Hi all, I came across the following PE interview question. You're asked to assess two investment opportunities -- company A and company B. You're asked which one you thought was the "better investment opportunity," and are expected to give an answer on the spot as opposed to running any excel models. The details of the companies are as follows:
Company A:
$100M revenues in year 0
$20M EBITDA in year 0
5% annual revenue growth for the next five years
Purchase price is 5x EBITDA (4x debt, 1x equity)
Company B:
$100M revenues in year 0
$20M EBITDA in year 0
10% annual revenue growth for the next five years
Purchase price is 6x EBITDA (4x debt, 2x equity)
This is all the information you are provided with, and you are free to make whatever assumptions as you wish (provided you can back them up). No additional information is provided besides what was noted above.
Can you please let me know how you would approach this question, whether or not there's a definitive answer to the question, and what the purpose of such a question would be?
Your thoughts would be much appreciated.
All things being equal Company B is the obvious choice. The 10% growth (as opposed to company A's 5%) more than offsets the higher purchasing price. The question is probably meant to test that you at least have SOME idea about compounding and the time value of money.
Pretty easy stuff, unlessss I'm missing something here and being that its 2:30 in the morning, thats a good possibility.
Reread the question. You are paying more for company B. You are also financing the extra $20M will all equity (1x more equity with 1x more EBITDA purchase price = $20M in equity). So you need to consider 1. the extra $20M 2. it needs to be financed by equity vs the extra 5% additional annual growth.
I was thinking about all the points you guys mentioned, and I reasoned that while it's possible to make all kinds of assumptions we'd like about WC, CAPEX, assets that can be held as collateral, and so forth...maybe the real key to this question is to consider the effects of (1) initial injection of equity and (2) FCF growth.
Based on the two factors I mentioned above, here's how I thought about the problem (and feel free to correct me at any point if you think I am wrong). I reasoned that since both companies have the same EBITDA margin, it wouldn't be out of the realm of possibilities to think that their working capital commitments are similar. We know nothing about CAPEX or collateral assets, so rather than making assumptions about these, I won't think about them at all.
So you have company B which requires 2x more equity investment, but will see annual revenue growth of 10%, which is twice as much as company A which will see annual revenue growth of 5%. Given that these companies are in the same industry and have the same initial EBITDA margins, I don't think it's too far fetched to believe that their OpEx commitments will be similar, so that company B's EBITDA will also grow in-line with its revenues (10%) while company A's EBITDA growth will be 5%. Thus, company B has twice the expected EBITDA growth as company A, and even in spite of the fact that company B requires twice as much initial injection of equity, there is the compounding factor for growth in EBITDA so that over a 5-year period, company B should generate a higher exit valuation (based on EV/EBITDA). We could consider all different factors of debt paydown and whatnot, but for the sake of simplicity and since we weren't prompted to assume anything in the question (such as debt paydown or prepayment rates), let's leave this stuff out of the question.
Overall, based on my reasoning, it seems that company B is a better investment -- please let me know what you think of my logic, if it is good, if it doesn't make any sense at all, etc. -- I am here to learn. As a side point, is it reasonable to assume that the company with higher leverage will experience a higher cost of capital (just because banks will demand a higher interest rate given the increased credit risk), or are there too many unknowns here to determine what cost of capital for each investment would be?
Thanks in advance for all your insights.
there is no definitive answer, the question is probing your ability to make reasonable assumptions and back them up.
eg what are you assuming about the financing cost of the two deals? What are the capex requirements? How synergistic are the two companies with your existing portfolio? etc.
Back of the envelope:
-Assume that EBITDA margins for both companies stay constant -Assume that you exit after five years at the same multiple you bought at
Company A: -Purchase price: 100 -Equity investment: 20 -EBITDA in Year 5: 25 -Value in Year 5: 125 -Net CF to equity: 45
So, you make $25M in profit on your $20M investment over five years, or 1.25x
Company B: -Purchase price: 120 -Equity investment: 40 -EBITDA in Year 5: 30 -Value in Year 5: 180 -Net CF to equity: 100
So, you make $60M in profit on your $40M investment over five years, or 1.5x
Company B is the better investment.
I've left compounding revenue growth (it's not clear from the way you've set up the problem if it compounds) and the cost of debt out, but neither of these should change the conclusion.
Just as an FYI, you should also be thinking about opportunity costs here. For example, Company B requires that $40 mm in equity, rather than $20 mm worth, be tied up in the investment.
Also, Company B would appear to have more exposure to the risk of exit multiple contraction than would Company A.
How's that? If the exit multiple in each case decreases by 1 turn, you only get your equity back out in the Company A case (you lose money if you factor in carry), whereas in the Company B case you make $30M in profit.
The higher EBITDA growth for company B means you're less sensitive to the exit multiple.
I was speaking more broadly to the fact that a higher investment multiple has a greater chance of "coming down" in a cooling market (e.g., I wouldn't expect both exit multiples to move in lock-step).
Isn't it just as simple as saying that the earnings growth, assuming margins hold, for company B would more than cover the cost of senior debt assuming an 8% interest rate?
Furthermore, do you really want to leverage a company that is growing at only 5% at 4 to 1? There is not a lot of room for error.
I actually did a little back pocket calculations, and found that company A is usually better unless you start getting freaky with your assumptions.
The way I approached it was if you are paying twice as much to enter you need to get twice as much upon exit to make company B worth it. Considering the compounding growth, let's say the EBITDA of company B is about 5*5 = 25% after 5 years (its a little bigger considering compounding, but lets keep it simple). Hold entry and exit constant for each company (the exits might be the same, but because I am making a case for company A I will give something to company B here).
I would make the large assumption that the companies pay off the same amount of debt (the reasoning here is greater cash coming in is essentially eaten out by larger capex and WC requirements to fund the growth as well as greater taxes). Let's assume they pay down two times leverage. Then you are comparing exit equity of 3x EBITDA for company A and 4x EBITDA for company B, which has 25% greater EBITDA. if you scale the last years EBITDA to 100 and 125 respectively, you are comparing $300 to $500, which is not twice as much. Company A it is.
Now there are a lot of assumptions here. If you are working in an industry with a large amount of operating leverage and low capex and WC requirements, this could be turned around. Classic example: restaurants that franchise out exclusively. They have low capex to start a restaurant (as they are franchising), restaurants actually have negative WC so you get cash from WC as sales increase, and most costs are overhead so there is a large amount of operating leverage yielding margin improvement (EBITDA increases at >10% growth).
Even ignoring margin improvement, you could just argue due to the cash that an extra turn of leverage is paid down over 5 years, which yields $625 v. $300 upon exit--so I would go with company B in this case.
PE Interview Question - Thoughts? (Originally Posted: 09/26/2007)
Hi all - my apologies for cross-posting this from the PE forum, but I wanted to get some feedback from you guys as this board seems to get a lot more traffic. Below is a PE interview question comparing two investment opportunities and I was curious what you guys thought. Link is as follows:
//www.wallstreetoasis.com/node/9256
I am very confused by some of the responses in that link; all things being equal the crux of the question is leverage. PE firms are interested in getting the most bang for their buck. Besides many of the essential factors of evaluation, our group is most concerned (when analyzing deals) with how much equity we need to put forth relative to how much debt we can put on the company.
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