Service Management Field Trip – Thessaloniki

Yesterday marked the last day of in person contact with our project sponsors. They have sent us some preliminary information to analyze and signed off on the project scope and definition. All that remains now is for us to do our analysis and provide our report. That coupled with the completion of our individual assignments will tie up the end of this course.

Shown above: View of Aristotelous Square from the Orizontes rooftop restaurant in Electra Palace Hotel Thessaloniki.

This has been a unique experience, to hear from the mouths of people who live here their opinion on a very timely topic: globalization, competitiveness and the structure of a nation’s (Greece’s) economy. Our professors did a lecture on Monday talking about the characteristics of the Greek economy, breaking down GDP components and telling a story about Greece’s economic focus and structure over the past 5 years as a backdrop for the current conditions the country is facing. They also prescribed a logical recipe for what would be needed to turn the Greek economy around and the challenges involved. These sentiments were echoed by many of the project sponsors who participated as many of them were looking to boost their competitiveness and engage the other economies of the world.

Today, I’ll be spending most of my time wrapping up all remaining loose academic ends in the hope of leaving nothing unfinished for my return to Toronto.

Back in Thessaloniki

After taking some time to do a whirlwind tour of the Mediterranean, I’m back in Thessaloniki to finish my last class of the Exchange as well as my MBA program: Service Management field trip. I’ve met two of my group members as well as classmates from other teams as we did some basic exploring of the city’s waterfront.

Shown above: Thessaloniki waterfront at sundown.

We have our first official class today. We've already been in contact with our sponsor company and also have our first group meeting today as well as we meet face to face for the first time.

Tomorrow, we have an arranged city tour which I am looking forward to. Also, today is Palm Sunday, which marks the beginning of Holy Week in Greece which is a very important holiday with unique celebrations that I am looking forward to.

I am also in the process of completing my final project for Managing Corporate Turnarounds as my other team members have sent me their parts and I finish up the write up for our class.

After my class is done here on April 21st, there are a few days to spend before flying back to London on the 24th. My flight back to Toronto is the 26th. While I have really enjoyed my time here, I’m looking forward to going home, visiting my sister in New Orleans on the 27th (to drive back to Toronto).

I’ll be spending May studying for the CFA II exam after which I’ll also have the opportunity to visit friends and family in Australia in June and Malaysia (with a chance to climb Mt. Kinabalu and dive in Sipadan hopefully) in July before I return to Scotia Capital in August.

Cheerio!

Later tonight (or, more accurately, early tomorrow morning) I will be flying out of London for Thessaloniki, Greece for my last course: Service Management Field trip, a consulting based project where we work with local companies. While the class doesn’t start until the third week of April, I’ll be in Greece and surrounding countries travelling.

So I apologize in advance if there are few posts between now and then. But who knows? In the country that spawned famous philosophers and mathematicians, maybe there will be some inspiration. Plus, I still have a few small assignments to complete for MCT.

Being Made Whole in Bankruptcy

In our discussions in our Managing Corporate Turnarounds class during our financial restructuring session, I got to thinking about what it would take to be made whole in a bankruptcy scenario. While the hard math will tell you that it is impossible in the short term (EV = 80, Net Debt = 100), I began to think back to the PIK and using a high yield to restore value in the future. So my question became this: If I hold the debt of an insolvent company, what can I negotiate to help me restore value? The most obvious solution is to renegotiate the terms of my debt which will probably result in me taking a haircut (discount) on the principal or face value of my debt. However, we’ve acknowledged that in scenarios where people become riskier, obviously the company’s related securities should bear a higher return. So my question then evolved to: If I have to take a discount of X percent, what additional spread Y would I have to earn in order to be made whole in N years. It turns out:

FV x (1 + kd) ^ N = FV x (1 – X) x (1 + kd + Y) ^ N

However, this assumes that you can break even with (or more accurately, catch up to) where your security would have been if the company had not defaulted to begin with. After playing with these numbers, however, it was quite clear that even with a small discount (say 20% discount), the spread Y had to be astronomically (unreasonably) higher in order to have any chance of being made whole relative to the standard debt, so I thought it would be unrealistic not to include a factor which accounts for the value lost:

FV x (1 + kd) ^ N = FV x (1 – X) x (1 + kd + Y) ^ N + Value Lost

In trying to understand what these numbers mean, I looked at Value Lost / FV as a proxy for the default rate of this type of security in distress which is obviously closely tied to the actual economic circumstances of the company. In the graph, it is reflected by the distance between the Standard Debt curve and the PIK (Realistic) curve.

Also, Y can probably be determined by looking at the spread between similar bonds with different credit ratings (dropping from BBB to C for instance).

X is reflective of the economic scenario (so if EV was 80 and Net Debt was 100, X would be 20%). It is also reflective of the negotiations, as well as considering a discount in order to liquidate the current assets of the company.

Another problem is also that once a company switches from PIK to cash sweep, its risk profile drops and it stops earning high yields, dropping the return on capital and therefore making it impossible to “catch up”. Also, a bank which was happy to finance your debt will not be interested in converting neither into a mezzanine structure better suited for hedge funds nor into equity.

This model is similar to the VC model of predicting the failure rate using the discount rate except in reverse. It is also similar to the interest rate parity (IRP) model and boot strapping by using compounding to determine where you would have / should have been otherwise as a benchmark for where you are going.

I guess the real lesson is that bankruptcy is really expensive and that being made whole in this scenario is difficult, regardless of the financial engineering and patience, although these two factors can be used to ease the pain.

Managing Corporate Turnarounds - Part II

Wednesday

Often when things go wrong, people are inclined to fire the management. However, in the real world, things are hardly ever that simple. Firing management, like anything in turnarounds, is decided on whether or not this action will speed up or slow down the turnaround. Besides packages given to executives on exit, there is also a great deal of institutional knowledge that they take with them. There is a counter balance to understanding the value they bring through their experience versus the inertia they create against the changes required. This is particularly true in SMEs as well as family owned enterprises where the institutional knowledge is often not formalized (pricing mechanics, customer relationships etc.)

Also, with the separation of the chairman and CEO roles, it is possible that a power divide coupled with an inappropriate strategy may have smart people being told to chase bad strategies. One remedy which is often used is an immunity period: the idea that employees in a turnaround situation have a window of opportunity to identify any potential problems. This allows an honest analysis of problems without reprimand and realigns expectations (Are we going to make the numbers? Are our margins as good as we expect? Are we doing things right? Are we doing the right things?) Because a new team is put into place to fix previously created problems, it is not appropriate to assign current problems to new management. However, eventually, whether or not these issues were created by you initially you will inevitably begin to wear them if you don’t fix them soon enough or don’t manage expectations of the company and all stakeholders.

Thursday

Like in any business strategy, there are two major things to keep in mind in a restructuring: operations and financing. For operations, it is necessary to check if the overall business strategy works (are people buying your product and do you have a viable business) and if you are able to profitably deliver (are our margins good or are we chasing low quality customers). Also from a financing perspective, it is important to understand the liquidity constraints of the enterprise. For example, what is an appropriate financing structure to keep the company alive while providing adequate and appropriate protection and returns to current and new capital providers?

One such useful tool is the paid-in-kind (PIK) security. It is a type of mezzanine high yield debt that doesn’t pay a coupon. Typically, these types of securities return 14 to 17%. They return higher than senior debt because they are subordinated but they don’t require cash payments which allow the company to maintain its liquidity for short period of time when it’s heavily cash strapped. However, what usually happens is this is coupled with a cash sweep. To use a structure like this in this circumstance is tantamount to saying: “We understand you are strapped for cash now, so you don’t have to pay us immediately, but we want an appropriate return for taking this risk that’s more similar to equity if things recover. However, we still want to be paid sooner rather than later and when you have any excess cash, you will give us everything you have and we’ll consider you less risky and ratchet down your interest rate to reflect the change in risk.”

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.

Travelling in Europe

The bizarre truth is that it’s actually cheaper to visit other parts of Europe than it is to stay in London. With the end of the term (and MBA program) upon us, many students (exchange especially) are planning a variety of trips before the academic program is over.

(Shown above: Bull fight, La Plaza de Toros de Las Ventas, Madrid, Spain)

So far this week, I’ve been to Madrid, Spain and Bordeaux, France. I'm travelling with a few students from LBS and we are driving down the coast of the south of France and into northern Spain, visiting coastal towns as we make our way down and are currently San Sebastian, Spain. My French has been a bit rusty, but enough to decipher menus, make orders, ask directions and generally get around. It has been almost 5 years since my CFES days.

(Shown above: Chateau Margaux, Bordeaux, France)

(Shown below: San Sebastian, Spain)

Having visited Lisbon, Portugal and Rome, Italy there is only one other country I need to visit to collect my PIGS set: I plan on visiting Greece in early April for my final block week course: Service Management Field trip, a consulting project based in Thessaloniki, Greece.

I have always enjoyed Greek mythology, especially after reading the Odyssey in high school which was one of my favourite books of all time. I will certainly enjoy spending time in Athens visiting some of the ancient ruins. Greece is also home to many famous mathematicians and philosophers that derived such elegant concepts such as the approximation of pi or the golden ratio. I'm really looking forward to the trip.

Emerging Markets - China

We just completed our final presentation in the Emerging Markets class taught by Linda Yueh at LBS. Our group chose China, and we did a cross section of important business factors and how they affect investment decisions and mechanisms into the country. While the presentation was performed by myself and my classmate Tim, the other team members contributed greatly to the material and their preparation was reflective in the cohesive and comprehensive story we presented. It was easy to present the highly refined material to create an investment thesis branching across a broad range of industries and tell a story about how specific companies would benefit or be hindered by government regulations and financial market mechanisms.

Tim did a great job going into the details of the domestic business environment with some personal anecdotes from some of our team members’ recent trip to China. JEMBAs (aka January intake Executive MBAs) at LBS are required to a week intensive in a foreign country and three of our JEMBA team members visited China together.

I think we represented the hard work and analysis of our team well.

Planned Obsolescence

With the last week of the core 10 week period upon us at LBS, things have dramatically started to pick up. I have my final exam for Behavioural Finance on Thursday which promises to be challenging.

I've also got a final PEVC assignment due in-class tomorrow where our take home individual case will also be released. Also, tomorrow, I have a big presentation for Emerging Markets with the final group and individual papers due by the 18th.

What a roller coaster it's been, not just here but in the MBA program in general. It seems like not too long ago, I was stepping into Rotman for the first time. After taking a look back at this blog, I've realized how much I've enjoyed my time at Rotman. And with the end of the program so near, it's time to plan wrapping up of all the loose ends.

I have two more classes left, block week courses (one week intensives) which I'll be taking between now and the end of April. However, this provides me with ample opportunity to take advantage of the easy access to Europe and as such I'm planning trips with some of the fellow exchange students between now and when I leave. My last two classes are Managing Corporate Turnarounds (last week of March) and Service Management Field trip, a consulting project where our class will be in Greece (jokingly referred to as "exchange on exchange") which will be my final class of the MBA program.

I'll continue to blog as interesting ideas pop up in the last few classes and probably put up a few nice pictures from my travels, but I expect that I'll put up a final post around the end of April as I head back to Toronto.

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.

MAJUP

The past few weeks have been pretty busy with a variety of events. LBS hosted its first combined TMT conference with the technology and media club on Friday Feb 25th with speakers on topics such as new revenue streams for IPTV and the forecast for cloud computing. There was one particularly interesting speaker who equated using cloud computing to storing informational currency in a bank. While you appear to be giving up control in the form of a physical box hosted on site, the security and convenience of cloud computing is similar to withdrawing money from an ATM.

That weekend I had some friends from Barcelona visiting (they were going to pursue careers in the TMT space) and they also had the fortune to stay for Tattoo, a school wide celebration of cultural diversity with artistic and gastronomic displays. The entire school was set up with tents as students prepared food native to their homelands wearing traditional dress and putting on performances to display their artistic talents.

This past weekend was spent in Lisbon. With exams coming up, it was a good opportunity for the exchange students to have one big go at a trip before many of us run off at the end of the 10 week term period. Time seems to have flown by as we are already in March.

Weekends in London

The past few weekends in London have been interesting.

This past weekend the LBS International office hosted a London sightseeing event on a red double decker bus touring around to see the major sights: London bridge, tower bridge, London eye, Buckingham Palace, Big Ben, Parliament etc. The tour ended at the British Museum where we had lunch and a few of us went to check out the exhibits which include the famous Rosetta stone.

On Sunday, a few of the exchange students also went to see a Fulham football match at Craven College. We were sitting in the “Home/Neutral” section and it was a great match.


The weekend previous was the big Private Equity conference held by LBS on Friday with speakers from major firms like KKR, TPG and The Carlyle Group.

Another exchange student and I also ventured into Oxford to the Said Business School to attend the Enterprise Africa conference with various speakers on topics such as Private Equity, China and India's relationship with Africa etc. Speakers were from Goldman Sachs, Bank Of Maurituis, MTN and other top banks and industry representatives.

While there, we also had the opportunity to check out Christ Church, the place where the main hall of Hogwarts was filmed for Harry Potter.

Bid / Ask Curves

At the break in behavioural finance, I was speaking to a prop trader about the mechanics of the market. This reminded me of my short trading exercise in the Rotman Finance Lab with the Trading Simulation software.

In microeconomics, we discuss demand curves and how they are based on individuals with different levels of willingness to pay. So as the price increases due to a supply curve shift right (less supply), the quantity demanded decreases.

In markets, this is a little more transparent if you look at the bid / ask lists. These lists show the prices and volumes people are willing to buy and sell for. The other unique thing about the capital markets, is that there is actually a set number of securities (assuming that banks do not issue or buyback securities in the short term, supply is price inelastic based on total float) and that investors can be both buyers and sellers (short term suppliers and consumers) of securities. Actually, a better way to put it would be they can either hold or release securities (demand based relationship).

If their intrinsic value (IV) of a stock is above the current market price, they will buy the stock. If their IV is less than market, then they will sell. And in an exchange market, that is exactly the case (orders, unless removed before execution, are commitments to buy or sell at the stated price).

Shown here is an illustration of a “complete” market. This assumes that everyone’s IVs are included, that there are no hidden orders and that people’s opinions won’t change with the market price (a snapshot by nature). The current ask price is $8.00 and the bid is $7.75. As people’s sentiments change (or new investors are introduced into the market), orders to buy are satisfied at $8.00 and orders to sell are satisfied at $7.75. If all the potential sellers at $8.00 are taken up, then people can only buy the stock at $8.25 and the stock price goes up. Note that the differential between bid and ask is a proxy for market liquidity, as the lower the transaction fee to enter and exit a position the lower the cost of trading the security.

Also note that the steepness of the curve is a good proxy for potential volatility as well. Because if the slope of the curve is steep over a variety of prices, it means that the market doesn’t necessarily agree on the price. And if a few people cross the line from one side to another, the price can change quickly and dramatically (shown below):

Flight of Fancy - Market Price for Courses

So it turns out I’m not entirely crazy.

Obviously, one of the benefits of going on exchange is to meet new people and learn from new experiences. Previously, I had posted on a flight of fancy, where I wondered what would happen if we extended the idea of our bidding system at Rotman to the “next level”. Well it turns out that elective bidding at some other schools can be slightly more complicated.

Talking to some students at other MBA schools, they have more “progressive” (market driven, while not entirely "pure") bidding systems for courses, where you can actually buy and sell courses for a profit (expressed as a gain in “points”) where you bid for classes early and then “sell” them at a later date when their point value has increased.

The only short coming of their system (from a market perspective) is that there is only one form of “liquidity”. The only way to truly “exit” the market? Take a course. There is no other way to liquidate these points. This could easily be solved if you could simply transfer the points to another student (a secondary market would develop and even create an OTC market price in $$$'s for course points).

And then you would have a market answer for the question: “How much is the margin worth to take the elective course you want?”

Chinese New Year in London

xin nian kuai le; gong hai fat choi; selamat tahun cina baru

Earlier this week, a few of the exchange students at LBS went to celebrate Chinese New Year in typical fashion, over a splendid meal, in London’s “alternative” Chinatown near Queensway. While the lineup was fairly long (we ended up waiting for 45 minutes due to exceptionally high traffic volume), the service was otherwise very good and the meal was delicious.

Earlier that week, I was also lucky enough to catch a dragon dance show in London’s official Chinatown near Piccadilly Circus while buying some groceries.

Senatus Populus Que Romanus

Quando sei a Roma vai dove vanno i romani
"When in Rome do as the Romans do"

One of the benefits of doing exchange, particularly in Europe, is the ability to travel to new places, see new things and meet new people. This weekend I visited Rome flying on EasyJet from Gatwick. Thankfully, my teammate for Private Equity / Venture Capital was a good sport, agreeing to meet well in advance of an assignment due for next week to finish it as I would be incommunicado for the weekend.

I visited the Colosseum and the Roman forums where ancient ruins stretched across parks. Even the city itself was sprinkled with fountains, statues and monuments. It was impossible to travel for even a few meters without encountering a plethora of fountains, making it surprisingly difficult to navigate the entangled narrow streets using landmarks.

Like many travellers collecting stamps on our passports, I was hoping to get a stamp from the Vatican (afterall it is technically its own country, the smallest country in the world). However, despite the tall walls surrounding the city, there was no security or passport control. The Sistine chapel and St. Peter's Basillica were very serine and it was nice to just enjoy the solemnity and gravity of the place.

The trip itself was actually punctuated more with food and wine then tourism to be honest. It was nice to just relax somewhere enjoy copious amounts of "vino della casa", putting down several "brave soldiers", and generous portions of fresh pasta and risotto.

My only regret is pushing my return so late, arriving "home" to London on Tuesday afternoon with just enough time to shower and rush to class, a mistake I will not repeat on my next excursion.

Veni, vidi, vici

Intuitive Explanation of Bayes’ Rule

One of my favourite math identities is Bayes’ rule. It also occurs quite frequently in Behavioural Econ / Finance as well as integrative thinking because it is such a good (mathematically provable) example of flawed thinking and model construction.

But like any formula, if not understood at an intuitive level (aka memorizing the formula vs rebuilding it from scratch), applying the formula incorrectly will yield meaningless (and potentially misleading) results.

Bayes’ rule states:

P(A\B) = P(B\A) x P(A) / P(B)

On the surface, this formula seems to make no sense: “The probability of A given B is the probability of B given A multiplied by probability of A divided by probability of B.”

However, walking through step by step we first understand that:

P(A\B) = P(A Λ B) / P(B)

This makes sense. The probability of A happening given that B has happened is the area encompassed by A and B (gray) divided by the total universe of probabilities, B (red and gray), because we are told that B “has happened”.

So from here we can also understand that:

P(B\A) = P(A Λ B) / P(A)

Which is simply the same rationale as the one above. However, using algebra, we can see that:

P(A Λ B) = P(B\A) x P(A)

And combining the two formulas, we get the original:

P(A\B) = P(B\A) x P(A) / P(B)

Example provided in class:
Of patients entering a chest clinic:
Event A – Person has cancer
Event B – Person is a smoker

80% of people with cancer are smokers: P(A\B) = 80%

10% of patients have cancer: P(A) = 10%
50% of patients smoke: P(B) = 50%

If you knew someone was a smoker, what is the probability they have cancer?

Solution:

Most people would over estimate the number, due to various incongruities in the probabilities, namely because such a high percentage of patients with cancer are smokers at 80%.

However, the math shows us that P(B\A), the probability of finding cancer given that you know someone is a smoker is (80% x 10%)/50% or 16%. Although it is higher than the average of 10%, is still relatively unlikely that they have cancer relative to what most guesses anticipated.

You'll notice that the answer is heavily affected by the rarity (and relative elasticity) of event A, or the chance that someone has cancer to begin with.

Behavioural Finance and Bounded Rationality

Whether fortunately or unfortunately, human beings do not behave in perfectly economically rational ways which makes them very difficult to predict. Even with our most complex models accounting for a variety of different factors, there is a high degree of volatility not explained by our multifactor regressions and the models they produce.

Behavioural finance (along with it's fraternal twin, behavioural economics) aims to better understand how humans make decisions that are non-optimal in the strict finance / economics definition and don't comply with what academics would have us anticipate as expected behaviour.

While this course is particularly interesting, what did strike me as noteworthy was that a lot of the foundation material for this course is based on the same principals as integrative thinking taught in our FIT class. In fact, it seems as if we've been doing a review of FIT, focusing on how humans make errors in judgment and build sub-optimal mental models based on well documented shortcomings in how we think.

In fact, some of the examples used in the class are lifted from the exact same material presented to us in Q1 of our first year highlighting anchoring effects, neglecting regression to the mean, availability heuristic, rational probabilty assessments, hot hand and gamblers fallacy etc.

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.

Arrived in Britannia!

I've arrived and moved in to my flat which is right across the street from London Business School which is convenient. Apparently, we happen to be very close to some famous addresses on "Baker street":

We've met our exchange classmates from around the world and are slowly going around meeting the 400 students in each of the 2011 and 2012 classes. There are some impressive resumes and experiences of the small sample of people we've met so far.