Distressed PE case study
Hi everyone,
I‘m currently recruiting for a small cap distressed/turnaround PE investor and they gave me a case study to solve. It includes a quick and dirty valuation part, based on a IM. So, the EBITDA of the company is slightly positive (~ half a million), last three years have about the same EBITDA. However, the company has about 20m in net debt.
I am now wondering about the valuation. I have no experience in distressed investing nor in restructuring. So, appyling an EBITDA multiple of, lets say 7-8x, results in an EV of 3-4m - but net debt is 20m. What would the purchase price be then/what should the PE fund pay? I mean, an EV of 3m - 20m net debt results in a negative equity value?!
I am a bit confused because of the high net debt. I heard that the fund sometimes pays 1$ for companies, or even get compensated for acquiring distressed companies. Could this also be the case here?
I hope somebody can help me.
Thanks!
Not an expert but have worked in distressed situations. A couple things you can do:
1) Calculate a normalized EBITDA, which is representative of normal course of operations.
2) Convert Debt into Equity and calculate IRR of the investment after the company has been turned around and is generating healthy CF.
Interesting thought on converting debt to equity. Here's what you're looking for:
1. Do a simple book valuation. Assets minus liabilities.
2. Do a simple liquidation valuation. Cash @ 100%, AR under 120 days @ 75-85%, Inventory @ 20-50%, LOTS of nuance in inventory. Finished goods should be 100%, WIP is usually zero or scrap value. Raw is usually scrap value. Fixed assets like plant, property and equipment need an appraisal by a professional appraiser. CRE you can usually get a broker opinion of value from a friendly broker. Equipment goes to an auctioneer who will give you desktop based on specs and photos or a more accurate appraisal with a visit. Computers, furniture, prepaids, goodwill, insider receivables are generally worth nothing.
3. Let's take your shitty company with $500k in EBITDA. Figure out what the EBIT is because depreciation is real. You're right with your original idea of an EBITDA multiple valuation minus the debt and there's your value.
4. Look at the ability for this business to service debt. SO, EBIT (as a proxy for free cashflow) needs to maintain a minimum 1.25 debt service coverage ratio. Use that to reverse engineer how much debt the business can service at, say, 10% APR. That gives you a sense of what the balance sheet would look like "right-sized". Let's just say that EBIT = $300k so the company could service around $240k in debt annually. So, $2.4M of interest only debt at 10%. Assume a 5 year ammortization and you're going to be closer to $1M. (check my math through this). SO there's your answer to the balance sheet, it should have only $1M in debt which means it needs a $19M haircut.
5. Market valuation - What would you pay for the company? Would you take it for $1? No one would. That's how $1 deals come to be. Would you take it for a $5M negative purchase price? Maybe. Probably. It depends on a hundred factors > what can you do to the income statement, what can you do to the balance sheet?
6. Market Valuation #2 - Does this business even have a reason to exist or should the business be killed and employees and capital be freed to find more productive uses in society?
7. Market Valuation #3 - how would this business be valued in bankruptcy? Could it get through a Ch11 and what would that look like? What would happen to the debt? What could a good operator do with the business?
8. Market Valuation #4 - what are other distressed investors willing to pay for this business?
9. Market Valuation #5 - how do I offload risk, cash cycle and capital needs to other parties? This will dramatically change the value and structure of your offer.
Good luck with the interview.
I have a case study due tomorrow and my model is not right, can you please help? I will pay
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