Going through prep for interviews, it seems that when we are looking at potential investments for LBOs we never consider a company's ROIC, ROA or ROE. From investing books I've read, these seem to be arguably the most important aspects of a company. Can anyone with some experience in PE give insight? Thank you!
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well there’s a certain reason to use metrics— exactly why are the above used in public markets? from what I can tell they’re used for banks or asset heavy businesses, or biotech, etc with high r&d. there’s a specific reason using a specific ratio may be appropriate in an industry. so if it makes sense for a bank to be trading on P/B metrics, then people will take note of that metric. Basically whatever you listed (don’t even remember and can’t see cause typing off phone) talk about efficiency of capital base, investment, etc.
If PE fundamentally trades off of ebitda multiples they care most about that and how to grow that number because that’s where they get the return. The most important number is how things flow to ebitda then.
in some essence everything is considered. I think you’re asking a weird question by asking why a simple high level marker may not be used— it probably is, just incorporated in the ground up analysis somehow somewhere. People don’t even really look at many “top line” numbers other than ebitda with any fascination (more or less few exceptions) because why would you ever just look at a metric when you can seriously and fundamentally dismantle and get to the core of what’s driving the business. However once you understand an industry you might say hey we want these things to filter investments e.g. contribution margin, GM, ebitda margin of software business.
hope you feel what I’m getting at- no one cares because no one cares, and the metric is unneeded because the due diligence will be done and incorporated that somehow somewhere. but the efficiency of reinvested earnings and r&d is important to figure out for sure it's just not as important a metric as one would think especially if control / operational improvements will be made.
It's also because you're going off of prep materials / lbo walkthroughs which are less comprehensive maybe.
These metrics can be a lot more helpful for public markets investing because you are studying companies outside-in and will be a passive investor. All of these ratios can inform you of profitability and capital reinvestment outcomes in these companies. The books on public investing will have plenty to say about using these ratios.
For an active investor and, specifically, for an LBO investor, these metrics have limited value. Why?
PE investors already know roughly average ROAs across industries and know what sectors are attractive and what sectors are not. That's the reason why we are unlikely to witness an LBO of an airlines business any time soon. And that's certainly what people like about asset-light industries. Unhelpfully, ROAs don't compare at all across different sectors, so this ratio has value only when comparing companies in the same industry. That's a limiting factor, isn't it?
ROE becomes somewhat meaningless in an LBO. You are changing the balance sheet dramatically post-LBO, so your ROE before and after you transact are not comparable, even in the same business. Why look at it at all? My IRR and MOIC calculations will be informative enough.
You may not target companies with great ROICs and ROEs. In private equity, we often look for businesses that lost their way. May be you are looking to acquire a company with a mediocre performance, change management, pursue operational improvement and exit a wholly different stellar business.
However, don't get me wrong, these metrics are useful and informative for asset-heavy businesses, as well as for banks and insurers. The book value of assets in some random company may be outdated as these assets may not be re-valued that often. In banks and insurance companies, book value of assets is pretty much equivalent to market value. Therefore, these financial ratios speak directly about their financial health.
Good luck with your interviews,
Tamara
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