• 116 01/27/2021

    This video is Part 3 of an introduction to private equity. In this video we will explore how to determine the appropriate amount of leverage for a target investment.


    DEBT RATIO ANALYSIS

    In a control private equity transaction, debt is commonly employed to acquire a business. This debt creates obligations of interest and principal payments that are due on a timely basis. If these payments are not made creditors can take action to recover the sums borrowed by the company.

    For this reason much of the financial analysis involved in underwriting a transaction will focus on the company’s ability to make timely interest and principal payments. The degree to which a company’s performance can decline while maintaining its debt obligations is an indication of safety. For example, if a company can continue to meet its debt obligations even if revenue declines by as much as 25% it might make investors more confident.

    To measure this flexibility, a company will be modeled under various scenarios with debt ratios for each projected period. This permits evaluating the business under a variety of different capital structures. On a most superficial basis, debt ratio analysis revolves around a comparison of liquidity or measure of profitability and the debt-related obligations of a company. The video linked in this newsletter starts by introducing the debt-to-EBITDA ratio.

    Debt Ratio Analysis


    FIXED CHARGE COVERAGE RATIO

    As the video demonstrates, however, EBITDA is not a good proxy for cash flow and the total debt balance fails to communicate what is required in each period to remain in compliance. The Fixed Charge Coverage Ratio (FCCR) is introduced as a solution to these shortcomings.

    The fixed charge coverage ratio is used to measure a company's ability to cover its "fixed charges" (largely debt-related payments but this can include additional obligations as you will see below) due in any given period. Below we will start with a simple visual and expand on this by including the definition a senior lender might use in a term sheet.

    The Fixed Charge Coverage Ratio gets more precise by subtracting additional uses of cash from EBITDA to get to a closer approximation of cash flow for the period. The logic behind subtracting capital expenditures instead of depreciation and amortization (the “DA” in EBITDA) is that capital expenditures are a cash outflow whereas D&A are noncash items. After that, cash taxes are subtracted to arrive at a better approximation of cash flow. Interest expense is not subtracted, but it can be found in the denominator (interest expense is one of the "fixed charges").

    Debt Ratio Analysis

    To elaborate on the denominator, rather than reference gross debt, this calculation looks at the actual cash required to remain in compliance in each period. Since you are more closely comparing the cash available for debt payments to the debt payments required in each period, a lender typically requires that this ratio remain above a minimum threshold of 1.2x.

    Example of what you might find in a senior debt term sheet:
    "Fixed Charge Coverage Ratio - Borrower shall not permit the ratio of (a) EBITDA minus the sum of (i) capital expenditures (excluding financed or equity funded capital expenditures), (ii) taxes, (iii) distributions, divided by (b) the sum of (i) cash interest expense and (ii) scheduled principal payments on total funded debt (including capital lease payments) to be less than 1.25x."
     
    Introduction to Private Equity Series:

     

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  • 115 01/26/2021

    This post is Part 2 of an introduction to private equity. In this video we will explore how leverage can both create and destroy value. To highlight the benefits and dangers of excessive leverage two examples are included below in both video and text format. The first was a wild win for investors in the early 80s, and the second a modern-day private equity horror story.

    Leverage Creates Value: 200x Return on Capital

    The acquisition of Gibson Greeting Cards Inc. (Gibson) is one of the best examples of using leverage to make money in private equity. In 1982 a private equity firm purchased Gibson, which, and this may not be a surprise, published greeting cards. The firm paid $80 million, but borrowed $79 million to make the acquisition. The transaction closed with only $1 million of equity invested, $660,000 of which was split between two of the partners of the firm.
     
    The private equity firm took the company public in a stock offering that valued it at $290 million sixteen months later. The two partners realized a return of 200 times their invested capital, turning an initial investment of $330,000 into $65 million each. This transaction instantly became legend and is credited as one of the variables that convinced Steve Schwarzman to pursue a career in private equity. 
     
    It should be noted that this amount of leverage would be difficult to secure today, but it is a tremendous example of how returns can be enhanced when an investment performs. The counter is what happens when leverage is aggressively applied in the wrong scenario.

    (Click on the image for a larger view.)
     

    Best Private Equity Transaction

    Leverage Destroys Value: 0x Return on Capital
     
    Private equity funds typically apply leverage to each portfolio company individually to diversify away from the risk that any single loss will affect the rest of the portfolio. Unfortunately, EnerVest Ltd., a $2 billion private-equity fund, learned first-hand the risks of applying leverage to a levered portfolio of investments. The fund used $1.3 billion of debt across the fund (beyond the leverage used in the investments themselves) to increase the amount of capital it could deploy in energy investments.
     
    Unfortunately, the fund had two variables with the capacity to affect all of its investments simultaneously: (1) the aforementioned debt, and (2) the price of oil. When the price of oil started to plummet in 2014 the firm began to realize losses that ultimately could not be sustained. Per an article in The Wall Street Journal, it may be the largest private equity fund loss to date: "Though private-equity investments regularly flop, industry consultants and fund investors say this situation could mark the first time that a fund larger than $1 billion has lost essentially all of its value." 

    Introduction to Private Equity Series:

     

    private equity training

 



  • 114 01/26/2021

    Most concisely, private equity is the business of acquiring assets with a combination of debt and equity. It is sufficiently simple in theory to be frequently compared to the process of taking out a mortgage to buy a home, but intentionally obfuscated in practice to communicate a mastery of complex financial science. When encountered, the latter should be thought of largely as a marketing effort. Vocabulary aside, the process is simple. Incredibly detailed and at times chaotic, but not the product of financial wizardry. 

    The Private Equity Training course will focus on the acquisition of operating businesses with a history of positive cash flow using the aforementioned combination of debt and equity. In an effort to get readers up to speed expeditiously, in this video (Part 1 of 4) we will cover a few basic concepts, including:
    1. Private Equity Defined
    2. Comparison of an LBO Model to a Three-Statement Model (please see video)
    3. The Benefits of Leverage

    The Benefits of Leverage: Debt + Equity

    The benefits of leverage are easily captured by comparing identical investments that differ only in the amount of leverage employed. If the value of the asset grows over time, the amount of leverage used to acquire the asset will enhance the amount by which shareholder value grows. Think about the two terms as follows: 

    Debt is borrowed money that earns interest until it is repaid. There are two components to debt payments: interest and principal. Interest is the rate charged by the bank to loan capital to a borrower, and the rate is determined by the amount of risk assumed. Principal payments, which are defined by an amortization schedule, are payments made to reduce the balance of the loan. The final payment, known as the “balloon” payment, coincides with the maturity of the loan. For so long as the investment performs, and principal and interest payments remain current, the remaining principal balance for interest bearing debt will remain fixed.  (This definition combines a lot of vocabulary. Future lessons will break this down to make concepts easier to grasp.)

    Equity, on the other hand represents ownership. It is the value available to shareholder’s after all debts have been paid. It follows that as an asset increases in value, so does shareholder’s equity. 

    Per the table below, in both the Equity Investment Case and the Levered Investment Case, the shareholders own 100% of the same asset even though $100 and $25 of equity was used respectively to purchase it. In year one both investments grow in value by 5%, but a 5% increase on a $100 investment acquired with $75 dollars of debt causes the equity value to grow by 20%, which compares nicely to 5% growth in the unlevered example. 

    How Private Equity Works

    (Note: Excel workbook available for download.)

    Note that the Value Change and the Cumulative Value Change are identical in both scenarios. The only variable contributing to the different return profiles is the amount of debt used to acquire the asset, which brings me to my next point. In this course we are exploring the acquisition of businesses with a history of positive cash flow. This cash flow can be used to further reduce the debt burden by paying it down over the course of the investment, which reduces interest expense and lowers the risk profile of the business. The terrific artistic rendering below, where E.V. stands for enterprise value, further demonstrates how this also benefits equity value.

    How Private Equity Works

    As these simple explanations might suggest, the limiting factor for the private equity industry was not ingenuity. It was the availability of capital. Private equity gained popularity quickly as debt became increasingly available to finance what had previously been considered too risky. The amount of debt available to finance an acquisition has fluctuated over time. In the 80s, easy money, which refers to lax lending standards, made outsized returns easier to achieve for the small number of private equity firms looking to benefit from this growing alternative investment trend. To highlight the benefits and dangers of excessive leverage two examples are included below. The first was a wild win for investors in the early 80s, and the second a modern-day private equity horror story. 

     
    Introduction to Private Equity Series:

     

    private equity training

 




 



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.