• 124 07/09/2021

    An EBITDA multiple is, very simply, a company’s enterprise value (EV) divided by its EBITDA at a given time (EV / EBITDA); conversely, EV can be calculated by multiplying EBITDA by the EBITDA multiple. This metric has long been used as short-hand approach to a company’s valuation, and you will frequently hear individual deals or entire industries referred to as “an [X] times deal” or “an [X] times industry,” with X being a multiple of EBITDA.


     
    EV / EBITDA quickly became the primary metric used by investors to evaluate, describe and benchmark leveraged buyouts in the 1980s, and it retains that title to this day. In most LBO models, cash flows and EBITDA growth are projected for five years, with an EBITDA multiple used to estimate enterprise value in the exit year. The underlying assumption is that the business is sold in the final year. In most instances, and certainly for most growing and healthy businesses, the sale generates the lion’s share of the proceeds to be distributed to investors (though in some cases dividends, refinancing, asset sales, or other cash generating events may also generate some portion of the proceeds). 

    For this reason – the critical importance of the event of sale, and thus the chosen exit multiple, in determining expected returns – it is generally frowned upon to use an exit multiple of EBITDA larger than the multiple paid on entry, especially if you cannot articulate why the investment is deserving of so-called “multiple expansion” (when secular changes in a business or industry justify higher multiples over time). But because the use of a higher exit multiple is one of the easiest ways to inflate returns and because multiples on private equity deals have generally been expanding over the past decade (for reasons we will expand on below), it can often be very tempting to bump your exit multiple up. Examining how multiples have expanded, however, provides a cautionary tale. 

    EBITDA Multiples in 2021

    Per McKinsey & Co., the amount of leverage employed in U.S. buyouts is at an elevated level. The two-year trailing average stands at 7.0x EBITDA. That compares with 6.4x in 2007, just prior to the Great Recession. The Global Private Equity Report released by Bain & Company contains an infographic demonstrating an aggressive reversal from 2007 to 2009, in the depths of the financial crisis. 

    Private Equity Debt Multiples

    The article citing leverage multiples continues on with purchase price multiples, citing that the two-year trailing average multiple "reached a record 12.8 times EBITDA in 2020, compared with 9.4 times in 2007." (The video above provides more detail on the variables driving valuations.)

    Private Equity Purchase Multiples

    Has the standard of value been raised? Citing OG value investor Benjamin Graham, Jim Grant compares peak multiples in the late 1920s to those of today. From his newsletter dated April 16, 2021:

    "Graham reminded his readers that such 'fantastic' reasoning actually led to price-to-earnings rations of 50 and more. This generation does him one better. Bloomberg counts 253 American companies with price-to-sales ratios of 50 and higher."

    At some point history repeats, but persistently high-flying multiples and an accommodating Fed make it difficult to get too worked up :) As investors, though, it's important to make certain we aren't lulled to sleep. 

    Suggested Reading:

    1. WSJ: Private-Equity Firms Regain Taste for Giant Buyouts
    2. Bain & Company: Global Private Equity Report 2021
    3. WSJ: Private-Equity Cash Piles Up as Takeover Targets Get Pricier
 



  • 123 07/07/2021

    This video explains how to project the cash flow statement in an LBO model built in Excel. The sequence required to project each line item is identical to the sequence laid out in the Integrating Financial Statements video series (which is focused on a three-statement model) and the LBO video series, so we will not explore that in detail. Instead this video will provide shortcuts to move through the process faster when you are working with new financial statements, and visuals to help communicate how the income statement and balance sheet link to the cash flow statement.

     

    Projecting the Cash Flow Statement:

    1. Copy / Paste Line Items: To move faster through the process, it can help to copy the line items from the target company's financial statements, and then paste them into your financial model.
    2. Link to Net Income: The cash flow statement starts with net income, which pulls from the income statement.
    3. Make Adjustments for Non-Cash Items: In most simple models this will require adding back depreciation and amortization at the very least.
    4. Make Adjustments for Working Capital: As a helpful rule, when a current asset increases it consumes cash, and when a current liability increases it creates cash.
    5. Cash Flow From Investing Activities: In this model only capital expenditures are included under CFI. This should be included as a cash outflow.
    6. Cash Flow From Financing Activities: The debt schedule will be addressed as the final item in this process. It is not included in this video.
    7. Calculate Cash: Sum cash flow from operations, cash flow from investing activities and cash flow from financing activities to arrive at cash flow for the period. This sum is then added to the previous periods cash balance to arrive at the current period's cash balance.
 



  • 122 06/23/2021

    Incentive equity compensation helps align investors with the management team running the business. In every control private equity transaction, it is one of the most important variables to get right. This post will explain how equity compensation generally works with visuals that should help cement these concepts.

    The amount of vocabulary surrounding equity incentives can be overwhelming. A lot of this complication stems from nuances in federal tax law, but the simple objective, no matter how equity incentives are structured, generally remains the same: incentivize the management team to increase the equity value of the business that employs them. This is achieved by providing the key personnel driving growth with the opportunity to own a piece of the business above a certain value. Ownership is represented by either units or shares (based on the type of entity), and the value above which the employee is entitled to a payout is generally tied to the value of the company when the employee is hired.

    So, let’s assume that a private equity firm acquires a company with an enterprise value of $100M dollars. To attract the right team the private equity firm also creates a management incentive plan equal to 10%. 

    Incentive Equity Compensation
     
    Per the image above, the 10% incentive plan does not entitle the management team to 10% of the company outright, but rather to 10% of the increase in equity value over time. More precisely, the management team benefits from 10% of the appreciation in equity value after the private equity firm recoups all dollars originally invested, which is the equivalent of earning a multiple of invested capital (MOIC) of 1.0x.

    The MOIC of 1.0x is known as a “hurdle rate,” because it is the rate above which the management team is entitled to compensation. A management incentive plan can have multiple hurdle rates (also referred to as tranches or tiers) to further incentivize outsized returns. For example, and per the image below, the private equity team could provide an additional 10% equity incentive above a hurdle rate of 2.0x MOIC.

    Management Incentive Equity with Hurdles

    Per the introduction, there can be any number of nuanced structures. But ultimately, whether you are contemplating stock options or profits interests (the two most common forms of equity compensation in private equity transactions), the mechanics are largely the same.

 




 



Models are:
 
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

 

 


*Answers a, b, c, d, e, f and g are all correct.