Just had an interview. Question was something as follows:
"You're choosing between two investments which both produce 20% IRR over same period of time; how do you choose which to invest in?"
I list qualities of good LBO candidate; conversation begins to center on capex and its effects on returns.
"So how would your equity multiple be affected by high capex? Which company, the one with high or low capex requirements, would have a higher equity multiple?"
Now this is where I got stuck. If both investments have identical IRRs and time horizons, doesn't the equity multiple have to be the same?
I get that capex hurts returns, of course, but if both the high capex and low capex companies return the same IRR over the same time horizon doesnt that inherently mean that while the low capex company may have produced positive stable cash flows throughout the entirety of the investment horizon and the high capex company may have generated big negative cash flows in the formative years followed by big positive cash flow years towards the end of the investment, the discrepancies in cash flow would net out to create zero difference in equity multiple?
Input is very much appreciated.
I am assuming the question is geared towards both companies having the same IRR during the period, but also having different combinations of earnings/equity multiple to come up with an equity value that generated that 20% IRR. If you are exiting the investment at the same IRR value (and during the same period of time), then only risks, the structure of the cash flows and overall size of the investment would make a difference.
As for the different equity multiple, capex could affect it in a variety of ways. One could be that one of the firms has better prospects of future cash flows due to the funds invested or also could mean higher entry barriers for competitors (and command a higher equity multiple). On the other hand, it could mean a less efficient company in terms of the reinvestment rate and the ROIC of that new reinvested capital yields. The company that spends more capex could also be riskier in a downturn if the investments are not liquid. And you probably know that less capital intensive companies can sustain more leverage (and therefore command higher multiples).
I'm not sure I necessarily understand your response / I think you may be confusing equity multiple (MoM aka cash on cash return) with the idea of a valuation multiple.
To your first paragraph, the question / scenario is two companies financed identically (so same make up of equity vs debt) which over an identical time horizon return an identical IRR. For the intends and purposes of this question, at least the way I interpreted it, it is a levered IRR.
I'm not sure I get what you mean by risks, structure of cash flows or size of investment affecting equity multiple. The risks are commensurate, theoretically, with an investment which returns 20% on a compounded basis. Size of the investment shouldn't have an effect on returns (I mean sure it would increase your WACC but we already know that the return is 20%) and I'm not sure I entirely understand what you mean by stx of cash flows.
Everything you mention about capex has merit but I'm not sure if it necessarily has anything to do with my original question. Yes, capex can affect value in those various ways, but we already know here that the investment will return 20% in x years. Maybe this is what you were leading on to with the "structure of cash flows" but I understand a company will spend on capex and suffer low or negative cash flows today if it means there is the prospect for large returns in the future. Circling back to my original question, I think the bifurcation is essentially that--that one company incurs negative cash flows in the beginning period while realizing large gains later on, thus allowing this investment to yield a 20% return, whereas the other company doesn't incur any large, dramatic realizations of profit later on but also doesn't have large outflows of cash during the beginning period and instead generates modest cash flow during the entirety of the investment horizon.
Spoiler: the interviewer revealed that the company with high capex would have to have the higher equity multiple in order to justify the risk of the capex projects--I still don't understand how this produces a higher cash on cash equity multiple though when the time horizon and IRR are identical. The way I envision it is that the former investment "balances out" to net the same returns and equity multiple as the latter investment.
Again, any further clarification would be much appreciated.
Hey sorry for the confusion, let me try to clarify:
Size of the investment. Here is an example of what I meant by this. Company A and Company B have an initial investment of $20 MM and $900 MM, respectively. Both are excellent investments, with 35% IRRs over 5 years. Clearly the 800 MM is more attractive for a big PE fund. Basically if your IRR > your cost of capital, the larger the investment the higher the NPV of the project.
Risks. Remember IRR does not measure the risk of the cash flows it discounts. Another example: companies A and B have the exact same EBITDA and UFCF for the next 5 years. Company A has higher sales, but lower margins. It also has high operating leverage. Company B is smaller, but has higher margins and low operating leverage. In the base case and if spreadsheet projections materialize, both will yield 20% IRRs. However, if sales are not as good as expected, the company with low margins and high operating leverage will have much more trouble than the company with more "margin cushion" and with the protection that low operating leverage provides.
Structure of the cash flows (this goes hand in hand with risks). What I meant is that investors prefer companies with steadier cash flows over companies with small/negative cash flows in the early stages and larger cash flows farther out into the future. This is because not only future cash flows are more uncertain five years out, but also because investors do not like the idea of possibly writing additional equity checks if things do not go as expected. And I know you are discounting to adjust for this, but this only works if you have a very certain model. In many industries, even the most sophisticated PE investor does not know what will happen in five years.
As for the equity multiple, I treated it as a valuation multiple because it helps frame the discussion. A higher exit multiple will increase your MoM, all other things being equal. A simpler explanation of what I think the interviewer meant is that the company with the higher capex will have lower cash flows in the first few years, but will compensate that with a higher equity value at exit. So the company with lower capex can have a lower MoM because it shelled out dividends before exit.
My guess is your confusion arises because the interviewer made it seem like there are only two cash flows for both companies, an initial investment at time 0 and an exit at year 5. If there are no intermediate payments and both projects have 20% IRRs then the MoM must be the same for both companies. This is how the math works, if you need to be compensated by risks as the interviewer mentioned, it would be by having a higher IRR for the riskier project. As I mentioned earlier, if the initial investment and IRRs are the same over 5 years, the only way one company can have a lower MoM is by paying dividends.
Hope this helps and good luck!
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