ROIC in LBO

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?

1. 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?

2. 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.

3. 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.

4. 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 The book value of assets in some random company may be outdated as these assets may not be re-valued that often.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