Financial modelling on the buyside

the_ferry's picture
Rank: Orangutan | banana points 277

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.

Comments (29)

Sep 17, 2017

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.

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Sep 17, 2017

Many thanks for the detailed explanation. This was very helpful.

Sep 18, 2017

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.

Sep 19, 2017

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.

Sep 20, 2017

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.

Sep 20, 2017

I don't work in PE but when we get a financials with projections from a sell-side banker we immediately temper them or sometimes throw them out all together. I'm not saying that all sell side banker models are overly aggressive but they are trying to sell you on a pretty rosy projection (typically a nice hockey curve).

Also from the sponsor's perspective, they will toggle growth rates and purchase price to get the proper returns (also do this on the Corp Dev side too).

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Sep 20, 2017

You must massage those numbers if they don't "add up"

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Sep 20, 2017
BankerC159:

I don't work in PE but when we get a financials with projections from a sell-side banker we immediately temper them or sometimes throw them out all together. I'm not saying that all sell side banker models are overly aggressive but they are trying to sell you on a pretty rosy projection (typically a nice hockey curve).

Also from the sponsor's perspective, they will toggle growth rates and purchase price to get the proper returns (also do this on the Corp Dev side too).

Hey all, many thanks for the replies.

BankerC159, but why don't you just use their model, add in the relevant details you need (maybe it is not so detailed for the revenue built up so you just change that portion) and then trim their assumptions in other areas of the model?

Seems like a more efficient way to work rather than constructing an entire model from scratch?

Appreciate the insights you guys have been providing.

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Sep 20, 2017

I don't know of any sell-side banks or processes that I've been a part of, where the counterparty willfully handed over their full operating model (with drivers etc). Typically we will get a barebones 3 statement financial statement (de-linked if in excel).

If there is a case where you might be able to get your hands on the full blown out sell-side model it might not even be useful to a buyer. For instance, if you are a buyer and you happen to like the product they are selling but don't think their revenue model is efficient (e.g. licensing vs selling units of the product), their model is driven off of licensing - makes the sell-side model not very helpful.

These are just some examples I could think of and my experiences. I'm sure there are some other PE folks on here who have some better insight.

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Sep 20, 2017
BankerC159:

I don't know of any sell-side banks or processes that I've been a part of, where the counterparty willfully handed over their full operating model (with drivers etc). Typically we will get a barebones 3 statement financial statement (de-linked if in excel).

If there is a case where you might be able to get your hands on the full blown out sell-side model it might not even be useful to a buyer. For instance, if you are a buyer and you happen to like the product they are selling but don't think their revenue model is efficient (licensing vs selling units of the product for instance) and their model is driven off of licensing - makes the sell-side model not very helpful.

These are just some examples I could think of and my experience, I'm sure there are some other PE folks on here who have some better insight.

Thanks, this was really helpful!

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Sep 20, 2017

Awesome explanation, +1 SB

Sep 22, 2017

This site's provides a good overview on LBO modeling and other buyside analysis - it's been making the rounds: MultipleExpansion.com

Macabacus.com is another good place to review a complex LBO

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Sep 20, 2017

Yeah never use a banker model. Car salesmen comparison is pretty spot on to be honest.

Sep 20, 2017

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.

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Sep 20, 2017

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.

Sep 20, 2017

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.

Sep 20, 2017

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.

Sep 20, 2017

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.

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Sep 21, 2017
NuckFuts:

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.

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Sep 21, 2017

You'd be surprised how useful is google trad in some cases ...

Sep 21, 2017
GhenkisSchwarzKhan:

You'd be surprised how useful is google trad in some cases ...

Ha. I have used google translate to convert asian languages before like Mandarin. It wasn't particularly helpful. I certainly wouldn't mind using it if I were drafting a random memo eg. story of my life. But if it were for the purposes of recommending an investment? I'd honestly be concerned about missing or misinterpreting items.

Sep 21, 2017

It was a joke but you mostly use google translate for quick trade when you have to go through a VDR full of non-english document (eastern european language, east asian language, etc.) then you select some documents to be translated by a proper team haha - also when pro forma is not in English ....

Best Response
Sep 21, 2017
the_ferry:

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.

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?

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Sep 21, 2017

Great explanation, thanks for this.

I think you could take the "sell-side model" and run it through a DCF to get an understanding of their value expectations. As a sponsor, you will run a different analysis to see what scenarios/purchase price will get you the returns you need (over the hurdle rate).

So in essence, I think of it as two different exercises - valuation vs returns (or whatever you want to call the purchase price a sponsor is willing to pay to get the returns/CoC they need).

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Sep 21, 2017

You're exactly right. Actually, in the most successful transactions I've worked on, both sides had a "heart to heart" early on and agreed to work together on the valuation model. 100% transparency on assumptions, the data behind them, the framework, etc. Of course we each did our own analysis on the side and changed the assumptions on our end, but because the process was transparent from the beginning, our models ended up within 10% of each other on value. This difference of ~$25 - $50mm was small enough in the context of the deal that we agreed to meet in the middle, and took into account the value gap in the negotiations over structuring, documentation, working capital adjustments, indemnification, expense reimbursement, transition expenses, equity kickers and options, etc...

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Sep 21, 2017

That's interesting, I wish all negotiations were this cordial!

I guess it also maybe depends on what kind of process is being run, I assume in your situation it was probably bi-lateral talks? I'd assume in an auction process its probably its in the best interest of the seller to be as least transparent as possible to get the highest bid? Then again there are many more factors that go into it than just purchase price (financing and other factors that go into the buyer being able to execute/close). Just me speculating/talking out loud.

That being said, in my experience I think we all get caught up as monkeys in the intricacies of the models ect. when in reality the negotiations end up being much more high level. For example, Seller wants 10x and buyer only wants to pay 7x, can we (the sponsor/buyer) support through our "model" something in between (8x-9x and get returns we need). Not trying to downplay the modeling aspect but sometimes its just a means to an end imo.

Always interesting to hear other's deal dynamics.

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Sep 21, 2017

Lol me too, unfortunately most of them are not this cordial though. There is a whole game theory science behind auction / M&A strategy, and in general you actually do NOT want to be transparent in an auction. You give out just as much info as you need to, and respond to diligence requests. If one party missed an obvious question and never dived into an issue, they may end up overpaying - in which case the seller wins. This only works if there are multiple interested credible parties, so typically a high quality asset or company is up for sale.

The bilateral negotiations I was talking about were between ourselves (a PE / mezz shop) and a management team that had banking / PE experience. It was a fairly niche deal and both of us knew it would be much cheaper and more efficient to not fuck around with a process that takes several months with a bunch of bankers involved... it also helps that the CEO and MD were both "no nonsense" ex military guys who had great respect for each other. It was definitely not a typical deal, but there's no reason why we as the next generation of dealmakers can't learn from stories like these and try to do better in our own projects.

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Oct 8, 2017

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Sep 21, 2017
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