PE interview question - If you can only know 3 things for an investment analysis?
(King Kong, 1,504
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on 12/17/10 at 4:38pm
I received this 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.
Well.....I'm an idiot but
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.
what is the number one
what is the number one product it sells
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.
1.) FCF- Most important in
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.
EBITDA, Revenue, Industry By
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.
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alexpasch wrote: EBITDA,
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".
HFFBALLfan123 wrote: 1.) FCF-
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?
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Agree with AlexPasch -
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
Yeah it really is funny how
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.
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I can't remember what I
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!
1. What's the business model?
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
I disagree. You have to
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...
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Marcus - thanks for the great
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?
Kanon wrote: Marcus - thanks
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.
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Damn, Marcus came in here and
Damn, Marcus came in here and dropped a nuclear bomb. Game ovah.
Check out my WSO Blog
Marcus_Halberstram
Marcus You can't just look at
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Marcus_Halberstram
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alexpasch: I wish I could
^^---- I wouldn't say its
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alexpacsh- Are you seriously
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Kanon wrote: alexpasch: I
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Good points.
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Marcus_Halberstram
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In my opinion, Alex and
- 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
Coming back to the real
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CaptK wrote: In my opinion,
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Marcus, what you said about
wamartinu wrote: Marcus, what
upon further reflection you'd
Marcus_Halberstram
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I simply skimmed the
CompBanker
Thanks guys - great
Yes, this was a great back
It’s no mystery that ass has always been tits’ greatest enemy... It’s almost like a Muslim-Jewish thing, but with tits and ass.
CompBanker wrote: Also -- the
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Marcus, I think you're stuck
CompBanker
Wow, lots of banker-speak in
pembahopeful wrote: Wow, lots
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Before I read anyone's
I'd like to know the
i need the historical
i would ask number one
I don't work in valuation,
---------------------------------------
When you assume, you make an ass out of you... and only you.
exclusiveness of
I just read through the
awp wrote: I just read
- 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
All great responses above,
One of those lights, slightly brighter than the rest, will be my wingtip passing over.
since they are asking for
One of the best threads I've
Sorry guys, I still don't
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