Do you guys ever use DCF?
Just curious if this is something I should bother sharpening up on before the summer, I've spent most of my time sharpening Excel and LBO modeling skills and have some spare time.
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In Infra PE, yes we use DCFs
Is this specific to Infra? I know infra modeling is pretty unique.
I don't think it's unique. But I get the sense that we use it more than other industries. I think it's because our acquisitions are so consistent cashflow heavy
Yeah what the other guys said about generally consistent cash flows on both revenue and expense side, plus some infra assets (solar, wind, etc.) have a clearly defined end of life where you have to scrap/decommission everything so terminal value is actually quite easy to estimate (and usually has minimal impact on valuation). Hence DCFs actually tend to be the norm for infra.
That's my experience too. Only thing I'll add is we also use exit multiples, target IRR, etc. as well as a sanity check, especially for platform acquisitions.
In tech PE. Not even once.
You need cash flow to run a DCF, to be fair. So that makes sense
Fuckin too right 😂
But actually, we're PE not VC/GE so all but 1 of our companies is CF positive. We've never tried to come up with discount rates or anything which is why I say no DCF, more just using target IRR/MoM to sanity check our bids and make sure we can hit our hurdles.
How is running an IRR model any different from a DCF? Sure it’s not an NPV model but the only difference is your output is the discount rate and your input is the present value being the transaction value? So you do run DCFs then?
But yea I agree coming up with discount rates is BS, even Fama and French did a study of correlations of beta to market returns and determined there’s literally no correlation between beta and actual market return. So CAPM is just a theory with no evidence supporting it basically.
They are completely different.
Cost of equity in a DCF is the rate of return an investor should expect to receive in exchange for the risk of an asset (the asset's volatility in relation to the broader market is represented as beta) and is typically done on unlevered FCF basis (aka no debt). It's derived from regressions of the asset's historical price (for public securities anyway) and estimates the cash generative potential of the asset in perpetuity (perpetuity growth models). A lot of large corps just pick a discount rate based on their preferred return needed for them to be comfortable with what they feel is the asset's risk when taking into account their own capabilities to change operations/leverage synergies post-acquisition e.g. Berkshire Hathaway, Roper Technologies, Constellation Software, etc. They recognize how much voodoo is involved in trying to figure out a "correct" discount rate in the academic sense and so don't even bother with all that CAPM silliness they'll teach in school.
IRR is the "target" return on your equity based on debt, entry / exit price, and cash flow assumptions in an LBO. The LBO is an affordability analysis for figuring out how much you can "afford" to pay for an asset determined by its the cash flows, capital structure, and expected exit. You'll use it to figure out the ceiling of what you can pay to still be in the black and, if you're smart, try to negotiate paying notably less or using IRR juicing tricks like an earnout (the later you can deploy your equity post-purchase, the better your IRR). Target IRRs / hurdles will vary significantly based on the types of LPs you have, sector focus, and overall investment strategy (early-stage VC, growth equity, buyouts, distressed turnarounds, etc.).
You guys ever use merger models? How in the weeds are you for addons?
What do you mean by a merger model? Like we've put together a pro forma? Because yes, we've done that both for add-ons on our portcos and when analyzing targets that recently made their own acquisitions.
If I'm trying to break in, what should I learn? LBO modeling?
You 100% need to know how both DCFs and LBOs work as best you can. Just because you may not be using them every day doesn't mean they aren't required skills. For breaking in, they're a filtering mechanism for seeing who can put in the work to learn a technical skill and demonstrate both understanding and proper application of that skill.
Edit: whoever tossed shit at this, I wish you all the best trying to make it through a serious banking/PE interview not knowing how to do either of these
Two years as an associate in PE forgot how to do a DCF at this point but probably could whip one out in a half a day and a more detailed/thoughtful analysis in two days if really needed
You guys ever use merger models? How in the weeds are you for addons?
Merger models are more useful for public companies as companies need to report EPS and focus on accretion dilution.
Our fund strategy isn't a 'buy and build' type of shop. That is to say, most of our investments do 2-3 add-ons over our investment period therefore while we do cost synergies analysis and understand the cash flow and P&L impact to the consolidated company we don't necessarily go in and adjust every balance sheet item or anything like that during diligence (nor would it really be worth our time)
Can be useful for next buyer analysis
You should sharpen up your PPT skills and make sure you can align right/top/bottom, make charts quickly, footnote quickly, and know where to look for debt/cash/equity investments/leases in filings.
This will be much more useful as an intern and even full-time analyst in most groups.
PPT even for PE? I feel pretty good in PPT, my QAT helps me do things quicker.
Yes this is one of the things that caught me off guard too, but you have to put together deal memos for your IC, deal pipeline updates, investment results presentations, etc.
In pure software M&A, no. Maybe 1 DCF or LBO a year to win a mandate or do a favor for a client.
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