bother with the company. For example, I don't need to do financial due diligence of any kind on the chemical company, because I am bearish on chemical companies right now. I do macro analysis on industries, and have buy/sell/hold on each industry and choose companies for what they DO (novel thought, right?). I screen first by this qualitative aspect, and then do financial due diligence to see if the company is cheap or not. I wish I had the study, but I remember reading that something like 60+% of the variability in a stock's performance is attributable to industry alone. I do a lot of pairs trading across industries.

    Consultant to a Fortune 50 Company

  • CompBanker's picture

    I simply skimmed the responses above, but I whole-heartedly agree with alexpasch's approach. Financial metrics mean very little if you don't put them in the context of an industry. For my shop, industry is far and away the most important consideration when evaluating a new opportunity. Market size / growth / trends are essential. Sure, the company's financial profile is important, but it doesn't necessarily drive investment decisions (besides, all forecasts are just some BS made up by management).

    If I got asked this question in an interview setting, I'd respond with the following:

    1) Industry description, growth/size (you can group these into a single bucket when answering an interview question such as this one)
    2) Financial profile (revenue/ebitda/CapEx/WC requirements)
    3) What makes the company's product/service proprietary/sustainable?

    Don't feel like you can only get a SINGLE data point per question, that's just silly. Also -- the point is to evaluate the company to determine whether or not you want to make an investment, not to determine how much you would pay.

    To further support the "industry is key" thesis, take a look at GTCR's investment model. GTCR helped to pioneer the concept where a PE shop identifies an industry that they are interested in investing in, finds an executive to lead the effort, and then searches an appropriate platform company from which to fulfill the investment thesis.

    CompBanker

  • Saccard's picture

    Yes, this was a great back and forth and clearly there is no right answer here.

    If you only had 3 metrics, I would think that a combination of EBITDA and capex would be powerful because it gives an indication of how much the company is spending to maintain growth. EBITDA growth itself is not that impressive if it takes huge capex to achieve it. You could also get a rough idea of FCF depending on the third metric you ask for.

    Good points about qualitative factors here. I think it's not just a question of qualitative vs. quantitative, but also historical vs. forward looking. When people ask about industry, sure they want to know historical figures, but imo it's far more important to see the growth prospects of the industry and look at it with some common sense. Sure, the VHS industry grew for awhile, but at some point a good investor would say, you've gotta be crazy to think VHS sales will continue at that pace.

  • In reply to CompBanker
    Marcus_Halberstram's picture

    CompBanker:
    Also -- the point is to evaluate the company to determine whether or not you want to make an investment, not to determine how much you would pay.

    How can you determine if you want to make an investment when you don't know the price? So when you decide you like a company's profile, you'll invest in it no matter the price? I can rattle off a dozen public companies that would make fantastic LBO candidates, but they're trading at 12x EBITDA and would either require a pretty large equity check or a leverage level the market would puke all over.

  • CompBanker's picture

    Marcus,

    I think you're stuck in the weeds on this one. You're too focused on what the "model inputs" would need to be to spit out an appropriate IRR rather than what makes a company a high quality investment.

    Per your statement about purchase price, I don't think that is relevant given the context of the question. Sure, you absolutely can't make an investment without knowing the purchase price, we all know that. But if I asked you this question and you responded "purchase price" I would dock you serious points. The question wants to know what are the three MOST important things to know when evaluating an investment -- they aren't asking you to make a go/no-go decision.

    With that in mind, I'll return to my previous recommended response:

    1) Industry dynamics: This is important because it is a key factor in determining growth, potential size, and relative market position. I'd much rather take a poorly run business in a great industry than a well-run business in a shitty industry. Also, with long term investment horizons (5-10 years), industry dynamics play a large part in shaping whether or not an investment is successful. Think of this question as the "macro" view of the investment.
    2) Financial Profile: This get's at many of the things you're looking to analyze Marcus. As an investor, you need to make sure that you can service your debt, so Free-Cash-Flow is incredibly important. Things such as EBITDA margin will help you determine how well the business is run (you can compare it to similar public businesses) and CapEx/WC will help you make ascertain the true amount of $$ that you're generating.
    3) Proprietary Nature: There are obviously winners and losers in every industry. Determining a company's competitive advantage can help you build an investment thesis and gain confidence in a company's ability to take advantage of positive market dynamics. Think of this as the "micro" view of the investment.

    So, that's my answer. I'm going to analyze your three asks in response to the original question posed:

    If I wanted to evaluate an investment opportunity for PE and I can only ask for three things, what would I ask for and why?

    Marcus_Halberstram:
    I'd ask for 5 year Revenue CAGR(%), LTM EBITDA($) and cash conversion(%).

    5-Year Revenue CAGR(%): Management informs you that they are projecting a 30% revenue CAGR over 5-years. (Note that this is just a management projection. You're clearly not asking a crystal ball here -- you're asking either a banker or a management team. If you were able to ask for CAGRs with 100% certainty that the projection would come through, I'm assuming you'd just cut to the chase and ask "What would the IRR be for a 5-year hold on this investment?")

    LTM EBITDA($): $100M. (I'm really not sure how much this tells you to be honest. Yes, you can use it as a basis to price the asset, but that would be an extremely dangerous approach without knowing anything else about the company. What if the company was selling through distribution and was practicing channel stuffing [signing up a ton of new distributors yet not producing additional end customer sales -- effectively inflating Sales/EBITDA temporarily until all the distributors start returning unsold stock and eating away at your FCF]??)

    Cash Conversion(%): 50%. (Probably the most useful metric you asked for, but still difficult to utilize appropriately given your other requests. Is this really one of the TOP THREE items you'd ask for if you sat down with a management team and could only ask them three questions??)

    Anyways -- I'm not trying to be a jerk with the above response. My point is that financial metrics alone really don't tell you much about a company. When you only have a precious three questions to decide whether or not to pursue an investment, you really need to make sure the fundamentals are sound. You simply can't do this by looking at estimated revenue growth, size (EBITDA), and FCF conversation rate.

    Finally -- I recognize that we both made different assumptions when answering the question (such as the amount of detail that you can ask for in a given question). As a result, you could probably quickly poke holes in my argument by making different assumptions (I'll save you the time -- I understand this).

    CompBanker

  • pembahopeful's picture

    Wow, lots of banker-speak in this thread on how to "value" a business. All numbers, all useless.

    Three things:

    - Industry dynamics

    - Position / quality / ranking of Company within industry

    - Price

    I think management quality should be captured by #2.

  • In reply to pembahopeful
    alexpasch's picture

    pembahopeful:
    Wow, lots of banker-speak in this thread on how to "value" a business. All numbers, all useless.

    Like I said in a prior post, this question weeds out the financial engineers, but it also weeds out the kids that should be doing consulting...

    Consultant to a Fortune 50 Company

  • Cold-Steele's picture

    Before I read anyone's responses I'd go with the following:

    1 ) P/E Ratio -- Give me an idea on how relatively expensive the company would be for my firm to acquire.

    2) Operating Cash Flow -- Gives me the indication on the businesses core operations

    3) Debt/Assets Ratio -- I don't want to buy a company with too much debt, that could be expensive to take on.

    This is of course assumes that the target is a public.

    Good day!

  • levelworm's picture

    I'd like to know the connections the company get. But of course this won't be shown in a investment report.

  • tcam's picture

    i need the historical (perhaps average) numbers on:
    1. ROIC - WACC spread
    2. FCF Yield (FCF/Market Cap)
    and then 3. leverage

  • blastoise's picture

    i would ask

    number one source of income(product)
    2 largest countries it sells in
    competitors

    1. - Will tell me if the company is legit or just another cash4gold
    2. - will tell me is it already in emerging markets aka room for growth
    3. - Will tell me what are the other possible investment possibilities instead of this company

  • jakhtar4299's picture

    I don't work in valuation, but my answer would be:

    1) Level (FCFF, EBITDA, etc)
    2) Growth (ROC, reinvestment, etc)
    3) Risk (WACC/capital structure)
    ...OF CASH FLOWS

    Industry and management are pretty damn important as well.

    ---------------------------------------
    When you assume, you make an ass out of you... and only you.

  • awp's picture

    exclusiveness of opportunity

    premiums paid at exit on comparable trans

    Shareholder structure

  • awp's picture

    I just read through the responses...

    I mean my willingness to invest i.e. the attractiveness of the opportunity should be a function of pruchase price to some degree, or am i completely off track?

    whilst most of you can determine whether it is a business that will grow you will not be able to tell whether its priced in or not. If i give you great numbers on your, either qualitative or quanitative, metrics, that doesnt mean anything without knowing price of the opportunity.

  • In reply to awp
    CaptK's picture

    awp:
    I just read through the responses...

    I mean my willingness to invest i.e. the attractiveness of the opportunity should be a function of pruchase price to some degree, or am i completely off track?

    whilst most of you can determine whether it is a business that will grow you will not be able to tell whether its priced in or not. If i give you great numbers on your, either qualitative or quanitative, metrics, that doesnt mean anything without knowing price of the opportunity.


    The price is a derivative of all of the factors above. As a private equity investor, you analyze all the factors in order to arrive at what you believe is a fair valuation for the business that will still make you a nice return. That's the price you bid for the business. The valuation is the output, not an input.

    So if a banker is shopping a deal at $400mm (or a public company is trading there) and your analysis says you believe you can pay $450 and still get a good return, you move to buy the business. If your analysis says you'd have to pay $350 to make your hurdle, you probably won't bid.

    - Capt K -
    "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham

  • 2x2Matrix's picture

    All great responses above, but I'd like to vote for industry as one of the three. Marcus mentioned the "should we spend any time on this;" in real life you'd always know what the company does before starting such an analysis. One set of revenue/EBITDA/revenue CAGR/etc. metrics would be very different for a pharmaceutical company that's R&D focused than they would be for a consumer goods company.

    One of those lights, slightly brighter than the rest, will be my wingtip passing over.

  • RWP's picture

    since they are asking for only "3" things, the answer should be in the grand scheme of things:

    1. historical financials
    2. historical operating metrics
    3. management forecast

    you want first to find out if it is a real company and the revenue drivers before you move on.

  • Mzz's picture

    One of the best threads I've read in months.

  • Marcus_Halberstram's picture

    Sorry guys, I still don't agree with you here. Where is capex in your analysis of this company? Where are working capital needs? Even if you know the industry, these can vary within a huge range from company to company. Does the company grow organically? Through acquisitions? This is something you see in the FCF and CAGR figures I mentioned. You don't see it in Revenue and EBITDA projections. What if a company has flat organic revenue growth and the only growth you're seeing is VIA acquisitions over the next 5 years, how are your 3 asks taking this into consideration? Isn't this something you should know when assessing a company?

    I definitely think some very good points were made (especially the one about demonstrating you understand the big picture), but I really feel like this question is not trying to check that box. If someone wants to see if you get the big picture, they don't ask you a question with such a limited scope.

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