Recently received 2 interesting questions during a PE interview:
Curious to get this forum's thoughts on how to approach these Qs.
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1. Depends on when you are in the cycle and if the business is a cyclical one. Concretely, if it's a cyclical one and you can catch it on the upswing/ that's your thesis (BX was doing these deals in the early 2000s, look into Celanese, cool case study), then more oplev is desired. If it's not cyclical, again more oplev is desired since there is no apparent reason for margin pressure (subject to competitive dynamics) - the best example I can think of is healthcare or staples retail - recession proof, scale is king (although Amazon is kinda killing the latter).
2. Obvi consolidated. I should qualify that in my mind that looks like a nigh-oligopolistic industry, meaning there is less chance of price wars/ high chance of stable margins (s opposed to a highly competitive market) and consequently stable cash flows, driving value for the PE sponsor via leverage. Though I could see the case of buying an asset in a fragmented industry with the view of selling it quickly as part of the incoming consolidation wave, but that's much more target-dependent (it has to have something to make it relatively more attractive).
The 2nd question reminds me of '80s - '90s case studies involving manufacturing companies or cigarette brands. The good times of the LBO boom, with 5%-10% of the deal funded by equity...
Really helpful.
My thought on the 2nd question is you could go either way. For a fragmented industry, even if the asset is not rolling-up, competitors are and will be reawakened with a higher multiple given the consolidation and market share. This when the sponsor wants to exit it could potentially receive a higher exit multiple given it’s comps, assuming operations are stable. Does that make sense?
That can make sense, but on a risk-adjusted basis, I'll stick to consolidated. Here's my thinking: the thesis that drives value in a fragmented industry is essentially betting on multiple expansion & some (organic, in our case) growth by paying a price to wait out the consolidation wave. Can happen BUT if your target doesn't have something to protect its margins (and companies in industries subject to roll-ups rarely do) then you need to be nigh-flawless operationally and keep on growing organically to reach a critical mass that makes the co. a compelling target for a consolidator.
On the other hand, ceteris paribus, buying a co. in a consolidated industry might mean paying a higher upfront price, but leverage makes a much bigger impact on returns (relatively more stable margins allow it to), same as operational improvements predominantly on the cost side (much easier to achieve than revenue growth). No pressure to invest in growth to become a valid target and little to no risk of competitive pressure from a larger competitor potentially torpedoing you on prices.
At the end of the day, it's a fascinating problem with a highly context-dependent solution, but as long as you show you've put thought into it and are able to debate the various nuances, you'll do fine.
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