Interview Brainteaser for Special Situations

This came up awhile ago. I thought it was a pretty neat question. How would you guys answer it?

You have an illiquid investment in an asset in which you put in $50m of equity and has $135mm in debt. It is not generating any cash. You have $120mm of excess cash to invest. You can inject $120mm to get the asset to cash flow $3mm / yr OR you can sell the illiquid investment for $55mm. What would you do?

 

Sell the investment. With any reasonable interest rate on the debt your FCF is wiped out and the problem doesn't indicate what % ownership you have so you don't even know what percentage of that FCF you're entitled to. Additionally, back of the envelope math indicates a perpetuity of $3m per year would imply a discount rate of middle single digits which is not very good for a typical investment, let alone an illiquid one.

 
juniormistmaker:

Sell the investment. With any reasonable interest rate on the debt your FCF is wiped out and the problem doesn't indicate what % ownership you have so you don't even know what percentage of that FCF you're entitled to. Additionally, back of the envelope math indicates a perpetuity of $3m per year would imply a discount rate of middle single digits which is not very good for a typical investment, let alone an illiquid one.

This. Of course this is assuming the interest rate is reasonable. Under certain conditions either answer could make more sense. Out of curiosity, what is the correct answer?

"Even if you're on the right track, you'll get run over if you just sit there" - Will Rogers
 
juniormistmaker:

Sell the investment. With any reasonable interest rate on the debt your FCF is wiped out and the problem doesn't indicate what % ownership you have so you don't even know what percentage of that FCF you're entitled to. Additionally, back of the envelope math indicates a perpetuity of $3m per year would imply a discount rate of middle single digits which is not very good for a typical investment, let alone an illiquid one.

I'm fairly sure this is all on a FCFE basis or this wouldn't be a question at all.

I might as well say use the $120MM to build a time machine so I could go back to 1975 and invest in Microsoft.

Though I agree that capitalizing $3MM of illiquid cash flow at 15x+ is an unreasonably high multiple.

 
Best Response

Going to assume FCF is FCF to equity (i.e. interest rate not relevant) and you own 100%.

Option 1 you invest $120m bringing your equity basis to $120m + $50m = $170m

You get $3m FCF p.a. implying a 1.8% equity FCF yield ($3m / $170m).

Option 2 you sell your $50m stake for $55m giving you 10% return.

However what can you reinvest the $55m proceeds in? Taking the question literally might suggest that Option 1 gives you 1.8% yield risk-free (as you get $3m forever). So what if the market is offering 0% for a risk free security? Or -5% for a risk free security?

At some point maybe Option 1 makes sense. Continuing with the risk-free point, if you have a risk-free $3m, could you not sell that at a yield that the market is currently pricing risk-free securities. So if you assume say 1.5% yield for a risk free security could you invest $120m, create $3m p.a. and sell that cash flow stream at a 1.5% yield ($3m / 1.5%) = $200m.

$200m compared to your $170m equity basis looks like a 18% return vs. Option 1's 10% return.

 
cortana:

Going to assume FCF is FCF to equity (i.e. interest rate not relevant) and you own 100%.

Option 1 you invest $120m bringing your equity basis to $120m + $50m = $170m

You get $3m FCF p.a. implying a 1.8% equity FCF yield ($3m / $170m).

Option 2 you sell your $50m stake for $55m giving you 10% return.

However what can you reinvest the $55m proceeds in? Taking the question literally might suggest that Option 1 gives you 1.8% yield risk-free (as you get $3m forever). So what if the market is offering 0% for a risk free security? Or -5% for a risk free security?

At some point maybe Option 1 makes sense. Continuing with the risk-free point, if you have a risk-free $3m, could you not sell that at a yield that the market is currently pricing risk-free securities. So if you assume say 1.5% yield for a risk free security could you invest $120m, create $3m p.a. and sell that cash flow stream at a 1.5% yield ($3m / 1.5%) = $200m.

$200m compared to your $170m equity basis looks like a 18% return vs. Option 1's 10% return.

this is a flawed analysis, the only factor driving your decision to invest an incremental $120MM is what is your return on that incremental $120MM. Let's say the decision to invest only another $1 would result in an immediate $1MM gain in value, by your logic that still looks like a bad investment because the total yield is only 2% ($1MM/$50,000,001).

 

In this case, the additional 120mm creates 3mm FCFE, which is 2.5%. I'm curious, should this be valued as a risk free perpetuity? If so, the long term T-bill yield is around 2.2, so you're looking at 3m/.022 = 136m. This is 13% ROI for your 120, but its a 20% loss for the total investment.

New question, would it be possible that the 50m stake was a restricted stake with some kind of contingency on dividend repayment where majority shareholders or preferred stockholders were draining the company of all net cash, so using 120m to acquire those shares doesn't create any operational improvements, it just frees up cash flows to you?

In that case you could say that your 50m initial investment was still worth 55m separately from the above transaction and your new 120m stake could be sold as a perpetuity for 136, which would allow you to sell the lot for 191, which is 12.4% ROI for the 170.

This kind of implies an arbitrage situation though, in that you're buying for 120 and flipping for 136 immediately. Unless the equity in question was worth 60m with a 3m return (5%) and you're buying that for (60m + 3m/.05), then marketing the package differently?

Is this realistic or am I thinking out of my ass? (my money is on ass)

 

Let's say follow up questions are allowed, I'd ask what industry the company is in and should you not be worried about short term FCF. If it is in industry such as tech, that has valuations based on other metrics such as users, or an off cycle industry, such as mining with strong term recovery once cycles rebound, that change the dynamic of the question and the answer. To me a response that thinks about those issues not simply a math equation is much more insightful and realistic to the investment world - especially in a special situations interview.

 

FV from capital gain, re-invested in similar risk category investment = 5m/r. FV from upping your stake = 3m/r. NPV from selling now = (55m-55m) +5m/r. NPV from upping your stake = -120 + 3m/r. From the above, liquidating and re-investing in a similar risk category investment would be the better alternative, as it produces a higher NPV.

I'm treating the 50m already invested as a sunk cost in the above calculations. My mgmt actg skills are rusty AF so I may be completely out to lunch here.

 

Assumption that the $50mm is a sunk cost is incorrect. Sunk cost is buying a movie ticket for $10, losing the movie ticket, and then deciding whether to buy another movie ticket. You can't get the $10 back so it shouldn't impact your decision. In this case, you can get your original investment plus a $5 gain back. The decision is, what is higher: the PV of selling out plus cash on hand, $175mm, or PV of a $3mm risk-free perpetuity. A 1.7% discount rate would make you indifferent. You can get higher than 1.7% on a liquid "risk-free" US treasury instrument so you should sell this investment.

 

After looking at it again, treating the 50m as a sunk cost (although, I do agree that it probably wasn't correct) has 0 impact on the NPV calculations, as it should be considered a 'cost' to set up both positions regardless, which would offset. You're right though that the way i approached it is heavily flawed - no idea where i got that a 5m annual perpetuity would cost exactly 55m... Anyways, your approach makes perfect sense. Thanks!

 

Would be important to clarify if the asset sale proceeds are before or after creditors are paid out, as well as whether the proceeds of your $120MM cash injection goes straight to operations, or also pays off some debt. However, assuming the $55MM sale price now is before creditor receipts, and the $120MM would go straight into operations:

Determine what the value of the asset would be at using comps. If estimated market value suggests that Enterprise Value less debt outstanding less your $120MM additional investment is greater than your $50MM current loss, then you do it. In other words, with $135MM in debt, and an equity investment of $120MM, you would need an asset worth greater than $255MM to begin reducing the $50MM loss you're currently facing. This implies a value/cash flow multiple of 85x.

"The power of accurate observation is commonly called cynicism by those who have not got it." - George Bernard Shaw
 
LeveragedTiger:

Would be important to clarify if the asset sale proceeds are before or after creditors are paid out, as well as whether the proceeds of your $120MM cash injection goes straight to operations, or also pays off some debt. However, assuming the $55MM sale price now is before creditor receipts, and the $120MM would go straight into operations:

Determine what the value of the asset would be at using comps. If estimated market value suggests that Enterprise Value less debt outstanding less your $120MM additional investment is greater than your $50MM current loss, then you do it. In other words, with $135MM in debt, and an equity investment of $120MM, you would need an asset worth greater than $255MM to begin reducing the $50MM loss you're currently facing. This implies a value/cash flow multiple of 85x.

OMG it's so obvious the sale and FCF numbers are to equity holders or else this would not be a question.

 

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