LFCF Yield Interview Question
Hey everybody - Interviewing for senior associate / VP roles currently and recently got a verbal case / paper LBO which ended with me calculating levered free cash flow. Math was simple enough to work through, though it's not something my PE firm ever looked at. Most of our underwriting / sensitivities were based on MoM figures (i.e., >3.0x return cutoff)
Have any of you spent more time on this at your firms? Curious what you're typically looking for with this metric / what the discussion around it looks like. Obviously understand you'd hope for a higher yield than lower but just hoping to get more nuance it case it comes up in any other discussions / processes
Additionally, would be curious what other metrics you all have been asked about on deals as you go through midlevel recruiting. I've often been asked about basic financials (revenue, EBITDA), multiples, capital structure, but curious what else I should have ready to go back pocket
Thanks!
Let's assume you own this asset forever. In that case, your return can only come from harvesting the free cash flow the asset generates. If you underwrite your purchase at a 20% levered FCF yield you would earn 100% of your initial equity back in 5 years (1 / 20%, or 5x free cash flow), assuming you distributed all of that free cash flow as a dividend. Your FCF yield can also help inform capital decisions...if you can reinvest your 20% yield into capital expenditures with an expected return of 25%+, you should probably do that. If not, you can explore alternative capital allocation policies.
This is basically the essence of what it means to buy something at a low multiple, its your payback period if you swept 100% of cash flows. Bridging your EBITDA entry point to levered FCF is always something you can do because it will reveal if something really is cheap or not. For example, you might be bidding on an asset at 8x EBITDA when all of the comps / precedents point to 15x+ as fair value and think this is cheap; but, if your asset has poor or non existent FCF conversion then the discounted multiple is likely already fair value or worse overvalued.
FCF yields can also help inform basics on optimal capital structure and financing. For example, if your business generates an unlevered return on capital of 10%, and you can get 60% financing at 8%, your return on equity is 13% which is good. If the same asset generating a 10% return on capital can only get financing offers at 15%, you should probably not buy the asset as it will not or would be a real slog to generate value to equity.
It ultimately comes down to the cash conversion aspect of things. An asset with poor cash conversion can still look good on headline EV / EBITDA, Debt / EBITDA, FCCR metrics and if I was interviewing someone I would want to make sure they understood how this works and how you can still generate a return on equity if the market is closed / you own the asset forever.
This is super helpful, thank you so much for taking the time on it! And it's good reminder to go back to the basics -- I either never appreciated or had forgotten this point that you make: "it's your payback period if swept 100% of cash flows", even after spending a few years on the job.
I want to make sure I understand your second point. It seems like if your interest rate was at 15%, your return on equity would drop to 2.5%, which clearly would be a pass.
However, would the underlying concern in that example be that that the financing markets aren't interested in the asset and that should be the red flag in this deal? The reason I ask this is because the underlying asset is still generating the same unlevered FCF yield (of 10%) and presumably is attractive for the same reasons it was prior to looking into the capital structure. With this in mind, you could just fund entirely with equity and maintain the higher rate of return as long as 1) 10% is good enough for you, and 2) you have the check size mandate to do that.
Let me know if I'm thinking about any of the above incorrectly. Thanks again for the response.
You are thinking about it correctly.
The 10% ROC example was just meant as an example, not that 10% isn't a good unlevered return. But to play devil's advocate on your question, lenders could balk on an asset for a variety of reasons that could increase their cost of capital. Most likely, it would be because there is a view the 10% isn't sustainable and will decline, which is also a reason a lower multiple could be warranted. As an aside, the inverse of the multiple does tell you your payback period roughly, but also the implied discount rate you're capitalizing the cash flows at. Low multiple = higher discount rate = more risk and uncertainty embedded in receiving those cash flows. So you might actually see an asset with 10% yielding cash flows transact at 3-4x because there could be a view the business will fall off a cliff in a few years which warrants a very high discount rate. To bring it back to your example, yes if you believe a 10% ROC is sustainable but there is no accommodative financing you should probably just finance it with equity and "season it" for a year or too; prove out asset longevity and then return to market for more accommodative financing to recap yourself out of it (i.e., take your 100% equity financing down to a more typical 40%).
And then on your last point, when you say "An asset with poor cash conversion can still look good on headline EV / EBITDA", it seems like you're trying to drive home where you started with respect to the fact that the EV / EBITDA multiple is attractive (i.e., cheaper than transaction comps) but the poor FCF conversion is the driver of that, which candidates need to get to the bottom of?
Yes.
You have $100mn EBITDA and you buy the asset at 8x because it is cheap vs. comps, so $800mn. You pay $13mn in unlevered taxes and $50mn capital expenditures for unlevered free cash flow of $37mn, a 5% unlevered yield on your purchase EV. Roll it forward...you get 60% debt financing at 8%, and now your levered free cash flow is only $9mn, a 3% levered yield on your equity. I don't think this is cheap...to make money you need to sell the business at either a very expanded multiple, grow EBITDA a bunch, or juice your FCF conversion.
Now lets assume you purchase this same business with same operating characteristics at 4x EBITDA. You still generate $37mn unlevered FCF for a yield of 9% on purchase EV of $400mn, and assuming the same 8% 60% LTV financing you have $23mn levered FCF which yields 14% on your equity. You make a perfectly acceptable ROE without going through the headache of the above. Also note in the former example you're basically running FCF breakeven, so the margin of safety isn't great as the first thing that breaks probably means you're burning cash.
Purchase price matters.
Had something similarfor a pc associate interview
Was asked on paper lbo to compare creditor and equity return without calculating irr. Answer was indeed that you could think of lfcf as dividend and effectively compare equity return vs credit interest
Was a very fun way to think about it!
This has been a super helpful thread. For those that look at this metric in their day-to-day, could you help shed any light on how you think about different FCF yield values? As in, what's attractive / what's a pass? How does that vary by growth rates?
My firm doesn't use this metric but I'd love to start anchoring my thinking in it to the extent possible.
At a LMM firm (I think this metric is more common in the LMM space as I never really looked at this at my last shop) and we live by this metric. We target high-teen's LFCF yields -- even better if we can get low 20%'s. We are primarily investing in services businesses with low maintenance CapEx requirements (as heavier maintenance CapEx as a % of Rev or EBITDA can swing the yield materially).
The high-level heuristic in our space (given that we are borrowing at ~7-9% right now depending on the deal) is that paying 5-6x purchase price with 50% LTV (e.g. pay 5.0x and get 2.5x leverage) almost always gets to the sweet spot of a LFCF yield in the high-teens.
One other way that I frame it up mentally is kind of like fixed income investing or an annuity -- basically assuming your business stays flat and the cash flows are flat over time -- what is your equity return? If you are entering at a high-teens or low 20%'s LFCF yield and you can re-invest that LFCF at similar rates of return (which for us usually means doing more add-on M&A at 5x EBITDA or lower), then over the long run your IRR should approximate this entry LFCF yield -- even if the base business (and all subsequent M&A) just stays flat. The key point to internalize is that you need to be re-investing your LFCF at this same yield or else your IRR will fall over time. Example: buy a business with $5M EBITDA that generates $2.5M of LFCF (all said and done; shortcutting at 50% EBITDA to LFCF conversion). Take that $2.5M of cash flow and go buy $500k more EBITDA with that cash (assuming 5.0x; no incremental interest given all-cash funding). Now you have $3.0M of LFCF. Take that $3.0M the following year and go buy (re-invest) $600k of more EBITDA. Now you have $3.6M of LFCF.
I think it's really compelling to think about things this way -- that if your business stays flat you can still earn a really nice return just by the cash flow generation of the business and stacking more and more (flat) cash flow annuities on top that. When things are framed up like this, the traditional levers of organic growth, multiple expansion, etc. are all incremental and are just gravy on top. The caveat here is that you HAVE to buy things for cheap for this math to have real meaning, which is probably why this is more a prominent metric in the LMM.
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