Financial modelling on the buyside
Happened to be taking some financial modelling courses and a thought came to my head. Suppose you were on the buyside and on a daily basis investment banks are sending you CIM for reviews. This would also mean the bankers have already done the financial models themselves. Thus, would a buyside firm create a model from scratch or would they obtain the financial models from the bankers and just perform their analysis from there? For example, stress testing the assumptions and so on?
If they create create their own financial models, how would they do so in practice. Would the CIM give all the information they need? What if insufficient information is provided in the CIM?
Haven't worked in the industry before so just curious.
Thank you.
Before first round bids are submitted, the sponsor will do an initial analysis based on the numbers in the CIM on their own, without consulting the bank. Usually this is some type of standalone model / projections in a case manager, which feed into another set of tabs that look at things like potential return on investment (basically a traditional LBO), expectations on working capital, fixed vs variable costs, capital expenditure expectations, leverage potential, roll-up acquisitions, and the like. Depending on how serious the sponsor is in the bidding process, I imagine they would have differing levels of granularity here. Also, generally speaking sponsors who get a CIM from a potential target company have probably already done some diligence on that company, so there may already be a model in existence. The sell-side advisor will not send sponsors a copy of the model used to create the CIM.
Using the above analysis, sponsors will put in a first round bid. Assuming they get invited to the MP, the sponsor will then get access to a fair amount of additional information which is in a VDR that the sell-side advisor manages. The sponsor will also usually get advice from tax and legal specialists (in my experience, these are folks at Big 4 firms) who put together some materials on the target company in question - most of the time this is a VDD, but it can be shorter if the target is a well-known, well-studied public company. It could also be longer, and I think here it also comes down to granularity.
If sponsors are confused on specific numbers or can't tie to the existing projections, generally they will call the analyst / associate working at the sell-side advisor and basically ask them to explain why the numbers are the way they are - there are frequently one-time changes or weird other expense lines which are not necessarily always explained thoroughly, even in the VDR. In my experience, sponsors also quite like calling to fish for information about what management is thinking regarding purchase price, PF ownership considerations, etc.
Many thanks for the detailed explanation. This was very helpful.
But why doesn't the bank provide the buyside firm with the financial model. If the buyside firm knew information about revenue built up etc wouldn't that help reduce their due diligence questions by a factor of 10000x?
Thank you.
Because sellside / banking models are nowhere near as complex or thorough as buyside / PE models. As a PE guy, you may ask for their model just to see their assumptions, but you're NEVER using that to underwrite your firm's investment. You're always going to build your own model.
I second ledger. Also OP if you did that you would be trusting the bankers to correctly model and value the firm. This is ridiculous, and PE shops also need to construct their own valuation, often based on what they can afford and what works in regards to an optimal capital structure. It is as if you were to trust a car salesman and to take his word on a car that you had never seen or driven, simply because he told you he was an auto expert.
Yeah never use a banker model. Car salesmen comparison is pretty spot on to be honest.
Agree with Whiskey5. Never rely on sell side model other than to get a general sense of the value drivers. From my experience, all the sell side models are full of crap assumptions and as if that wasn't enough, they may go overboard on the level of detail they provide you to throw you into the "analysis paralysis" mode.
I primarily rebuild the sell side model completely even in the first round to ensure that I understand where the BS is hiding in the sell side model and to make sure I have the proper flexibility to evaluate the key value drivers and risks.
At the end of the day, if you are not an industry expert, you will have a hard time assessing the assumptions. This means that if the bankers put in garbage assumptions into the financial model, the first round process simply becomes a high level screening process by which the bankers try to tease out who is interested in the business itself and has the lowest cost of capital.
Of course far into the deal process when the potential buyers deem it worthwhile to spend $$$ on consultants and specialists, they uncover the BS and their valuation comes down dramatically from the first round. Of course, the bankers will get all butt hurt over this, but it's all semantics at the end of the day.
Agreed. I think at the end of the day - each side has a number in mind and then can you build a model to support it.
But sometimes you can't even make mgmt meeting if you don't give credit to banker growth rates. I HATE this as I think its intellectually dishonest but you gotta do what you gotta do to compete.
Another side of this is some firms might put in a competitive non-indicative to get invited to the next round and take a peek under the hood. Wouldn't be something you want to do a lot since you would garner a bad rep.
It's absolutely fine to rely on banker or management models early on in the transaction to save time. Many times you will find that the deal won't work even under the Happy Days case in the model you receive, because you change one variable like the amount of debt financing you'd be willing to live with and the deal just falls apart. No need to waste time building some sophisticated valuation model until you know the deal is really going live. Of course, you can't bang out the full model overnight either, so you have to plan ahead and manage the process efficiently. In the beginning you build everything from scratch, as you move up and learn in this business one of your greatest skills becomes knowing when you are allowed to take shortcuts.
Hi all, many thanks for the insights shared.
Could you experts also share how trading comps / precedent comps analysis is done in real life? My coursework shows you need to read their financials, adjust for one-off items to get your actual values. This seems like an awful lot of work. Furthermore, what if your comps come from a country whose language you don't speak eg. Russia? Do you just rip the comps from capital IQ if that's the case?
Lastly, how often is DCF used in practice? Seems like you can get any value you want just by tweaking the assumptions.
Thanks.
You'd be surprised how useful is google trad in some cases ...
Comps, precedents, and DCF analyses are done different in banking versus PE.
In banking, you tend to follow industry-accepted guidelines for things like fairness opinions, so there is a stringent process and set of parameters. For example, the ECM team might tell you the equity risk premium is currently at 6.75%, and the country risk premium is 1.75%, and etc... senior bankers will opine on adjusting these levels, but their hands are somewhat tied. At the end of the day though, you tend to show the client what they want to see, almost always.
In PE, the theoretical framework is much less important than getting it right. Judgement plays a much larger role in the valuation process, because all that matters is whether the investment works out, not whether you delivered an impressive valuation deck with a million sensitivities.
That is not to say that PE guys don't go into as much detail. It's just that we don't waste time on calculating WACC - we typically make decisions on an IRR basis (i.e. while we will look at unlevered DCF at various discount rates, we focus more on levered IRR's under various scenarios). ROI / MOIC also plays a big role. We will look at trading comps but typically it's hard to compare large public companies to smaller PE-backed ventures. Transaction comps are also fine to look at, and we do, but again who cares what other people paid for similar assets? Comps are much more relevant in public M&A, corporate acquisitions, mergers of equals, etc... in PE we will go into as much detail as possible, but only on the parts of the analysis that we believe are directly relevant to our risk/return judgement of the investment.
Oh, and if the shop is large enough and happens to have relationships with investment banks (typically the banks that underwrite the credit facilities that finance a lot of the PE's portfolio companies), then we get to outsource the trading and transaction comps analysis to the bankers. We will stick those pages in the appendix just so we can point to the median and tell the investment committee that the deal is being done below market comps. This looks good when our investors diligence our investment recommendation memos, but make no mistake - the committee will not pay any attention to the multiples unless the deal team makes a compelling case that they are especially relevant for the deal in question.
Make sense?
Awesome thread.
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