Managing Corporate Turnarounds

This week, I’m taking a block week course (one week intensive following the 10 week standard course period) at LBS: Managing Corporate Turnarounds. So far this course has actually been really interesting, with us looking at business cases for salvaging distressed companies and learning about the mechanics and considerations of struggling businesses.

Unlike my undergraduate strategy course, which I nicknamed “doom and gloom” because the distressed companies in our cases never seemed to recover, this course talks about different cases that were successfully turned around using a variety of different techniques to improve operational efficiencies and use financial tools like LBOs to capture the upside.

We’ve also had great guest speakers come talk about their specific experiences and their perspective on different aspects of turning companies around (shedding assets for cash, improving operations, recovering debt, how to identify target companies etc.) One of our requirements in class is to summarize some key learnings from the class, and in a similar fashion to the Latin America study tour which had a similar component, I plan on using this blog to jot a few notes for me to recall later as I compile my thoughts:

Monday

In turning a company around, it is important to understand where control lies. Since equity is flirting with bankruptcy, it may lose control to the debt holders. Some debt investors may be holding “grenades”, the intent to liquidate their holdings ASAP when a trigger event happens (broken covenants, default etc), and may not be interested in salvaging the company, even if there is potential to recover equity value because they just want to unwind their positions.

Companies need to have good strategies when it comes to M&A, otherwise they can fall victim of a vicious cycle: accretive acquisitions increase EPS (albeit in an inorganic manner) and can give false impressions of growth, which could potentially boost the P/E multiple. A higher P/E multiple gives the company expensive equity which it can use as a better transaction currency for buying other companies (low P/E) and still be accretive. This is a vicious cycle if the M&A is not well integrated with substantial delivery of synergies and/or overpays for targets. This typically occurs in new industries where there are a limited number of potential buyers (targets with low P/Es as there is no other mechanism for exit) and the industry is consolidating into larger players (large strategic buyers displace financial buyers niche shopping).

Another version of the problem above is when companies which are asset-light use M&A as a backdoor for raising leverage. Services companies cannot raise leverage in a traditional manner because they have neither hard assets nor collateral to borrow against, so they can acquire companies which have higher leverage ratios to boost their own ratios. Also, this type of reckless acquisition can divert focus from the core business. In turning around companies which have fallen along this path, one of the immediate remedies is to spin off non-core assets for cash.

Tuesday

When you are on the buyside for any company (not just distressed companies for turnaround), it is important to have multiple targets in the pipe, not just for the more obvious negotiation leverage points, but to prevent yourself from getting too much deal heat over one deal and to avoid negotiating against yourself and your emotions.

Negotiating a transaction involves much more than a “price”. There are terms of payment, the structure of the compensation, workouts, milestones, terms and conditions. A price which is seemingly too high can be restructured to be paid out overtime so that the undiscounted amount remains the same, but the risk and cash outflows can be spread over a longer period with the appropriate covenants and milestones.

KKR at LBS - Socially Responsible Private Equity

Just now, we had the inaugural talk for the Socially Responsible Private Equity talk given by Ken Mehlman, KKR's Global Head of Public Affairs. He was the Chairman of the United States Republican Party, campaign manager for President George W. Bush's re-election campaign, and White House Political Director. He was also a classmate of Barack Obama at Harvard Law.

He gave a great talk on how social responsibility is integral to sustainability of a business, especially one with patient capital in PE. One point he made which I thought was particularly poignant seemed to echo the ideas of Integrative Thinking. He said that there are generally two common models with regards to social responsibility:

1. Corporate CSR – Where a company makes contributions to organizations outside of its operations that show it cares.
2. It focuses solely on strong operations and generating business returns to the bottom line without much consideration for social responsibility.

He mentioned that KKR takes a third approach, and that it integrates social responsibility not just at some abstract corporate or portfolio level, but right down to the alignment of its operations to produce. Examples of this would include involving a broader definition of stakeholders versus shareholders such as environmental agencies and unions in determining the best course of action for a company’s future operations and how it should be run.

Besides some of the insightful deal war stories, future PE trends and industry knowledge he shared, he also gave great advice on what he thought it took to be successful which was well received by the crowd.

There were a host of excellent questions asked by the crowd in the Q&A session as well as the cocktail reception following. I’m looking forward to the next event hosted by the PEVC club.

Bridge to Value

One graph I've seen which I thought was clever was a breakdown of change in EV. This brings together many other details I've learned about M&A, LBO's and transactions in general.

Previously, I mentioned a framework for PE deal success, but it is easy to cut into more detail if necessary and really define and put a mathematical value to "synergies".

For example: After a transaction, we've increased sales by 21%. How does that affect EV? Well on one hand, you've immediately realized a 21% increase in revenue. After you account for associated costs with that increase in revenue (ie. You've sold more widgets, but it still costs you money to make those widgets), what do your future growth prospects look like as a result of this new growth (ie. Should you trade at a higher multiple? Have you gone from "boring" to "exciting"? Or is it just general market conditions?)

Previously, you had:

Market Cap = $100
Shares outstanding = 100
Price per share = $1

Debt = $100 (@ 5%)
Excess Cash = 0

EV = $200

Revenue - $100
COGS - $40
GPM = $60

Op Ex - $20
EBITDA = $40

DA - $10
EBIT = $30

Interest = $5

Tax = 40%

NOPAT = $18
NI = $15

Therefore:

EPS = 15 cents

P/E = ($1/$0.15) = 6.67x

EV/EBITDA = ($200/$40) = 5.00x

Let's tell a story: The 21% increase comes from opening a new line of products. You are selling 10% more products by introducing a new product line and this new product line actually increases your revenue per unit (across the board) by 10% (110% x 110% = 121%). All margins are the same.

What should we do? Bring everything down to the EBITDA level:

Now:
Revenue - $121
COGS - $44 (10% more products at same costs)

GPM = $77

Op Ex - $22

EBITDA = $55

DA - $10
EBIT = $47

Interest = $5

Tax = 40%

NOPAT = $28.20
NI = $25.20

EPS = 25.20c

(Magic happens - Which we will explain shortly)

New Price per share = $1.80

Market Cap = $1.80 x 100 shares = $180
Debt = $100
EV = $280

P/E = ($1.80) / ($0.2520) = 7.14x
EV/EBITDA = ($280 / $55) = 5.09x

Analysis:
So a lot is going on. The price of the equity and the enterprise has changed, but how can we do a cross section such that we know exactly where all the value is being driven from?

How much of this value is because of leverage (hint, we didn't change amount of leverage)?
How much of this value is simply because we are operationally better?
How much of this value is because we have a "brighter future" (better growth prospects)?

Step 1: Value from leverage arbitrage:
No change = 0

Step 2: Value from "synergies":
Total EBITDA level changes: $40 to $55 or $15
At a multiple of 5.00x (previous multiple), value increased is $75

Step 3: Value from "Brighter future"
Brighter future (higher multiple) due to either market conditions or expected future growth:
$55 at 5.00x versus at 5.09x = $55 x (5.09 - 5.00x) = $5

Total value created: $75 + $5 = $80 (note total increase in value of EV / Market Cap)

Next step, look closer at Step 2:
Change of $40 to $55 is created by:
$21 in Revenue (Price +10%, Volume +10%)
$4 in COGS (Volume + 10%)
$2 in Opex (Volume +10%)

For a $21 increase in revenue, keeping margins constant we would have expected an increase of:
$8.4 in COGS (40% of revenue) and $4.2 in Opex (20% of revenue). COGS is lower by $4.4 and Opex is lower by $2.2 versus what is expected.

Note we mentioned we can sell products for 10% more across the board.
This created value for existing product base (at EBITDA level) of
$110 - $40 - $20 or $50 versus $40 creating $10 of additional EBITDA level value (makes sense, increase topline growth by 10% without changing expenses / sales volumes results in increase of EBITDA by 10% of revenue)

Also, selling an additional 10% at old price we would expect:
$10 (additional sales) - COGS ($4) - Opex ($2) or $4

But selling new products at new price: Gain $1 (similar to math shown above)

Total change in EBITDA: $10 + $4 + $1 = $15
At 5.00x
$55 or ($10 + $1) x 5.00x of EV is generated from selling at a higher price
$20 ($4 x 5.00x) of EV is generated from selling new products (higher volume)

Above is what the bridge would look like if a PE firm had 60% ownership and management had 40%.

Note, this framework is iterative and can be applied across multiple product lines to help do a break out and sum of the parts analysis for companies to see where value is hidden in undervalued divisions.

Also note that as an interesting aside, if you were actually to build out a proper DCF model of this (using some basic business assumptions holding margins constant etc.), your short term growth rate would have to be adjusted upwards in order to come to the same intrinsic valuation that would justify the higher multiple.

A Framework for Measuring PE Deal Success

The Analyst Exchange and Marquee group showed us how to build LBO models and the basic framework for showing how LBOs generate returns to private equity holders through 3 mechanisms:

1. Leverage arbitrage – Increasing leverage and paying down through cash sweeps
2. Operational arbitrage – Improving operations to generate higher earnings / EBITDA
3. Multiple arbitrage – Selling the company for a higher exit multiple

Of the three, the most meaningful method of generating returns is the second, operational arbitrage. Leverage arbitrage can generate returns, but is not a strategic differentiator when it comes to a bidding process (unless you have some unusual advantage in raising capital) and multiple arbitrage is simply based on market conditions. However, operational arbitrage is directly related to value creation and is the reason why a strategic buyer can afford to pay more than a financial one.

While this is useful notionally, how can we use this to build a framework to understand how each dimension performs in a deal? In my Private Equity and Venture Capital class, they proposed the following framework and example:

So the total gain in equity value is 78.9 (112.9 – 34.0)

1. Return from leverage arbitrage is actually negative because debt increased rather than decreased at -9.2 or (4 - 13.2) and contributes to the equity gain by -12% (-9.2 / 78.9).
2. Return from multiple expansion is 27.3 or (13 x (9.7 - 7.6)) and contributes 35% (28.6 / 78.9)
3. Return from operational improvement is 60.8 or (7.6 x (13 – 5)) and contributes 77%

Using this information, you can benchmark the deal against different performance metrics and determine if the deal generates equity gain simply because of leverage or multiple expansion versus creating value by improving operations.

Unlevered Beta

A quick recap:
Beta of a company is determined by a statistical regression of returns of a given security against returns of the market.

As a result, "beta" usually refers to a company's equity beta or observable beta. Using CAPM, we can calculate the expected cost of equity (ke) using:

ke = RFR + beta * ERP

Where ERP is Equity Risk Premium

So what is unlevered beta and why is it important?

Well, recall from CAPM that you can change a company's capital structure in order to add leverage to increase beta and thereby increase expected return of equity (with a company's cost of equity being the investors return on equity).

Unlevered beta tells you how much a company's industry is expected to return, regardless of the leverage employed by looking at the systematic risk of an industry regardless of the financing decisions. Theoretically, the unlevered beta should be constant across companies in an industry.

Why is this important? Here is one example. You are trying to determine the cost of equity (so you can determine WACC for DCF) of a new company in an industry. However, because it is a new company, there is no previous history in terms of what they can be expected to return relative to the market. So it is impossible to calculate its equity beta. So what can you do?

You can look at a variety of other companies in the space, unlever all their betas to get asset betas and average them (as they should be theoretically the same, but will most likely differ slightly) and then relever it to the new company’s capital structure to approximate its expected equity beta. Armed with its equity beta, you can calculate its cost of equity using CAPM.

While this is how it would work in theory, there are some major problems with this model, the most obvious being:

• How do you do “comps”? How do you define “a variety of companies in the space”, especially if few or none of the companies are exactly the same?
• CAPM has its own issues which make it a less than perfect model
• As a new company, they will probably not behave in the same manner as more mature companies in the space.

Here is an example:

There are four companies with different betas and leverage levels. By unlevering all the equity betas, you can have various approximations for what the asset beta should be. An average of all four gives you a decent approximation for the beta of the industry.


Now assume we have a new company in this space that will have a D/E of 50% at the same tax rate. We can use the leverage formula to calculate what the beta equity should be:

Equity Beta = Asset Beta * (1+(1-Tax)*D/E)

In this case, the equity beta would be approximately 1.3, which makes sense as it has a leverage between B and C and therefore should have an equity beta in between.

Defined Pension / Benefit Obligations

One of the interesting topics in the CFA Level II material is the mechanics for Defined Pension / Benefit Obligations. Previously, in the Rotman Finance I exam / CFA Level I material, I posted an example of the basic mechanics of how a pension plan would be valued (how much would be the PV of future benefit cash flows based on life expectancy and % of salary expectations and what rate of saving would be required to save the required FV to generate those future CF's).

However, if you notice, the "mechanics" of a pension plan are suspiciously similar to that of a bond. And that should come as no surprise. In the retirement or payout phase of retirement, it is as if the retiree is cashing out a fixed income investment (getting regular payments over time) or similar to amortizing a bond liability for the pension plan. However, when they are still "young and saving money" the pension plan is receiving regular payments overtime. The because the payments are regular and defined, they have all the characteristics of a bond.

This metaphor extends even further when you think about what the worker is doing. First a few contrasting scenarios:

Scenario 1: The worker makes a salary of $100k per year.

Scenario 2: The worker makes a salary of $70k per year, but has a defined benefit plan where the company contributes $30k per year into it.

In both of these scenarios the worker (assuming fair treatment) is being given the same value through salary (note also, the I/S in both scenarios reflects a $100k expense with regards to this worker... the only difference is that the $30k would be recognized as deferred wages or change in pension benefit non-cash expense on the CF/S).

However, let's take a closer look at that $30k. What is another way of looking at this? Well, another perspective is to say that the worker is deferring $30k of salary in the hope of future gain as realized through the defined pension benefit. In essence, the worker is loaning money to the company. Assuming that the DPO/DBO is as risk free as the company can guarantee (it is a contractual obligation) in terms of seniority of capital, this money actually ranks as quite senior (priority claim). This is a topic of particular interest with the recent financial crisis, especially as it related to Chrysler and it's recent financial trouble and relationship with the UAW / CAW.

This answers the next question: What is the appropriate discount rate for these funds? Well if you assume this obligation to be one of the most senior forms of claims against the company, it should have the most risk free rate the company can afford which is usually the same rating as it's highest quality bond.

This also raises an interesting point, if you were a lender or potential acquirer (through M&A or LBO) and you were analyzing a company with a defined benefit plan, would you consider the liability similar to debt? While it is not strictly a form of debt in the same way as a revolving credit facility, debenture, high yield bond, PIK or other, it noticably has many of the same characteristics (and is often modeled as a bond liability).

Tax Implications of Bankruptcy

One thing that I've always been fascinated with (and need to look into more) is mergers and acquisitions. However, in this environment of post-financial crisis recovery, the M&A environment is very different that what it was previously. Particularly, there was a good window recently of purchasing companies at a 50% off sale with equity prices so low if only you had the cash to do it.

One thing we discussed in financial modeling courses I've taken looks at modeling Tax Loss Carry Forwards (TLCF, Canadian) and Net Operating Loss (NOL, American).

As a financial acquirer (rather than a strategic acquirer), I wonder if there are any vulture funds which specialize in purchasing bankrupt companies if only to get their hands on their TLCF / NOLs. Obviously, there are some concerns, including the laws, regulations and transfer rules for obtaining these credits as well as what the capital structure of the acquiring company looks like. I'd imagine that the equity would be worthless (or trading like an option) and the debt would be trading for pennies on the dollar.

Especially with so many failed entrepreneurial ventures, there must be a sea of dead companies which should at least be as valuable as their potential tax credits. This could also potentially reduce the exit cost of early stage companies (for early investors to at least recoup the cost of the tax credits for all losses taken).

Having said that, would it be a potentially good idea to go out looking for strong companies to purchase distressed companies if only to utilize their tax credits? That is to say to purchase these companies only for their deferred tax assets. Or some other metric like break up value or price to book.

Jim De Wilde - Venture Capital

I recently signed up for a Venture Capital competition. I've been trying to find more opportunities to work with classmates. The PSO has made a good effort to mix up the groups we work in, Q1,2 Teams, Q3&4 Teams, 24h case comp and MarkStrat (to date). However, I was looking for more opportunities. I'm also doing the CIBC IB Comp and the Investment Challenge with different teammates. I came into this competition hoping to find an opportunity to work with some friends on something interesting.

It turns out this VC competition is a big deal, forcing you to "compete" for a spot in the competition before you can even participate by sending in an essay with all the profiles of your team members. Quite a few teams got cut also as the interest seems to be quite high. Our team was lucky enough to snag a spot and I turns out there are some ROCKSTAR teams in the competition.

Right now we are listening to a prep talk from a venture capitalist, Jim de Wilde. He comments that venture capital is not just capital applied to starting a profitable bowling alley. Jim de Wilde has a very specific definition of what constitutes a true definition: "Looking to create new value."

He took a look at Silicon Valley and how it is a prime example of how VC in Canada differs from VC in the US and is giving us the foundation for what perspective to take and how to think about the competition we are about to participate in.

[Operating] Working Capital - What's the Difference?

I was working with a buddy on a financial model recently and this came up as an issue. It's very confusing because Working Capital is defined by operating assets and liabilities (short term or current assets and liabilities) and it *seems* synonymous with Operating Working Capital, which it is not. First, the definitions:

Working Capital is defined as:
WC = CA - CL
CA - Current Assets
CL - Current Liabilities

However, when doing M&A or LBO's we aren't concerned with Working Capital as much as we are with Operating Working Capital. Why?

Cash and Short Term debt instruments are actually financing components and aren't actually included in Operating Working Capital (OWC). In an acquisition, the target firms capital structure is usually zeroed out (unless there is a debt roll over clause) and the capital structure used to purchase the company is plugged in (including good will, recognisable intangible assets etc).

So Operating Working capital has some adjustments:
OWC = CA - CL - Cash + Short Term Debt

It's the same idea as excess cash rather than cash in Enterprise Value.

Mubadala

[MEIST - Dubai -Abu Dhabi 1, 2, 3, 4 - Jordan]

One company which was paritcularly impressive on this trip was Mubadala (arabic for "Exchange"). They are owned by (and intimately related to) the government of Abu Dhabi (the directors on the board are also the same ministers in government), yet operate seperately in many important respects which makes them a good proxy for what is happening the Emirate in general. While related to the Abu Dhabi Investment Authority (ADIA) and the Abu Dhabi Investment Council (ADIC) as a government owned entity, Mubadala has a different mandate to undertake long term, capital intensive projects with the intent of making competitive market level returns while diversifying Abu Dhabi's economy.

It was best explained on our trip as a "PE firm with a soul" where they have what they call a double bottom line: Financial returns and social / strategic improvement (will the project increase jobs, generate intellectual property etc). They try to balance their projects on "the curve" - a production possibility curve where the axes are financial return of the project and social and systematic improvements in the economy (shown above).

Another interesting characteristic is that Mubadalah recently (this year) released it's financial statements publically which is surprising considering it's size, the fact that it is essentially a sovereign entity. Our speakers made a point to emphasize Mubadala's focus on three guiding principles: Transparency, Accountability and Corporate Governance.



Some of their projects include Masdar city, an ambitious project attempting to build the first carbon neutral city in the world. They also have partnerships with the Ferarri Group which has a strong investment team and partners up in ownership of companies such as Piaggio Aero. We were told Mubadala has a particular investing style in bringing in partners. In order to ensure that they behave in a manner that is "best in class" (not being complacent with it's wealth - they have the funds to wholy own companies, but bring in partners anyways), they bring in parters for a variety of reasons:

• To "test" projects as if they were capital constrained and to get an affirmation that their project is financially sound by bringing in external institutions
• Gain additional expertise of partners who participate in principal co-investing on projects
• Lay off risk - balance risk and reward
• Find the sweet spot between 'optimal' versus 'maximum' leverage

Because of the nature of Abu Dhabi (in a similar nature as Dubai) a large proportion of the workers are Expats (we have constantly heard about the 80/20 split, 80% expats and 20% locals). This creates an interesting challenge. How can you create industries, business models, infrastructure and (eventually) jobs to benefit the local Emirates while attracting the international talent to help develop the human capital to support it? As a result, some of their projects have a high degree of automation since there is relatively low population numbers and the locals are actually in "minority".


These two sisters, Dubai and Abu Dhabi, have been exceptional at putting up the infrastructure and buildings required as shown by the Burg Dubai / Khalifa (above). However, developing human capital takes longer with training, experience and opportunity. As a result, Mubadala has emphasized what they called the "C's": CA, CFA etc as education beyond the MBA which are required to succeed. They believe in this philosophy so much that they have a special CFA training program for their local Emirates which acts as an accelerated training program as a fast track to management positions. The locals write the CFA level I exam and those that pass advance in the program.

Venture Capital - Burn Rate

In preparing for our accounting exam (final exams for this quarter start next week with the rest of the university), I wanted to have a quick look at burn rate. One of the concepts taught in our class is cash flows of companies in different stages. An idea I wanted to look into a bit deeper was the idea of cash flows for start up companies.

Cash flow is the primary metric of financial health. For a start up company, there is a lot of money going out the door, but often little money coming in. Revenues are low or non-existant, R&D (and expenses in general) can often be high, and working capital and CAPEX are growing.

Although I've seen different "interpretations" of burn rate it is essentially an FCF which is negative. An operational definition is how much cash is going out the door excluding what is being replaced through financing activities (CFF). I would say that CFO less CAPEX is generally a good proxy of where burn rate is. The assumption is that other sources of cash flows (selling assets, raising cash through financing etc) are not guaranteed and also not sustainable.

The next important measure of financial health is the actual cash and equivalents account. Between the two values, burn rate and cash, you can approximate how long the company will survive without additional financing activities (cash / burn rate per quarter = approximate longevity in quarters).

The goal, of course, is the hockey stick shaped recovery: eventually investing enough to develop a revolutionary product or service that causes revenue and profits to go through the roof (and provided dramatic long term IRR).

Predicting Venture Cost of Capital with Failure Rate (or Visa Versa)

I just did a little more math and came up with an amazing (in my opinion) result.

Question: Can I use the failure rate to determine an appropriate cost of capital (or visa versa)?

Imagine our previous company, but let's simplify it:

Cash Flow: $10 (it doesn't matter - We'll see why shortly)
Regular discount rate: 8%
Venture discount rate: 20%
Failure Rate: ???

Let's look at a given cash flow in period (n) in isolation:

Well using Method 1 - Venture capital discounting @ 20%:
PV1 = $10 * (1 + g)^n / (1 + 20%)^n

Using Method 2 - Regular equity discounting @ 8%, but undetermined failure rate:
PV2 = $10 * (1 + g)^n * (1 - f)^n / (1 + 8%)^n

Note that PV1 = PV2 according to the law of one price.

Also note: for any given period, you can cancel the effect of:

• period because the failure and discount rate affect the PV in the same way,
• the value of the actual cash flow doesn't matter, and
• the growth factor

All of these factors cancel out algebraically.

So we now know that:
1 / (1.20) = (1 - f) / (1.08)

Solving for f = 10%

[Solution]

So we can see that there is a general relationship:

• ke, "normal" cost of equity
• kv, cost of venture capital
• f, failure rate

(1 + ke) / (1 + kv) = (1 - f)
f = 1 - [(1 + ke) / (1 + kv)]
f = (kv - ke) / (1 + kv)

Similarly:

kv = (ke + f) / (1 - f)

Why does Venture Capital Require High Returns?

Intuitively, we can understand how venture capital requires high discount rates because of the high potential of failure of ventures and speculative projects. However, I wanted to see if it was possible to build a model to describe and bridge the gap between "traditional" valuation modeling and modeling for venture capital firms. What do I mean? I wanted to price a theoretical company using two methods:

1. A traditional venture capital method which accounts for failure in the high discount rate.
2. A variation of a standard method which uses a lower discount rate, but uses probability to account for failure in the cash flow itself.

Company Details (Assumptions):

Next Year's Cash Flow per stock: $10
Super Normal Growth for 3 years: 15%
Perpetual Growth: 2%

Note - Raw Cash Flow Would be:

Year 1 2 3 4 5 (2% - Growth)

Raw Projected Cash Flows $10.00 $11.50 $13.23 $15.21 $15.51

Method 1: Typical Venture Capital Model

Use a high discount rate to account for the failure rate, but assume project will work.
Venture cost of capital (ke) = 20%

Using DCF, the value of the stock is:

Year 1 2 3 4 TV Price

Raw Projected Cash Flows $10.00 $11.50 $13.23 $15.21 $5.07
Method 1 (PV) $8.33 $7.99 $7.65 $7.33 $2.44 $33.75**

Method 2: New model using standard discount rates, but also accounting for possibility of failure (not collect cash flow).

Failure rate: 55% every year
Typical discount rate (ke): 8% (exclude effects of leverage - assume venure can't raise debt)

Year 1 2 3 4 TV Price

Method 2 (Undiscounted)* $10.00 $5.18 $2.68 $1.39 $23.56
Method 2 (PV) $9.26 $4.44 $2.13 $1.02 $17.32 $34.16**

* Cash flow in this method is calculated as Raw cash flow * (1 - Failure Rate)^(Years in Operation - 1) - Note this assumes the company's first year is guaranteed (Big assumption)

** The price is about the same (same ballpark) using both methods, which makes sense with the law of one price.

The difference between the two methods is that Method 1 accounts for the chance of failure in the high discount rate, but Method 2 accounts for the chance of failure as a probability of receiving the cash flow. The same concept would apply with junk / high yield bonds.

The point I'm trying to investigate is the idea that there is an intrinsic relationship (possibly even isomorphic in the same way Womack called Price isomorphic to yield with bonds) between a high required rate of return and high failure rate.

Rotman Finance Association - Building My Prep Team

It seems the most popular clubs feel like they can have their kick off meetings late on Friday afternoon and still get pack rooms. Which they did. The two undisputed heavy weight champions in terms of clubs interest are the Management Consulting Association (MCA) and the Rotman Finance Association (RFA), both of which held their kick off meetings on consecutive Friday afternoons. Last week was MCA, this week was RFA (today).

The info session was a good primer for those with little or no background in finance as well as an introduction to the upcoming events. They emphasized some key points (which I've been talking to some of the Club Executives about) in terms of how to prepare for what amount to the most competitive and desired jobs available to MBAs. The RFA Exec made a good point, essentially: "All the skills you need to interview for summer jobs, you won't learn until it's too late. You're on your own." There's just too much going on too fast. It's really up to you to take the initiative. Keep in mind that if you went to Ivey (One year program), you'd be facing the same challenges except you'd be worried about full time rather than internships.

I'm currently in the process of putting together a team of people who are interested in investment banking and high finance. I offering to teach them what I know (learned over the summer and through CFA) in exchange for having serious partners for preparation in the same way we're building a case interview / competition team for consulting. The Analyst Exchange was very good in prepping me to discuss and build valuation, consolidated financial statement modeling, leveraged buy outs, mergers and acquisitions.

My goal is two fold. In terms of what I'm offering to give, I hope my Rotman counterparts and I can improve our odds to boost our recruitment and offer batting average (the other side of the hiring batting average) which I promised as my speech for Rotman 1st Year rep.

More selfishly, I want to find a group of dedicated people who I can potentially draw upon as teammates for investment challenges and (in the future) network contacts.

"10 years from now when we've all reached our potential, I want you to tell your executive assistant to take my call when I'm looking to find partners interested in doing a deal." ~ Josh Wong, 2009

Informal Case Study Preparation Team

As I had mentioned before, we have a small but growing group of people preparing for case interviews at this early stage. While many people are focusing on the academic component of the MBA, those who are ahead are looking for opportunities to prepare for upcoming interviews. While I've often been critical of colleagues who need to "chill out" (sometimes doing work in advance is 'doubling work' rather than 'front loading', such as reading cases too far in advance), I think that those who are aware of the need to understand case preparation earlier rather than later are getting a distinct advantage. For those with little experience in this area, there is always the initial shock value when they realize that case interviews can become very complicated very quickly.

I've been nominated to 'chair' our little informal group as I've had the good fortune of doing case preparation over the recent past and I've been building a list of skills which most people are not aware of as being important for case interviews.

There will be a meeting with the Management Consulting Association (MCA) today to talk about what the club can offer us. They are one of the most expensive clubs on campus, second only to the Rotman Finance Association (I am a member of both). As I have a keen interest in Private Equity and Advisory services (such as M&A or restructuring), I have to decide if I will take the investment banking route or the management consulting route to get to where I want to go.

Analyst Exchange Financial Modeling

For those of you who don't already know, I'm currently in NYC and have recently finished my financial modeling course with the Analyst Exchange.

While taking an Engineering and Management degree exposed me to all the core business courses (finance, accounting, marketing, HR etc) and the CFA focused even more so on finance, it was refreshing and confidence inspiring to be able to take a class where the principles we learn move us away from the strictly academic and theoretical into the real and practical.

I'd recommend this program to anyone who was interested in making active use of their finance knowledge and who wanted to have an edge making their entrance into the world of finance.

As I'm quite happy with my experience, I thought I'd pass it along for anyone else who was looking into similar training programs.

[DISCLAIMER] This advertisement was unsolicited and non-compensated.

Nothing Lasts Forever, Perpetuities and Terminal Values

I've done a review previously of geometric sequences and series, as a prelude for explaining perpetuities (the DDM is a form of growing perpetuity to determine a price in today's dollars).

I'll probably be doing a lot of valuation modeling at my equities research position over the next two months, so I though I would posts some thoughts on the techniques and methods regarding the basics of modeling (with my posts becoming more sophisticated as I become more sophisticated).

Technically speaking, a stock is a form of perpetuity (with the incremental value as the earnings per share). Most models assume that the company will exist forever and discount the earnings flows to come up with a price for the asset. In the current climate of bankruptcies, anyone would be naive to believe this is the case any more (if it ever was).

However, in private equity this isn't always the case (in fact it often isn't), as firms will buy undervalued companies (or companies in which they plan on making management or strategy changes) in an attempt to flip the company (buy it, fix it up and sell it) for higher exit multiples.

In modeling, there are different reasons for creating terminal values. It simplifies the valuation process (rather than calculating 10 more years of earnings growth estimates, you can boil it down to one number to represent the value of the earnings of the remaining years) or if you plan on selling the company, you can model a target exit price.

Price to Cashflow (or Proxies) - NPV and DCF

I think one of the most intuitive measures of value is cash flow in. The only problem with this valuation technique is that cash flow can often be erratic and unpredictable.

EBITDA can often be used as a proxy for cash flow either free cash flow to firm or free cash flow to equity (FCFF or FCFE). This is because managers can influence depreciation and amortization (which in turn affect income and therefore taxes). A normal EBITDA multiplier (enterprise multiple) to determine price is usually in the range of 3 to 7x. That means if your EBITDA is $50M per year, you might consider paying between $150M to $350M to acquire the asset (depending on various factors).

Enterprise Value = EBITDA x enterprise multiplier

In fact, it is these 'various factors' that I think warrant a closer look. After all, what would justify a higher multiplier for companies with identical EBITDA profiles?

I submit that your enterprise multiple is affected by different premiums. The top two that come to mind are business risk and liquidity. If the asset you are looking resides in an industry that generates cash flows irregularly or with a high degree of volatility (unpredictability) then you would expect the enterprise multiplier to drop (to compensate investors purchasing the asset with higher returns in the event of good cash flows).

Also, liquidty would be a factor regarding how well EBITDA acts as a proxy for real cash flow. This metric is much harder to quantify as it describes the reason why EBITDA is used as a proxy to begin with (probably because more accurate information is unavailable).

However, like any asset valuation technique, prices ranging beyond the standard range could be indicative of a few key points. Having assessed an asset's enterprise value being significantly below your EBITDA x enterprise multiple could indicate that the asset is currently undervalued. Conversely, being significantly above your EBITDA value implies that the asset is overvalued.

EBITDA is particularly valuable in M&A scenarios for private equity where public market prices do not exist. The black magic of this valuation technique is accurately projecting EBITDA into the future to determine the NPV using DCF. Particularly when modeling the life of an acquisition, enterprise multipliers can be applied to the terminal year of an asset (with appropriate assumptions) to determine the future exit price of an investment vehicle so an appropriate purchase price can be proposed using DCF.

Vulture Funds and Angel Investors... Similarities?

Looking into the mirror to see your true reflection. I've been watching the news lately about the bad rep that short sellers have been getting in the market. They are perceived as being ruthless profiteers who will cut throats in order to make a buck. While there is a lot of justification for this view by the media, I would like to make the case for efficient markets and perhaps putting short sellers and other seemingly "evil" profiteers (such as vulture funds) in a unique light.

The first complaint about our market crash was that we should have seen it coming. PE ratios were high, LBOs were progressively looking less attractive (but still being done). All the signs were pointing to the market being generally overbought (too much money chasing too few investment opportunities). While most people agree that bubbles were forming, no one was willing to really do anything about it. Except, that is, the short sellers.

Short sellers are blamed with the precipitous decline of the market. By betting against the highly valued stocks, they are blamed with triggering the stop loss sales of equity associated with the rapid decline in price. Although I don't doubt short selling triggered the decline, I would also emphasize that they put themselves in a position of great risk. After all, no position in the stock market comes free, and a short position is decidedly not "group think" in the stock market, the giant positive reinforcement machine as described by Jim Chanos in Hedge Hunters. It is notable Chanos' short biased firm was among those asking the right questions which highlighted the accounting irregularities (and eventual fraud) at Enron. However, the real cause of the precipitous decline in equity prices is the automated stop loss sales.

Stop loss sales are limit orders placed on stocks by traders who essentially say this: "If the stock drops below a certain price, I want to sell of my position to prevent further losses". If I own 100 shares at $20, I want to sell it if it goes to $10 to recover $1,000, rather than lose all of it if it drops to $0. It is an automated stop gap measure to prevent total loss. However, look at the underlying logic: "I understand that there is a possibility that what I'm holding isn't worth even $10."

While incredibly oversimplified, this fundamental doubt acknowledges the distinct possibility that the stock is overvalued.

For those who said that the stock market was overvalued in 2007 / 2008 and that this crash is a "reckoning of careless and risky capitalist pursue of profits", the correction of such an oversight would be to bet against the market (ironically, also framed as a "risky capitalist pursuit of profits" but in the opposite direction).

I don't feel it is entirely fair for those who complain about the market being over valued to also complain about those who agree and are willing to put their money where their mouths are (by positioning themselves in a risky position against the consensus of everlasting growth).

Having said that, is it entirely fair that some companies crashed, reaching a point where they are utterly distressed? Again, in an efficient market, I would say yes and no. A company that has crashed beyond it's intrinsic value immediately becomes a target for a vulture fund. If it's equity is depressed because of overselling by emotionally panicked investors, I think this is a golden opportunity for vulture funds to step in and pick up cheap investments with the intent of saving the company.

The risk profiles of vulture funds and angel investors (venture capital) is surprisingly similar (except that I would assume vultures to be assuming more risk... The momentum is in the wrong direction). I would even go so far as to say that vulture funds are the last chance before the capitalism hell of bankruptcy (as Elizabeth Warren describes on the Daily Show: "Capitalism without bankruptcy is like Christianity without hell"). Metaphysically, I suppose a logical question to this analogy is are you selling your soul to the devil or seeking divine redemption as your escape?

This means that if a company is worth saving, even malicious intent by unscrupulous traders should be offset by intelligent analysts who can see value and pick up depressed stock prices (to the loss and chagrin of the "evil" short sellers). This is directly similar to my previous post about the mechanics of sales and trading. In an efficient market, even those who want to cheat should (and would likely) get burned.

In an ideal scenario, if companies became TOO distressed and all their financial vehicles (bonds, mezz, equity) became overly depressed, if the company could still be saved (good fundamental business model), this is a textbook example of how investors could come in, acquire a controlling share of the company and turn it around.

Yes, concessions and covenants have to be made, but without the assistance of vulture funds providing additional financing, the companies are about to go bankrupt anyways. The mechanics of short selling and vulture funds are simply investment and trading mechanisms, and like any technology can be used for "good" or "evil". However, I think it would be a error to generalize and mistake the white knight for the dragon.

CPPIB picks up its socks and gets vindication

The Canadian Pension Plan Investment Board (CPPIB) has had some unfortunate luck when it came to making acquisitions. They were constantly outbid by rivals who applied higher levels of leverage to out bid them in LBO's. But we all know how that story ends for many of the firms out there who had too much leverage and now find themselves in deep trouble.

Well now might be CPPIB's vindication, as they start to pick up heavily discounted acquisitions which passed them by the first time around. The article cites the deal to acquire Macquarie Communications Infrastructure as a case in point. While Macquarie had gotten the better of CPPIB at the time, it appears that the tables have turned: even though CPPIB's bid assumes a relatively low valuation, it is still endorsed by the Macquarie board. While investors may reject the offer, a better question is: "Who do you expect to step in to up the price?"

I guess there is some truth in the old adage that some of the best deals are the ones that aren't made.

Timing is everything it seems and, as I've been reiterating, the PE winners in today's markets are the ones who don't have to liquidate prematurely (taking unexpected losses) and who have cash to make purchases (to realize future gains).