How PE Professionals Think about a Model?
Private Equity Experts. This one's for you.
Preface: I know it’s difficult and it doesn't work like this at all in practice, but for the sake of this thread can we exclude sector & speciality (for arguments sake let’s make this broad).
When you get handed a company's past accounts/statements/ high-level operating model, what are some of the first things you do to really understand the company, and look for in the model?
- i.e. do you look straight at margins, do you go straight to increasing the debt and seeing what covenant capacity it would have? I'm really trying to understand how you guys think when you get handed the accounts so I can start practicing a) what you do, but I believe more importantly, b) how you think about a company, and how you form opinions on the numbers/how you think about what the numbers tell you.
TDLR: Can an expert instantly look at a model and decide how good a business is? How do they go about this? What are some of the key things they look for? How do they start forming opinions on a company with respect to its accounts/model?
Few areas I focus with a software lens (ignoring ARR roll-forward for now, focusing more on P&L below):
Thanks really helpful.
If you typically don’t get many BS items, do you really only see an Income statement from the TargetCo?
Is this why when building LBOs for entrance exams you typically wouldn’t build full operating model and you’re only really building of IS?
3rd bullet is an interesting way to look at revenue, not thought of it that way before but makes sense. Kinda separate question, is there any way you think about/poke holes in run rate EBITDA?
Can you give some stock reasonable % assumptions for the list you’ve given. Ie what would be too much in a particular OpEx bucket..etc
If you typically don’t get many BS items, do you really only see an Income statement from the TargetCo? Correct, you often don't get a full BS, particularly since the pre-acquisition capitalization (their debt, cash balance, etc.) aren't really relevant to the future buyer
Is this why when building LBOs for entrance exams you typically wouldn’t build full operating model and you’re only really building of IS? Yes, plus often it's a better intellectual test to see how a candidate thinks about the P&L (more room for novel thinking) than the BS (which is really just memorization of how to link up)
3rd bullet is an interesting way to look at revenue, not thought of it that way before but makes sense. Kinda separate question, is there any way you think about/poke holes in run rate EBITDA? First I'd look at what run-rate EBITDA even means (last month annualized, last quarter annualized, etc.) and what this run-rate captures / is the cost structure sustainable or deflated.
Can you give some stock reasonable % assumptions for the list you’ve given. Ie what would be too much in a particular OpEx bucket..etc It depends on the company's growth stage. I often look at "Rule of ~40" for software where revenue growth + EBITDA margin should meet or exceed 40% for a healthy growing company. If the company is growing 30%, EBITDA can be 0-10% margins (and therefore more OpEx investments to fuel the growth), while if a company is more mature (0-10% grower), I'd expect more optimized EBITDA profile with lower OpEx spend and 30-40% EBITDA margins. The %s for each bucket will flex accordingly. You can also layer on some sales efficiency metrics (LTV/CAC, S&M spend versus bookings, etc.) to specifically compare the S&M spend against revenue/ARR/bookings growth.
Thanks so much for this. How are you looking at/judging sustainability of EBITDA margins?
I'd look at any adjustments feeding EBITDA and ensure they're legitimate (e.g., if run-rate EBITDA includes an add-back for some role that was terminated like a CFO but it's not acceptable to keep that role vacant, I would re-burden for that adjustment).
Along a similar vein, I'd also look at it if EBITDA margins are overly optimized (often more common for founder run businesses). So if they have 40% EBITDA margins but missing lots of key c-suite roles and starving certain areas of the business, I'd look at that too. More art than science to sniff out.
Finally, I'd also check that the margins aren't inflated by any one-time events (e.g., some inflow of high margin non-recurring revenue, a one-time tax credit, etc.).
If you can't summarize your investment thesis on the back of a cocktail napkin, you don't know what you're talking about.
Im not in PE but we pride ourselves to build models that can easily compete or be better (and frankly looked at many PE lead deals where the model was sub-quality IMO). The two things we spent a lot of time looking at is a) how efficient is the business in generating returns through its own B/S and b) working capital
You would be surprised what nonsense ROCE some models spit out that are just cash flow focused....Cant expect to make a 25% IRR if the business is generating single digit returns on its asset base
This is also what I was hoping for.
Much appreciated.
Couple things.
What are the key differences you expect a good business to show when comparing its efficiency in generating returns through its BS compared to its WCAP. What exact ratios would you use for each and what do you expect to find?
Also, why do you think PE doesn’t chose to model this (or in my ignorance, why have I not heard it spoke about much in PE)?
At a small PE firm that does not usually focus much on the asset base, so I fear I fall into the camp of nonsense ROCE models. Do you mind elaborating on what you for when evaluating efficiency?
Usually look at overall curves, then focus on tits and ass
I just know you were sat in a work cubicle when you wrote this.
I'm at a bar
I likely have less buyside experience than the other posters and am also less structured, but the model assumptions I receive (or even build from outside in assumption) are just there to confirm / test my investment thesis.
Not really sure how to explain it, but the model doesn't run the show, it's just a tool for me to test scenarios and understand what circumstances / drivers are favourable for this investment, what may not be. Then I assess the chances of the thesis playing out and consider whether it's worth the risk.
Generally, things that'll jump out straight away are:
It's really hard to say from the model whether a business is "good" or "bad" (let alone the investment). You could get nice margins and stable cashflows from the model, but it may very obviously not live up to the real world.
Models have such a halo but they're really just to process the output of risk assessments & insights that are relatable to the real world.
From personal observation, those who treat the model like the be-all and end-all tend to be horrible at making commercial and investments decisions, which is what really matters...
Really Interesting. Especially those last 3 short paras.
I think perhaps this is one of the largest parts of the job that really doesn't get aired as much on WSO, ...becuase it's different at each shop and would require perhaps long/cumbersome explanations. But, how different IC's/professionals make decisions on a TargetCo, placing X% importance weighting to the model vs different aspects of consideration would be interesting to hear more about.
I don't think it's just that, but also because it's pretty hard / impossible to "teach" decision making and risk assessment skills?
And given how political PE is, there are seniors at the top who have made shitty decisions but got away with it because of politics.
I've been in 2 different IC processes, and this statement doesn't make sense to me at all, because the model outputs just reflect whatever considerations that can be quantified. It isn't a standalone entity in itself.
You may weigh the downside case against the normal / upside cases, see how bad it is or wtv, but no PE model on earth will tell you the probability of each happening (and I doubt it's worth trying to build an actuarial one - if you can, go be a quant and earn more for less stress).
You may also end up losing money in a scenario where the upside factors did occur, for various reasons.
Getting a very good feel of the odds and whether to take a particular gamble is a skill that not alot of PE seniors have - if anything, the easy exits during >10 years of QE let alot of flotsam and jetsam rise to the top.
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