Financial modelling on the buyside
Happened to be taking some financial modelling courses and a thought came to my head. Suppose you were on the buyside and on a daily basis investment banks are sending you CIM for reviews. This would also mean the bankers have already done the financial models themselves. Thus, would a buyside firm create a model from scratch or would they obtain the financial models from the bankers and just perform their analysis from there? For example, stress testing the assumptions and so on?
If they create create their own financial models, how would they do so in practice. Would the CIM give all the information they need? What if insufficient information is provided in the CIM?
Haven't worked in the industry before so just curious.
Thank you.
Before first round bids are submitted, the sponsor will do an initial analysis based on the numbers in the CIM on their own, without consulting the bank. Usually this is some type of standalone model / projections in a case manager, which feed into another set of tabs that look at things like potential return on investment (basically a traditional LBO), expectations on working capital, fixed vs variable costs, capital expenditure expectations, leverage potential, roll-up acquisitions, and the like. Depending on how serious the sponsor is in the bidding process, I imagine they would have differing levels of granularity here. Also, generally speaking sponsors who get a CIM from a potential target company have probably already done some diligence on that company, so there may already be a model in existence. The sell-side advisor will not send sponsors a copy of the model used to create the CIM.
Using the above analysis, sponsors will put in a first round bid. Assuming they get invited to the MP, the sponsor will then get access to a fair amount of additional information which is in a VDR that the sell-side advisor manages. The sponsor will also usually get advice from tax and legal specialists (in my experience, these are folks at Big 4 firms) who put together some materials on the target company in question - most of the time this is a VDD, but it can be shorter if the target is a well-known, well-studied public company. It could also be longer, and I think here it also comes down to granularity.
If sponsors are confused on specific numbers or can't tie to the existing projections, generally they will call the analyst / associate working at the sell-side advisor and basically ask them to explain why the numbers are the way they are - there are frequently one-time changes or weird other expense lines which are not necessarily always explained thoroughly, even in the VDR. In my experience, sponsors also quite like calling to fish for information about what management is thinking regarding purchase price, PF ownership considerations, etc.
I don't work in PE but when we get a financials with projections from a sell-side banker we immediately temper them or sometimes throw them out all together. I'm not saying that all sell side banker models are overly aggressive but they are trying to sell you on a pretty rosy projection (typically a nice hockey curve).
Also from the sponsor's perspective, they will toggle growth rates and purchase price to get the proper returns (also do this on the Corp Dev side too).
Hey all, many thanks for the replies.
BankerC159, but why don't you just use their model, add in the relevant details you need (maybe it is not so detailed for the revenue built up so you just change that portion) and then trim their assumptions in other areas of the model?
Seems like a more efficient way to work rather than constructing an entire model from scratch?
Appreciate the insights you guys have been providing.
I don't know of any sell-side banks or processes that I've been a part of, where the counterparty willfully handed over their full operating model (with drivers etc). Typically we will get a barebones 3 statement financial statement (de-linked if in excel).
If there is a case where you might be able to get your hands on the full blown out sell-side model it might not even be useful to a buyer. For instance, if you are a buyer and you happen to like the product they are selling but don't think their revenue model is efficient (e.g. licensing vs selling units of the product), their model is driven off of licensing - makes the sell-side model not very helpful.
These are just some examples I could think of and my experiences. I'm sure there are some other PE folks on here who have some better insight.
It's absolutely fine to rely on banker or management models early on in the transaction to save time. Many times you will find that the deal won't work even under the Happy Days case in the model you receive, because you change one variable like the amount of debt financing you'd be willing to live with and the deal just falls apart. No need to waste time building some sophisticated valuation model until you know the deal is really going live. Of course, you can't bang out the full model overnight either, so you have to plan ahead and manage the process efficiently. In the beginning you build everything from scratch, as you move up and learn in this business one of your greatest skills becomes knowing when you are allowed to take shortcuts.
Hi all, many thanks for the insights shared.
Could you experts also share how trading comps / precedent comps analysis is done in real life? My coursework shows you need to read their financials, adjust for one-off items to get your actual values. This seems like an awful lot of work. Furthermore, what if your comps come from a country whose language you don't speak eg. Russia? Do you just rip the comps from capital IQ if that's the case?
Lastly, how often is DCF used in practice? Seems like you can get any value you want just by tweaking the assumptions.
Thanks.
Comps, precedents, and DCF analyses are done different in banking versus PE.
In banking, you tend to follow industry-accepted guidelines for things like fairness opinions, so there is a stringent process and set of parameters. For example, the ECM team might tell you the equity risk premium is currently at 6.75%, and the country risk premium is 1.75%, and etc... senior bankers will opine on adjusting these levels, but their hands are somewhat tied. At the end of the day though, you tend to show the client what they want to see, almost always.
In PE, the theoretical framework is much less important than getting it right. Judgement plays a much larger role in the valuation process, because all that matters is whether the investment works out, not whether you delivered an impressive valuation deck with a million sensitivities.
That is not to say that PE guys don't go into as much detail. It's just that we don't waste time on calculating WACC - we typically make decisions on an IRR basis (i.e. while we will look at unlevered DCF at various discount rates, we focus more on levered IRR's under various scenarios). ROI / MOIC also plays a big role. We will look at trading comps but typically it's hard to compare large public companies to smaller PE-backed ventures. Transaction comps are also fine to look at, and we do, but again who cares what other people paid for similar assets? Comps are much more relevant in public M&A, corporate acquisitions, mergers of equals, etc... in PE we will go into as much detail as possible, but only on the parts of the analysis that we believe are directly relevant to our risk/return judgement of the investment.
Oh, and if the shop is large enough and happens to have relationships with investment banks (typically the banks that underwrite the credit facilities that finance a lot of the PE's portfolio companies), then we get to outsource the trading and transaction comps analysis to the bankers. We will stick those pages in the appendix just so we can point to the median and tell the investment committee that the deal is being done below market comps. This looks good when our investors diligence our investment recommendation memos, but make no mistake - the committee will not pay any attention to the multiples unless the deal team makes a compelling case that they are especially relevant for the deal in question.
Make sense?