A question i missed during a PE interview
I recently got this question during an interview : « As a PE fund, if you are interested in buying a company which equity value is 100M But the next day, the company adds on a debt of 25M, at what price do you buy the company ? » My answer was still at 100M since on the next day I’ll have the debt and the cash from the debt (so they cancel out each other) Although the associate did not give me the answer I could tel that I was wrong
Could someone help me find the right answer ?
You're right, it wouldn't change the valuation, since deals are typically completed on a cash-free, debt-free basis.
You’re correct
Depends on what the use of proceeds are. If the debt was used to fund cash to the BS then there is no change to enterprise value. If they issued debt to do an acquisition or for capex, then enterprise value would increase by 25
You're correct - my advice (in case you didn't do it) is to explain your reasoning (in case the cash was immediately spent or set on fire for example and the interviewer didn't explain that), or ask a clarifying question to that effect.
The enterprise value absolutely does not change (in response to an earlier comment). That should be assessed independently of the capital structure.
Above answers are right from enterprise value and theoretical perspective but perhaps he was asking about real life implication. In real life, since these deals are handed over on cash free debt free basis, you would expect what you are buying to be paid off its debt. However, if this means the company has additional capacity to debt now, it will increase the amount of leverage from your end when you finance so although enterprise value doesn't change, you will have higher leverage and you can afford to put in $25mm less equity into the deal
Yeah maybe this was a prelude to asking about the debt financing terms for the sudden 25m and how it compared to assumed acquisition financing, and OP missed this in favor of the obvious answer. Assuming he read the interviewer right this is the only explanation I can think of unless the interviewer is incompetent.
So this looks like 100M valuation before new debt say old capital structure has 25M debt, 75M equity, no cash. Raise new debt and get cash. Have 50M debt. 75M equity, 25M cash so still EV=100M.
Sources for deal will be 100M of new debt/equity and cash and uses will be the 100M purchase price. (assuming that the cash is used to pay off 25M debt?)
I'm trying to reason through how the equity you need to put in is decreased, any help would be appreciated.
Okay I am drawing a slightly different case. So let's try assuming something like this. EBITDA was $10mm. Let's say - initially the business was levered at max level, which was 4.0x. And we thought we can buy this business at 14x (ignore fees for a second). So we were planning on paying EV of $140mm, borrow $40mm, and put in our $100mm of equity. Forget about how much cash or debt the company has right now because we will receive the company on a cash free debt free basis (forget all the purchase price adjustments math for now). But now if we say the company has different leverage characteristic (for whatever reason) and borrowed $25mm extra, pushing the leverage level to 6.5x. Again, I don't care what they do with cash because when I receive the company, it will be on a debt free cash free business (if the seller didn't spend it and pay off the extra debt with the cash, they get the same proceeds) and let's assume my purchase multiple is still at 14x. I hand $140mm over to the seller, receive a company that has no debt and no cash, borrow now $65mm instead of $40mm, which brings my equity check lower to $75mm
How do you know the debt before was 0 tho... meaning 100m was never established to be the ans in the first place since he just gave equity
It wouldn’t change. At the end the day, you’re going to be doing your own valuation regardless of the capitalization, based off a multiple of EBITDA. If you’re paying 10x EBITDA then that extra debt has no bearing on your valuation. Taking it an extra step further, that’s one reason why EBITDA multiples are used, to remove the noise of debt structure.
Edit: But, to some people’s point above, the company could get some EBITDA credit depending on where the money was spent. If it was used for capex or an acquisition, the future EBITDA that will be gained from those investments should probably be taken into consideration. For purposes of an interview question though, the first answer would check the box. Adding this layer would be icing on the cake.
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