Private Equity - Working with Imperfect Information

WBI2994's picture
Rank: Gorilla | 592

So I've resolved to spend the rest of my (13/14 month) tenure as an IB analyst thinking from the perspective of a PE associate. In its pure irreducible form, this basically boils down to the following: What data points are needed to make an informed investment decision? What is the associate on the other end of the deal plugging into his model?

Given my experiences on the sell-side, I would assume a PE associate has to make do with incomplete information. Sell-side bankers are masters of withholding the truly useful data points until later stages of a process. How does one properly construct an operating build without access to detailed information (gross margin/volume by product line, fixed vs variable cost structure, project/SKU level revenue information, etc.)

How can you possible submit an intelligent/substantive bid without these conrete underlying metrics (i.e., only the summary level data available in a CIP)?

Comments (14)

May 13, 2018

I would be very interested to hear thoughts on this as well.

May 13, 2018

In my experience, most of the reasoning for a bid comes from comps.

Lets use you withholding gross margin for example. If the company you are pitching has substantially better margins than its peers, you are going to disclose that in the summary level data to attract higher bids, if not, you're the worlds worst banker. So by you withholding that information in the deck, we just assume it is no greater than the industry benchmark and base our bids on that.

Then if we move forward to a DD process and gross margin turns out to be substantially worse than the industry benchmark, we use it as a reason to negotiate a lower value / better terms for the deal.

    • 2
May 21, 2018

That's interesting. From a Strategic perspective, we have never used comps for valuation. We are certainly aware of the comps and generally have an idea what other industry players might offer, but that is never the driver of value for us (or my previous company). All Bids and agreements are based on DCF, even if DCF is influenced by comps.

twitter: @CorpFin_Guy

    • 1
May 21, 2018

Same here for our shop actually with the exception of like SaaS or BPO related businesses where we need good intel for valuation because of how volatile these multiples really are for these business models.

Most Helpful
May 21, 2018
accountingbyday:

That's interesting. From a Strategic perspective, we have never used comps for valuation. We are certainly aware of the comps and generally have an idea what other industry players might offer, but that is never the driver of value for us (or my previous company). All Bids and agreements are based on DCF, even if DCF is influenced by comps.

If you use comps to get inputs for a DCF, you use comps for valuation. All our bids are based on DCF too but you've gotta put some reliance on inputs from comps because bankers like to withhold information.

    • 2
Learn More

9 LBO Modeling Tests, 10+ hours of PE Cases and 2,447+ interview insights across 203 private equity funds. The WSO Private Equity Interview Prep Course has everything you'll ever need to break into the competitive PE industry. Learn more.

May 13, 2018

Would also add that after you've seen industrial widget business plan #100, you won't have a hard time valuing and coming up with estimates for #101.

Also an initial bid is never a final bid. It usually comes with the understanding that further DD is needed to give a better (more detailed offer). The legal paperwork before closing and purchasing papers are signed gives the buyer legroom to exit a deal if they don't like the color of the wallpaper that day.

May 15, 2018
oldrow:

The legal paperwork before closing and purchasing papers are signed gives the buyer legroom to exit a deal if they don't like the color of the wallpaper that day.

How often does this actually happen though? I would imagine it's generally a no-no and only done after egregious actions by the target or sell-side firm

May 15, 2018

What stage of the deal are you referring to? Buyers walk away from deals all the time, from initial NDA, through LOI, and final offer rounds and negotiations.

From my stint on the sell-side I've been involved in two deals where a large corporate walked away "last minute". One was because of a new corporate development head who wanted to "change things up." In all fairness though, these were strategic buyers not PE firms.

May 15, 2018

If you're screening an opportunity, you'll rely on previous deal experience, comparable data rooms you've been in, and cross checking assumptions against what your portfolio companies report.

Past first look, you and your team will have their own views and rational for key industry assumptions and you'll almost never take what's in the data room at face value. Short answer to your question is it comes down to experience and going through the process a few times.

May 15, 2018

I agree with the posts above, and would add that in healthcare deals (or deals in any highly-regulated space) I take a hard look at legal/regulatory issues that might impact a deal. In the mid-market, bankers can be incredibly naive about revealing non-financial information that would signal a go/no-go for a savvy bidder.

In the lower mid-market, I've seen kickbacks, general fraud, and any number of comments from management that indicate the business isn't entirely above-board. For true mid-market deals, it's often a regulatory change that would get revealed in post-LOI diligence, but that my firm has already known about from being in the space.

May 21, 2018

Not in PE, but an acquisitive Corp. I wouldnt make broad assumptions that Bankers are masters of much in the deal process and infer they're smarter than the buyers. I don't say that to be insulting, but Bankers are marketers and counsel on sell side deals.

Being Strategic we usually know the companies that we're interested in. We probably already know the margins, almost always know the customer base well, etc... The out of the blue deal sheets where we dont know the company are much less likely to close. Obviously, this may be different for Financial buyers.

If we're serious about an acquisition and the banker has withheld information we just put in a conservative estimate and move on with the process. We know this will be disclosed later and we'll true up purchase price. I havent seen any studies, but this probably hurts the seller in the long run on average because once we're re-negotiating price based on new information we'll walk if it doesnt go in our favor.

I think of bankers VERY similarly to a real estate agent. If the listing on Redfin doesnt include a picture of the kitchen I either skip to the next house or assume it's going t cost $100k to renovate. Either way, probably not good for the seller since I'm going to see the kitchen anyways if I'm a real buyer.

twitter: @CorpFin_Guy

    • 2
May 21, 2018

A lot of times its a "here is what I need to believe" type model initially to back into a threshold return. From there its a matter of "does a company like this even exist on earth?" type analysis based on what you can find and know about an industry. Once you have experience in an industry long enough you get to a point where you know about what companies can do.

Additionally, its pretty rare for a company to really start performing drastically differently than it has previously, so if that's what it takes to achieve a return, its unlikely the projections are legitimate.

You can tweak your model and assumptions as you move through the process, but the number one thing you should consider now is "what would I be willing to pay for this business?" The ONLY thing that matters for returns is price.

May 21, 2018
Comment
    • 1