I received this PE interview question awhile back and I was wondering how one would answer this?
If I wanted to evaluate an investment opportunity for PE and I can only ask for three things, what would I ask for and why?
No details are provided about the company (not what it does, not what industry it's in, so on...)
Can any of you veteran or PE-based monkeys help me out? I'd like to know how to approach something like this in the future.
Private Equity Interview Question: Three things for Investment Analysis
If I wanted to evaluate an investment opportunity for private equity and I can only ask for three things, what would I ask for and why?
There are two alternate solutions to this question. Each of these solutions approaches the question from a slightly different angle. The first focuses some basic facts about a company. Those basics are EBITDA, Revenue, and Industry
The second answers the question in a more quantitative manner. This answer proposes using CAGR, LTM EBITDA and cash conversion. This solution is more thorough and would allow you to make a reasonably informed investment decision. It is worth noting that both solutions are based on understanding how private equity firms invest. Let's quickly define the measures used in both explanations.
- EBITDA: a useful measure for a companies cash-flows.
- Compound Annual Growth Rate (CAGR): measurement of the compounding growth over years of an investment .
- Cash Conversion: a measure of how long it takes a company to convert initial investment in working capital to subsequent cash collection.
- Revenue: Money brought into a company by it's core business activities.
- Industry: groups classified by their primary business activities.
EBITDA, Revenue, Industry
By Industry I mean specific (i.e. what it does, ideally as specific as possible), so not just "healthcare" but rather "hospital company" or "medical device company"...something that will at least give you enough to get a good idea of a good comp groupWith these three things, you could put it in a comps and get a good idea as to valuation and company efficiency (i.e. multiples relative to peers, EBITDA margins, etc.). You could then compare valuation to industry fundamentals and see if you think that's reasonable. I used to work in PE, that's how I would answer the question.
Ideally you want historical, current and projected revenue and EBITDA, but that could be violating the spirit of the question (i.e. you could just ask for all of the financials as one of the three things, lol)
I would not answer insider trading, even if I were interviewing for a big megafund that did a lot of public to private. For most companies it is insignificant, and not one of the top three things I would ask for (granted it can be important sometimes, but the question is more what are the three absolute most important things for a quick go-no go investment). EV/EBITDA is better than P/E ratio. P/E can vary depending on leverage and in PE capital structure often changes after the investment is made.
CAGR, EBITDA, Cash Conversion
User @Marcus_Halberstram", an industry CEO, shared the following overview:
You have to understand what they're trying to determine with this question. And my view is they're trying to determine if you understand private equity investing, how/why it works and how to analyze an investment.
If you're given the choice of 3 pieces of info:
I'd ask for 5 year Revenue CAGR(%), LTM EBITDA($) and cash conversion(%).
From there you can ball park an internal rate of return (IRR) in about 5 minutes in Excel.
For this type of quick "should we spend any time on this" type analysis, you're not going to dig into the industry and management team. You're not going to build out a big elaborate model and make all these assumptions based on the industry you're given.
After you answer this question, the interviewer will give you your 3 asks, and you'll have to give him an answer without any follow-up questions.
The problem interviewers get into is they get intimidated by these sort of questions and tend to give very broad and general answers, which doesn't work for a "should I invest in this company"-type question. You need to get specific in your answer as to what data you would need, so that you get specific answers from the interview. From there you have to be able to say YES I would invest or NO i would not.
If you get your 3 asks... can you give him an investment answer? Lets take a shot at it...
Example one: free cash flow (FCF), industry and management experience.
- Free cash flow
- Company will generate $450 million over the next 5 years
- Industry
- healthcare/pharmaceuticals. They manufacture pharmaceuticals for race horses
- Management
- the CEO has 25 years of experience in pharmaceutical manufacturing, undergraduate degree in biochem and an MBA
- CFO has 20 year experience at a big pharma company
- COO similar background.
Almost all members of an executive teams will each have 15-30 years experience, some sort of higher education degree etc... they'll all be "impressive" on paper.
Should you invest in this company?
Example two: Business Model, 5 yr growth opportunities, management team
- business model
- company manufactures pharmaceuticals for race horses; they develop, design, manufacturer, market and distribute their products throughout the world to elite race horse trainers; raw materials are typical medicinal ingredients, not high volatility in pricing. Seek to differentiate themselves by working closely with trainers to identify bespoke products for particular breeds of horses.
- 5 year growth opportunities
- 5 year growth opportunities lie in developing new products to sell to existing customers and increasing market share in the industry. If you had asked for a specific qualitative figure you would have gotten something more concrete.
- management team
- the CEO has 25 years of experience in pharmaceutical manufacturing, he has an undergrad degree in biochem and an MBA,
- CFO has 20 year experience at a big pharma company
- COO similar background
Should you invest in this company?
Example 3: CAGR, LTM, EBITDA
- Compound Annaul Growth Rate
- 5 yr rev cagr is 5%
- Last twelve months EBITDA
- LTM EBITDA is $70 million
- Cash Conversion
- Cash conversion is 50% (unlevered)
Summary
- Estimate deal size based on EBITDA x purchase multiple (informed by CAGR)
- Ball park FCF generation over the next 5 years by applying cash conversion % to EBITDA and growth that FCF by CAGR each year.
- Apply a boilerplate capital structure to come up with an IRR.
Understand the business model, the industry outlook, where comps are trading at, any potential fatal flaws (i.e. material litigation, environmental liability issues, etc...). The only reason you care about revenue is because it drives your EBITDA, if you can get to EBITDA you don't care about revenue. The only reason you care about EBITDA is because it drives FCF and because it drives valuation.
You want to keep your answers as simple as possible, Therefore you want assumptions to be as simple as possible, you purchase the company outright, no breakage costs, etc..
---Message from WSO Below---
EBITDA, Revenue, Industry
By Industry I mean specific (i.e. what it does, ideally as specific as possible), so not just "healthcare" but rather "hospital company" or "medical device company"...something that will at least give you enough to get a good idea of a good comp group
With these three things, you could put it in a comps and get a good idea as to valuation and company efficiency (i.e. multiples relative to peers, EBITDA margins, etc.). You could then compare valuation to industry fundamentals and see if you think that's reasonable. I used to work in PE, that's how I would answer the question.
Ideally you want historical, current and projected revenue and EBITDA, but that could be violating the spirit of the question (i.e. you could just ask for all of the financials as one of the three things, lol)
I would not answer insider trading, even if I were interviewing for a big megafund that did a lot of public to private. For most companies it is insignificant, and not one of the top three things I would ask for (granted it can be important sometimes, but the question is more what are the three absolute most important things for a quick go-no go investment). EV/EBITDA is better than P/E ratio. P/E can vary depending on leverage and in PE capital structure often changes after the investment is made.
Yeah it really is funny how often those are like the only three things that really matter. So many people on this board (particularly those still in school) worry way too much about stuff like Excel and modeling. There was a time when those things didn't exist, and it was all about industry, and basic financials analysis. Thing is, it still is only about those things. At the end of the day, a model is not going to make or break a deal and that is why analysts and associates, despite doing all the "work", get paid the least. They're just not doing the real value add. Being a rainmaker (buy-side or sell-side) is much more about social skills, network, negotiating, sourcing, etc as well as having a good sense for good businesses, industries, economic trends, etc. Get good at THOSE things, and you'll go a lot farther than the "star" modeler.
I disagree.
You have to understand what they're trying to determine with this question. And my view is they're trying to determine if you understand private equity investing, how/why it works and how to analyze an investment. While knowing the industry is important in making an investment decision where you've got all sorts of detailed information... if you're given the choice of 3 pieces of info, the industry should not be one of them.
I'd ask for 5 year Revenue CAGR(%), LTM EBITDA($) and cash conversion(%).
From there you can ball park an IRR in about 5 minutes in Excel.
While you need to know about the management team and industry outlook etc... for this type of quick "should we spend any time on this" type analysis, you're not going to dig into the industry and management team. You're not going to build out a big elaborate model and make all these assumptions based on the industry you're given.
After you answer this question, the interviewer will give you your 3 asks, and you'll have to give him an answer without any follow-up questions.
The problem interviewers get into is they get intimidated by these sort of questions and tend to give very broad and general answers, which doesn't work for a "should I invest in this company"-type question. You need to get specific in your answer as to what data you would need, so that you get specific answers from the interview. From there you have to be able to say YES I would invest or NO i would not.
If you get your 3 asks... can you give him an investment answer? Lets take a shot at it...
Someone said FCF, Cap structure and management experience. - Company will generate $450 million over the next 5 years - the industry is healthcare/pharma (they manufacture pharmaceuticals for race horses) - the CEO has 25 years of experience in pharmaceutical manufacturing, he has an undergrad degree in biochem and an MBA, CFO has 20 year experience at a big pharma company, COO similar background Should you invest in this company? Almost all members of an executive teams will each have 15-30 years experience, some sort of higher education degree etc... they'll all be "impressive" on paper.
Business Model, 5 yr growth opportunities, management team - company manufactures pharmaceuticals for race horses; they develop, design, manufacturer, market and distribute their products throughout the world to elite race horse trainers; raw materials are typical medicinal ingredients, not high volatility in pricing. Seek to differentiate themselves by working closely with trainers to identify bespoke products for particular breeds of horses. - 5 year growth opportunities lie in developing new products to sell to existing customers and increasing market share in the industry. If you had asked for a specific qualitative figure you would have gotten something more concrete. - the CEO has 25 years of experience in pharmaceutical manufacturing, he has an undergrad degree in biochem and an MBA, CFO has 20 year experience at a big pharma company, COO similar background Should you invest in this company?
If you had asked for 5 yr revenue CAGR, LTM EBITDA and cash conversion you'd have gotten the following to work with: - 5 yr rev cagr is 5% - LTM EBITDA is $70 million - Cash conversion is 50% (unlevered) ---- You should be able to get an idea of how big of a deal this is based on EBITDA x purchase multiple (informed by CAGR) ---- can ball park FCF generation over the next 5 years by applying cash conversion % to EBITDA and growth that FCF by CAGR each year ---- slap a boilerplate cap stucture on it, come up with an IRR and you know if its in the realm of do-able or not
If its showing a 11% IRR do I give to shits if the CEO and CFO are the smartest guys in the world? Do I care which industry they are in?
I would ask for those 3 things and explain how I would use them to ball park an IRR. Then I can gauge if I should spend more time on this or not. If the IRR is in an attractive range I'd want to dig in more. Understand the business model, the industry outlook, where comps are trading at, any potential fatal flaws (i.e. material litigation, environmental liability issues, etc...). The only reason you care about revenue is because it drives your EBITDA, if you can get to EBITDA you don't care about revenue. The only reason you care about EBITDA is because it drives FCF and because it drives valuation. Capital structure is meaningless. You want to keep your answers as simple as possible, why would you voluntarily propose some convoluted share structure? You want assumptions to be as simple as possible, you purchase the company outright, no breakage costs, etc...
Marcus
You can't just look at quantitative measures. A revenue CAGR is not guaranteed going forward. You can't assume EBITDA margins stay constant, etc. This is why industry is so important; so you can place the numbers in a context. I don't care if the financials are horrendous if the industry explains why that is so and I have a plausible reason for predicting a rebound.
People who focus so much on quantitative factors are the ones who do stuff like sell CDS or buy MBS because their entire due diligence into industry consists solely of "housing never goes down". They get burned. I don't care if a company's financials are great if I believe their industry sucks and is not going to do well. An IRR does not tell me anything about risk, industry does. What if the IRR is 30% but the company is very risky? It might not be an attractive risk/reward proposition. Also, your IRR is based purely on financial theory, which ignores reality and market fundamentals. From my three numbers, I can get actual comps and get a much better picture of what the company is worth, and based on the EBITDA multiple of comps and projected growth rates in the industry, I can back into an IRR as determined by current market prices (not what I think a multiple should be, but what I'm going to have to pay). You could do your analysis based off your three questions, and say go, and the market could be using a multiple on cash flows much lower than what you're assuming (i.e. you are overpaying).
I read the question as you can only ask for three things, period (i.e. you are not doing a quick financial screen, you get three pieces of info and have to make a decision solely from that).
Again, if you don't have industry, you have no way of putting your numbers in context. It's saying you ask for three pieces of info, it does not say you have to give an answer in 2 mins after receiving that info. With your info, I can't do much other than the 2 min long IRR analysis you did in your post. If you know industry, you can do a lot more due diligence and build a more complete picture of the investment.
There is not a single situation I can think of where you give me the three bits of info I ask for and I can't give you a basic go, no-go answer. I don't care what numbers you give me for your three metrics, I can't come to a conclusion because I have nothing qualitative to go on.
From my experience, when that question gets asked (and I've asked/received similar questions multiple times), what people want to see is that you get the big picture; i.e. you are an investor, not a financial engineer. Not mentioning a single qualitative element is a big no-no in my opinion. One of my fav interview questions is "what is the most important thing when deciding whether to invest in a company"? then ask them the second thing, third thing, etc. (with their answers in between, and basically no comment from me, so they don't know if I like their answers). See how many quantitative things they say before they say something qualitative and vice versa. Who would you hire? Someone that said "FCF/EBITDA" and then said "Industry" for their second item? Or someone that says "Rev. CAGR", "EBITDA", "Cash conversion %", "P/E", "FCF" one after the other? I've heard a whole myriad of answers and IMO it really weeds out the financial engineers (and the consultants, who don't know finance) from the very top, balanced candidates, who are the best investors.
P.S. - My favorite interview question is "What is the best investment someone could make right now and why?" I know whether I want to hire someone solely based off their answer to that.
alexpacsh-
Are you seriously that dumb?
Its an interview question. What 3 things do you need to know to do an investment analysis. Analysis is by definition quantitative. I didn't say those are the ONLY 3 pieces of information anyone needs in order to make an invest / don't invest decision. It’s the answer to an interview question. Knowing all possible quantitative/qualitative specifics are important in the practical world. Knowing all those things in an interview room when you're given 3 asks, is stupid. You're given the option to get 3 pieces of information. If you're answer to that interview question is to ask for a full blown diligence process. In an interview, the person asks you that question and you give them the 3 pieces of info you would request and then they give you specific answers to your 3 asks and tell you do walk them through how you'd come to a conclusion.
The question was not "what type of diligence needs to be done before making an investment decision?" The question was "I went to an interview and was asked this question, how should I have answered it?"
PE investors have a variety of strategies. I don't think you're shooting yourself in the foot by coming off as a financial engineer oriented PE investor. Financial engineer and investor are not mutually exclusive FYI.
I simply skimmed the responses above, but I whole-heartedly agree with alexpasch's approach. Financial metrics mean very little if you don't put them in the context of an industry. For my shop, industry is far and away the most important consideration when evaluating a new opportunity. Market size / growth / trends are essential. Sure, the company's financial profile is important, but it doesn't necessarily drive investment decisions (besides, all forecasts are just some BS made up by management).
If I got asked this question in an interview setting, I'd respond with the following:
1) Industry description, growth/size (you can group these into a single bucket when answering an interview question such as this one) 2) Financial profile (revenue/ebitda/CapEx/WC requirements) 3) What makes the company's product/service proprietary/sustainable?
Don't feel like you can only get a SINGLE data point per question, that's just silly. Also -- the point is to evaluate the company to determine whether or not you want to make an investment, not to determine how much you would pay.
To further support the "industry is key" thesis, take a look at GTCR's investment model. GTCR helped to pioneer the concept where a PE shop identifies an industry that they are interested in investing in, finds an executive to lead the effort, and then searches an appropriate platform company from which to fulfill the investment thesis.
Marcus,
I think you're stuck in the weeds on this one. You're too focused on what the "model inputs" would need to be to spit out an appropriate IRR rather than what makes a company a high quality investment.
Per your statement about purchase price, I don't think that is relevant given the context of the question. Sure, you absolutely can't make an investment without knowing the purchase price, we all know that. But if I asked you this question and you responded "purchase price" I would dock you serious points. The question wants to know what are the three MOST important things to know when evaluating an investment -- they aren't asking you to make a go/no-go decision.
With that in mind, I'll return to my previous recommended response:
1) Industry dynamics: This is important because it is a key factor in determining growth, potential size, and relative market position. I'd much rather take a poorly run business in a great industry than a well-run business in a shitty industry. Also, with long term investment horizons (5-10 years), industry dynamics play a large part in shaping whether or not an investment is successful. Think of this question as the "macro" view of the investment. 2) Financial Profile: This get's at many of the things you're looking to analyze Marcus. As an investor, you need to make sure that you can service your debt, so Free-Cash-Flow is incredibly important. Things such as EBITDA margin will help you determine how well the business is run (you can compare it to similar public businesses) and CapEx/WC will help you make ascertain the true amount of $$ that you're generating. 3) Proprietary Nature: There are obviously winners and losers in every industry. Determining a company's competitive advantage can help you build an investment thesis and gain confidence in a company's ability to take advantage of positive market dynamics. Think of this as the "micro" view of the investment.
So, that's my answer. I'm going to analyze your three asks in response to the original question posed:
5-Year Revenue CAGR(%): Management informs you that they are projecting a 30% revenue CAGR over 5-years. (Note that this is just a management projection. You're clearly not asking a crystal ball here -- you're asking either a banker or a management team. If you were able to ask for CAGRs with 100% certainty that the projection would come through, I'm assuming you'd just cut to the chase and ask "What would the IRR be for a 5-year hold on this investment?")
LTM EBITDA($): $100M. (I'm really not sure how much this tells you to be honest. Yes, you can use it as a basis to price the asset, but that would be an extremely dangerous approach without knowing anything else about the company. What if the company was selling through distribution and was practicing channel stuffing [signing up a ton of new distributors yet not producing additional end customer sales -- effectively inflating Sales/EBITDA temporarily until all the distributors start returning unsold stock and eating away at your FCF]??)
Cash Conversion(%): 50%. (Probably the most useful metric you asked for, but still difficult to utilize appropriately given your other requests. Is this really one of the TOP THREE items you'd ask for if you sat down with a management team and could only ask them three questions??)
Anyways -- I'm not trying to be a jerk with the above response. My point is that financial metrics alone really don't tell you much about a company. When you only have a precious three questions to decide whether or not to pursue an investment, you really need to make sure the fundamentals are sound. You simply can't do this by looking at estimated revenue growth, size (EBITDA), and FCF conversation rate.
Finally -- I recognize that we both made different assumptions when answering the question (such as the amount of detail that you can ask for in a given question). As a result, you could probably quickly poke holes in my argument by making different assumptions (I'll save you the time -- I understand this).
i like the guy who said industry, price, and industry rank...and also the one who gave the scenario in which cerberus is offered an auto parts maker at 11x and they will be able to say no based on those 2 data points, 1) auto parts manufacturer (slow growth assuming US, cyclical = risky, capital intensive = some risk and lower ROIC...all together = lower multiple; 2) 11x (= premium multiple)
i take the question to be a go or no go based on 3 questions. therefore, you need to know the asking price (unless your answer is "this is a buy at x price."
1) detailed company description - this should tell you what the company does/sells and what industry it's in. with that, you have a lot of information about the growth profile, capital intensity, riskiness, probable margins...i.e., the things you need to know to determine the free cash flow profile and growth and the riskiness of those cash flows so you can discount them
2) 5yr historical market share/rank - i guess this is two things but this would give me more insight into margins, and risk. if there's lots of competition there's more risk and lower margins. also, with 1 and 2 i could make assumptions about market size and the size of the company...that would also help me figure out risk. i want both share and rank because if it's 10% share, is it #3 with 1or 2 much bigger comps or is it #1 in a very fragmented industry. if i had to pick one, i guess maybe share. or maybe i'd just ask for EBITDA margin
3) price in the form of TEV/EBITDA. I'd use 1 and 2 to determine what kind of multiple i'd be willing to pay and then i'd compare that to the selling price multiple. Then i'd tell you "go" or "no go" (actually i'd only say go or no go based on that limited info if i had to for the interview...otherwise, i'd tell you "pass on this one" or "let's do a little more work")
Even if you're looking at a public buyout, the price is still an end result of your analysis. You need to do all of the analysis that has been discussed in this thread in order to arrive at what you believe to be a fair valuation for the business. If your valuation is higher than the market cap plus a premium - that's a business you want to buy. If not, you pass. You can't possibly know whether you believe the market cap is an attractive price until you do the analysis.
Valuation is the end result, there is no paper price tag on a business that is for sale. If you say "price" in response to this question, I would ding the shit out of you, because you give away a lack of basic understanding of how companies are valued, bought, and sold.
On another note, I think this discussion brings to light an important hurdle when interviewing.
One of the key things you can do to dominate your interviews is to hear a question and immediately be able to focus in on exactly what it is your interviewer is looking to figure out about you. In this case, some of us (even seasoned interviewing veterans) disagree on what that is.
So with this question for example, if the interviewer is looking to seek if you understand the "big picture" and you perceived the question to be "I need to demonstrate i understand the nuts and bolts quantitative aspects of PE investing" you may very well nail the question in your own mind, but the interviewer thinks you completely missed the mark and don't get it.
Just as when you answer a brain teaser / technical question you lay out all your assumption, you can diffuse miscommunications by confirming you understand the question... so "by investment analysis I'm assuming you mean quantitative analysis, so I'd look at x, y and z". I've always used that approach in the past and its saved my ass quite a few times if the interviewer replies with "actually Im looking more for high-level aspects of a deal you would try to understand", you can then address that specific question... as opposed to just spitting out your answer and the interviewer thinking "ok, this kids been modeling and crunching numbers for the last 2 years and thats all he really has the mental horsepower to do at this point."