Private Equity Valuation: Academia vs. Reality

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of best but Never Final. Hi, I'm Lloyd Metz, joined by Doug McCormick and Sean Moon. Together we'll navigate the corridors of private equity, revealing the uncommon knowledge, challenges, successes, and lessons that drive the world of private equity and business forward.

[00:00:30] Let's go.

[00:00:37] Sean Mooney: It is awesome to be back with Lloyd and Doug. Doug and Lloyd. How are you guys?

[00:00:42] Doug McCormick: Good.

[00:00:43] Lloyd Metz: Good, Sean. Good to see you guys. Hey Doug.

[00:00:45] Doug McCormick: How you doing Lloyd?

[00:00:46] Lloyd Metz: Doing good. Doing good. What's on deck for today? Sean? What are we talking about?

[00:00:50] Sean Mooney: We got a good one here. We are gonna talk about the difference between academia and reality, between truth and fiction, between how academics value companies, and how the PE pros do it, right?

[00:01:05] Lloyd Metz: Wow, that's a good one.

[00:01:07] Doug McCormick: I think we'll talk about how PE pros do it. I don't know if we're gonna talk about how PE Pros do it, right?

[00:01:11] Sean Mooney: Every time I did it, it was right.

[00:01:16] The ways I got to that number were never with reasons I thought they would though.

[00:01:21] Doug McCormick: You know that old saying two kinds of models, lucky and lousy, they are always wrong. It's just a quantum of wrong and how you got there.

[00:01:30] Sean Mooney: So why don't we do this to get into this conversation. Let's talk about how the academics do it.

[00:01:38] And for the toss up here, what I want to ask you is like what were each of your grade points coming out of business school? To see who actually knows what the academic approach is better. Okay. 1, 2, 3.

[00:01:48] Lloyd Metz: Doug, you got this one

[00:01:50] Sean Mooney: Front row, Doug, as he was known back in business school.

[00:01:53] Doug McCormick: Awesome. I'll take it. I'll take it.

[00:01:56] Hey Lloyd, thanks for that man. I appreciate you nominating.

[00:01:59] Lloyd Metz: Hey, you're welcome.

[00:02:00] Doug McCormick: So I'm on the hot seat to talk about how academics do valuation work. Is that what I'm hearing?

[00:02:05] Sean Mooney: Yeah. How do they, how do they teach in business school? This is how you value a company.

[00:02:09] Doug McCormick: The most common approach. That academia braces is discounted cashflow analysis.

[00:02:14] There's a pretty common belief that there are like three fundamental pillars of valuation. So one is the discounted cashflow analysis. The second is public market comparables, and the third is kind of comparable transactions. What are we seen in the marketplace? Comparables differ from public comps in the context of they're often private marks.

[00:02:32] They don't have to be, they reflect what someone's willing to pay for control. And there are a discreet point in time versus being able to look at the Publix over time and just to maybe just put a little more meat on the bone with discounted cash flows. Obviously that is an attempt at forecasting what the business is gonna do over generally a five year period.

[00:02:53] And we can talk about the challenges or inadequacies of that. And then lots of assumptions around what the cost of capital is, what the balance sheet looks like, and ultimately. What cash flows are generated from that business over the forecasted period. So those are really the three key metrics that people think about.

[00:03:11] And then usually use some combination of those to triangulate around a common belief, if you will. Lemme just stop there. Questions, reactions to the description before we beat it up and, and tell you why those are no good.

[00:03:26] Lloyd Metz: I don't know if they're like no good, but I think you characterize it the right way.

[00:03:30] Those are the three main pillars and. With the DCF, it is a good exercise, and I guess we'll talk about it some more later, but developing those assumptions that drive the revenues, that drive the cost structure, that drive the operating cash flows, the assumptions behind CapEx, the assumptions behind the networking capital and the asset intensity of the business.

[00:03:55] Those are good things to think about and be mindful of for sure. I think one of the bigger things that you learn as you come out of business school and get into the real world is that it's not just one output answer, right? There's a range around your assumptions. It's not a super precise exercise, right?

[00:04:14] This valuation, you have a range of growth rates. You have a range of assumptions around receivable days or payable days. So you put ranges around all of those things and you kind of. Sketch out an area of valuations, I think when you play around with it. But that exercise is useful to develop a better sense for what drives value and the bigger piece than you probably remember these days.

[00:04:40] Doug, terminal value in that. DCF is a big driver for a lot of companies.

[00:04:46] Doug McCormick: I think actually mathematically for all companies in a five year discounted cash flow model, I think something like 75% of the answer is the terminal value assumption. So it's always way backend loaded. First of all, Lynn, I agree with you that the process of building the DCF model, I think is excellent because it forces you to explicitly wrestle with the assumptions that are gonna drive success or failure in the investment case.

[00:05:11] So I love the discipline of it. The shortcomings are in how it's used and how you like derive value from it.

[00:05:18] Lloyd Metz: That's right.

[00:05:19] Doug McCormick: To transition. Let's talk a little bit about the shortcomings of each of these three. And that'll help us also talk about the positive things. So I think the shortcoming of the DCF in my mind is the long dated nature of the assumptions and the accuracy or the precision that you can forecast that far into the future.

[00:05:39] That creates a challenge versus, I candidly think most investors are much more simplistic about what's the financial performance today? And if I capitalize that as a multiple cash flow, I think that. It's generally much more of a reflection of like where the market is than someone's ability to underwrite long dated forecasting.

[00:05:58] The two big, other big negatives for me are the terminal value assumptions are pretty academic based on cost of capital. You can do much better by looking at other precedents in the marketplace or how you think about exit and the overall cost of capital assumption, how people think about weighted average cost of capital and tax affected weighted average cost of capital.

[00:06:19] Versus saying, I know the market will lend three times leverage or four times leverage. I know that interest rate's gonna be 10% and I really care about my equity return, not my discounted cash flow based on some weighted average cost of capital. So anyways, I think we talked about the positives of the DCF.

[00:06:39] I kind of gave you some of my views on the challenges of making it practically useful. I'll stop there for a reaction.

[00:06:46] Lloyd Metz: Yeah, it sounds like Doug. Your last piece that you mentioned is you're describing a, sounds like a leveraged buyout model as sort of a fourth. I don't know if it's a pillar, but it's a fourth approach to thinking about valuation.

[00:06:59] Yeah.

[00:07:00] Doug McCormick: Yeah. And I would say to me, that's probably the one that is most interesting and relevant and in many ways is kind of a, to me, the best of all worlds, because you're often using precedents or comparables to think about terminal value, but you're using a real world capital structure with a real world interest rate that's knowable today.

[00:07:17] And as the equity guy, I care more about like theoretical risk and theoretical optimal capital structure based on a bunch of comps that are imperfect versus what I believe the market will bear today.

[00:07:31] Sean Mooney: And what I would say is, maybe before we get into that, 'cause I think that's exactly where we're going, is why this is used in some of the shortcomings, right?

[00:07:37] And so I think all of us were investment banking analysts, right? And the first thing they do is teach you how to do market comps. Which was a much more cumbersome exercise back in our days. Right. You're like getting CDs and printing out 10 Ks and Qs and like highlighters and finding things and then some VP would knock you on the head because you had a typo or like all of that's pretty much automated now.

[00:08:02] Right? The comparable transactions were pretty good problem with both of those, right? Is they're historical and they're not always very good at like, they're not very comparable. The thing that I had on the DCF you like as an investment banking analyst, when they teach you how to value a company for their purposes, it's really about what do they think is a broad range that a market will value something.

[00:08:22] And so they use like market costs of debt, market costs of equity, pretty high level assumptions on the future. And then they'll spit that back to their client and say, here's what the company is, because we don't care what an individual thinks about it. We care what the market in total will think about it.

[00:08:40] And so it flies at a much higher level and it gives a much broader range. And I remember. The second I came from investment banking into pe I was ready to show my DCF skills and he immediately is like, Ted, what are you doing? Like, get that outta here kid. Like what? No. Lemme show you how I unle and rele beta and we will not bore our audience on that.

[00:09:02] You can Google that or, or chat btia. But there's, there's this, all this thing to kind of like remove bias and do all this theoretical mumbo jumbo. And some of the stories that we would talk about when I was going through business school and they were teaching all this stuff. I happened to have been, at that point, I was already a vice president at a private equity firm, and I was going to business school because the private equity firm was paying for it.

[00:09:21] And they said I needed a credential. And so I said, great, I'll take a free MBA. And so the big story was like I know exactly how it's done, and my group was, four of us We're all like overworked. We got day jobs. We're doing this full-time curriculum, and we're all kind of like, we help where we can, we're in the finance class and they go, okay, you're gonna value a company.

[00:09:44] That was like a real buyout transaction. I go, I'm like, team, I got this. I'm just gonna just get this thing knocked out. It's gonna be awesome. I officially don't have to do the next three projects 'cause I'm gonna do the whole thing myself. And they're like, yeah, that's awesome. And so I take it and I just do the whole thing.

[00:10:02] I actually call the actual bankers that were involved and like get all the thing done. Like the real life set. We get our grade back and it's a c. What, what, because I used all the real world stuff and I was like, what? What are you talking about? I go to the professor's like, well, you did not bring earnings into steady state.

[00:10:21] You didn't lever and un lever your betas, and your capital structure was not the same. I was like, this is exactly how I, like, I saw this deal. This is how, exactly. How it was valued. Seriously. Needs to say. The group was so pissed at me.

[00:10:38] So why is that different? It makes sense. Like you buy a company based on the future. You look at what other people are paying for stuff, either in the public markets or like historically. Why did I get a C on that and why should I have really gotten an A?

[00:10:53] Lloyd Metz: You bring up an interesting point with the story, which clearly left an impression and maybe a bruise or a mark still upset about this.

[00:11:00] You're still upset about it. There's a couple of things, right? So we're talking about valuation, and I think we mean in the context of pursuing an investment, a company you wanna own and buy. Arguably that's different than a more academic quote unquote, valuation of a business as if you were conducting your quarterly portfolio valuation, right?

[00:11:24] Where you would use those three pillars that Doug laid out and then. Apply some judgment as to how you weight them to say, our portfolio investment is worth X, Y, or Z. In which case you do use all three of those, the public comps, the m and a comps, the DCF, maybe an LBO model, and then decide how you wanna weight those four elements to come up with a valuation.

[00:11:49] But I think we're talking about how do you value a business that you wanna own, that you want to go buy, right. The DCF is helpful, gives good guidance, but ultimately you have to figure out what is the current market for this business that you want to own. And so you gotta go talk to bankers. You run your own LBO model, which has assumptions like a DCF as well, depending on the size of the business and the nature of the business, the industry it's in.

[00:12:20] There may be relevant public comparables often not. So a lot of it does depend on the m and a multiples m and a transactions that have been in the space, and you tend to wait the more recent ones, more than some of the older ones. And ultimately that takes a lot of, like you did in your class, you call bankers, you call other private equity sponsors and their data sets out there that you can subscribe to, but that's often.

[00:12:53] Where you get the most input into your decision on, okay, what am I willing to pay? What is this thing worth? What am I willing to pay? That's kind of how it really happens, right?

[00:13:06] Sean Mooney: This episode is brought to you today by HCI Equity Partners, a lower middle market private equity firm, focused on partnering with family and founder owned manufacturing service and distribution companies.

[00:13:19] ICV partner. An innovative private equity firm supporting management teams of leading companies at the lower end of the middle market and BluWave, the Business Builders Network connecting the most proactive business builders in the world with the best of the best service providers for critical variable, on point and on time due diligence and value creation needs.

[00:13:40] Now back to the episode.

[00:13:44] Let's dig into the LBO part of it because I think that's really where we're going here. What is A-L-B-O-A-K-A leverage buyout model? How is it similar to A DCF and how is it different?

[00:13:56] Lloyd Metz: So, with the LBO model, different than the DCF in, in some respects, your valuation answer is gonna be driven by the debt capacity that those set of projections can support, and that debt capacity is heavily influenced by the current market terms of debt in the moment.

[00:14:18] So you can have the same underlying set of projections around a business. If you are in a credit tight environment where leverage levels are maxing out at four times and debt is 10, 11% and there's a fixed charge covenant that you need to adhere to, you're gonna get a very different valuation. IE lower than if it's a.

[00:14:42] Wide open risk seeking credit environment where folks will go to five or five and a half or six times leverage, and there is no fixed charge. Covenant and interest rates are 5%, 6%. You get a very different valuation answer simply because of the credit terms. So to me, that's the biggest difference between A LBO model and a traditional DCF That answers heavily.

[00:15:12] Driven by driven credit terms and credit availability that you assume in the model.

[00:15:17] Sean Mooney: So like on your DCF, you're gonna say, here are like the market capitalizations, here's what the market cost of debt is, and you're gonna look at a bunch of public companies and see what they pay for debt. On average, you're gonna look at the cost of equity through some very kind of theoretical calculation, and then you're gonna take all those balance sheet and cash flow statement and discount the cash flows back to get to like a current value, right?

[00:15:40] Lloyd Metz: Correct.

[00:15:41] Sean Mooney: But your LBO model, what you're saying here is you're gonna still do your income statement and your balance sheet, your cash flow, but you're gonna overlay very specifically the capital structure that you know you can get and use without breaking the business based upon actual conversations with lenders in the marketplace.

[00:15:59] Lloyd Metz: Yeah, exactly. Doug mentioned it earlier, the real world capital structure today that's available, that's one of the bigger. Differences, I think between the answer you get from A DCF and the answer you get from an LBO.

[00:16:14] Doug McCormick: Yeah, and and least a small byproduct, but obviously that changes like A DCF is using this optimal capital structure, which implies a certain effective tax rate.

[00:16:25] The LBO given more leverage, more interest expense, has a different kind of tax shield benefit. And then just the other one that's a little bit different is often in a. An LBO, you're gonna pick a terminal value exit multiple. And in A DCF, you may do that, but you also may do like a cashflow perpetuity growth rate calculation.

[00:16:47] And personally I think that's skewed toward more academia as well. So I think like using a kind of expected multiple of cash flow is a more market based approach. So in general, basically I think it's like the LBO model is a more market-based approach where you have more inputs that reflect the way you will manage the business versus what the market would say is theoretically the norm.

[00:17:11] Sean Mooney: And I think you highlighted again, one of the key issues with both, whether it's a DCF or an LBO model, is that. Most of the value on your projection comes five years out when you have the least conviction least information, and you're taking the biggest flyer on what's the exit multiple gonna look like in a very far away time in a galaxy far, far away with a business that's gonna be fundamentally different.

[00:17:34] Right? And so you're like, yeah, I guess you, you end up being kind of triangulating, well, here's gonna be our entrance to multiple. And then you say, well, this is probably our exit multiple.

[00:17:42] Lloyd Metz: And to that point, Sean, a lot of private equity firms just make an assumption. No multiple expansion. Your purchase multiple and your exit multiple are the same, or in the last few years.

[00:17:54] Some people will say, well, you may have higher interest rates in the future over the next five years, so take your exit multiple down a turn or bump it up a turn. It depends on people's points of view, but you can play with that more directly in an LBO model where it's a little bit more straightforward than a DCF and all that.

[00:18:14] Assumptions that are baked into your discount rate, your weighted average cost of capital.

[00:18:19] Doug McCormick: Yeah. So I think this is a entry point into a really interesting conversation about where in the private equity market are we talking. I would create the general analogy, and this is not perfect, but the larger cap you go, the more you are an investor, the smaller cap you go, the more I think you are a business builder.

[00:18:39] And that has some really interesting implications in the context of modeling. So for example, for us. When we're making investment decisions, if I don't see multiple arbitrage, I probably am not gonna be interested in doing that deal. And I'm willing to bet on multiple arbitrage to my benefit because I intend to do things to the business that will make it infinitely more saleable and a better, more skilled business.

[00:19:01] And so I think that's where the market's really matured over time is people willing to bet on what you can do with an asset versus assessing what it's worth in a steady state

[00:19:11] Sean Mooney: kind of assumption. I think that's a great segue here. Let's talk about what goes into these models and maybe to set the stage, there's gonna be essentially a projection that you feed into the model at a very high level.

[00:19:24] You're going to have an income statement, which is the revenues, the cost of good, sold, the operating expenses, the taxes you pay. You're gonna have a balance sheet, which has your receivables, your expenses, your payables, your property, plant and equipment. And then you have a cashflow statement, which essentially bridges the two.

[00:19:42] Many people will tell you it's the cash flow statement that matters most, but it really depends on kind of where you play. And so there's a lot of information that needs to be fed into that, that ultimately at the end of the model, tells you what the company is worth. After you grow ebitda, you build cash, you give a portion of the capital structure to the management team to incentivize them, and then ultimately you get paid your money as an investor on behalf of your LPs.

[00:20:11] How do you decide what goes into that income statement, balance sheet, cashflow statement that ultimately allows you to get to a purchase price at the end of the day? So maybe starting with the income statement, how detailed are these for you all? What are you using as the basis to start the model? How do you figure out where to project revenues?

[00:20:29] How do you understand what kind of gross profit margin you're gonna have? What kind of expenses? What's the process that leads to all of that?

[00:20:36] Doug McCormick: I think it's flawed logic to think about these models as a model of one homogeneous business because when you start making assumptions like revenue's gonna grow at X percent, and gross margin will stay constant and overhead and G and a is gonna be X percent of revenue, there's really no fidelity and very few businesses behave that way.

[00:20:58] A good model is uniquely designed to the attributes of the business, and so you often have. Product categories, service lines or revenue channels that dictate how each one of those behaved. And many times you'll see a business where it's growing at 8% in aggregate, but one aspect of the business is growing at 20% and one aspect is an annuity.

[00:21:22] And so like you gotta get that figured out. And then those same business lines have very different margin profiles. And so kind of, you need to break that out. And then the same thing happens when you think about like the overhead. Some of it scales with revenue and size as a normal growth and some of it is fixed, which should drive operating leverage.

[00:21:43] It's less about the complexity of the assumptions and more about really understanding the drivers of the business and having a view on each aspect of that business.

[00:21:53] Sean Mooney: So your teams will do some very detailed work, like on the income statement, we're gonna say, Hey, you're gonna sometimes project revenue.

[00:22:02] By product, right? Or category or business line and profitability by that. And so you're getting to know the unit economics of the business and you're gonna project that. And then you're gonna project operating expenses sometimes down to the people, right? That you're adding. And so a very detailed but also dynamic way, right?

[00:22:20] Doug McCormick: Not only does that influence how you think about value, but I think that's how you get to know a business to decide is the forecast that the seller's proposing realistic? Do I think this is a good business? You learn a lot about like the individual customer cohort trends and product line attributes, where the margin's coming from, et cetera.

[00:22:37] Lloyd Metz: Yeah, I think that's right, Doug. And you were asking Sean, like what goes into the models? You have to get a good enough understanding and get to a sufficient level of detail to understand the drivers. Sometimes you have to go way into the weeds, so then you can take a step back out and abstract and figure out, okay, this is what really matters.

[00:22:59] You don't wanna necessarily build a model that goes down to every single SKU, every single employee or every single, whatever store location. Sometimes you want to actually do that, but the point is you don't want to lose sight of the forest for the trees or the bark on the trees, right? But sometimes you have to go to that level of detail, so then you can step back and figure out, okay, this is what really matters.

[00:23:24] But ultimately you wanna be able to understand volume and price. For your revenues, distribution costs, discounts, spoilage, depending on the business model, gross profit, direct costs for production, direct costs for delivery, et cetera. You wanna understand that well enough to understand what are the units, is it hours of labor?

[00:23:50] Is it number of units produced? Is it number of SKUs, is it whatever? That drives the revenues and the profitability of the business. That's what you want to have in your model, and it can take some time to kind of figure out what the right drivers are in which other ones are tertiary or actually not particularly relevant.

[00:24:14] That takes some judgment. That does take some work to get to that point. And Doug, to your other point about business building. You definitely do wanna have an understanding for the business, particularly when you're talking about smaller companies. It's usually more straightforward to understand what the drivers are.

[00:24:32] Sean Mooney: What diligence streams are you feeding into this thing to inform your

[00:24:36] Doug McCormick: answers? Q of E is obviously a big one. Quality of earnings. We kind of think about it as commercial diligence, and commercial diligence would be like voice of the customer. Assessment of the product, understanding like the end market, what's the backdrop in terms of growth rates, how discretionary is the product versus consumable, recurring, those kind of things.

[00:24:59] A really fundamental question is like, what's the entry point here? And so it's not just the forecast, but it's the starting point. My analogy would be nobody wants to sell a business when it's not performing. So almost everything we look at is performing in a way that is growing reasonably rapidly, and you kind of gotta figure out.

[00:25:17] Is that an abnormal growth profile or should I capitalize the run rate of the business relative to the historic profile to figure out what does the market clearing price today?

[00:25:27] Sean Mooney: So as I kind of hear what you're saying, you are using your quality of earnings review, which is what your accountants will put together to say, here's the true verified financial performance of the business.

[00:25:39] You can use that then to apply to get validated confident metrics that can then serve as the basis to. Have relationships and a projection as they go forward. So we know that here's the true relationship between cost of goods sold and revenue and operating expense over time. Then you can use those metrics as the levers to grow with a business.

[00:26:00] Doug McCormick: I agree with everything you said with one caveat, which is I think there is a judgment element where you say, Q of E quality of earnings is a reflection of like. What gap is generally, and then you say, how comfortable am I that that's gonna repeat itself. So did you have an abnormally profitable or unprofitable contract?

[00:26:17] Did you have one big contract that may not hit again? Then you kind of like socializing with judgment. What's recurring or what's normal behavior?

[00:26:26] Lloyd Metz: Your quality of earnings are generally looking at your recent history. Right? Often the trailing 12 months up to some point. So the question that I guess we're raising is.

[00:26:37] When you think about valuing a company and paying for a company, are you basing your valuation on the latest 12 months of actual performance? Are you trying to value it based on the next 12 months of expected performance or your judgment on what the company is going to do in the next 3, 6, 12 months? Is valuation, backward looking or forward looking?

[00:27:00] How do you balance the two?

[00:27:02] Doug McCormick: Yes,

[00:27:04] Lloyd Metz: yes, and yes.

[00:27:07] Sean Mooney: And I think that's a great point. It's a scatterplot. There's no one answer, right? You're taking all of this and have to make judgment.

[00:27:14] Doug McCormick: I agree. To me though, at the end of the day when the investment's over, you will only care what the business was going to do.

[00:27:23] The forward looking. But I think you get conviction and forward based on run rate and based on history. They compliment the real thing I care about in giving me the ability to get comfortable with it, I think.

[00:27:34] Lloyd Metz: And Doug, what do you mean by run rate? Just to make sure we're speaking the same language.

[00:27:39] Doug McCormick: We often see situations or we make arguments for situations when we're selling where, hey, we just want a big customer.

[00:27:46] That customer's gonna ramp up over the next 18 months. It's a five year contract, and in the last 12 months. Percent of what it will be when it fully matures on the contract, you should gimme credit for that kind of run rate. So a lot of times you see rapidly growing businesses, I think people will give you credit for as is today versus the trailing 12 months, which are not reflective.

[00:28:08] Lloyd Metz: Got it. So paying you for efforts, work, projects, customers, contracts, whatever it is that are in place today, but that are at the early stage of. Development evolution ramping up. So in the recent financials and the backward looking financials, there's not much evidence of what it can do or what it's expected to do.

[00:28:33] Doug McCormick: Yeah, and I guess I would say the quality of these arguments are all different. But the same way when you market a company or your evaluating company, there are often adjustments to EBITDA for things that are cost and will no longer continue. Maybe we move to a new location so that you're pro performing in that new location, which has not been in the last 12 months.

[00:28:52] Revenue and growth add-backs I think are a little bit harder, but I think depending on the nature of what the growth is, I think some is more under writeable than others.

[00:29:02] Sean Mooney: And this is a good point for our listeners. When you're selling a company, an investment banker and is selling it, they're gonna do everything they can to say everything that was a little bit odd, but only happened in theory once is extraordinary.

[00:29:14] So that doesn't count. It's gonna be called an add back. Well, that was a one-time cost. We only have recalls once every one year, so we're gonna add that back. I mean, obviously tongue in cheek there. And so there's been this trend in, in investment banking, they're doing their job, but saying like it's ebitda.

[00:29:32] Before expenses, anything they can, they want to add it back. And then Doug, to your same point, you also wanna say like, Hey, if our last quarter is our best quarter, let's multiply that times four. So you're really not paying 12 months of history. You're paying on an annualized version of the last quarter.

[00:29:47] So we can say that EBITDA is even better Now, that's if you're selling,

[00:29:51] Doug McCormick: and I think sometimes people get comfortable in, I'm paying nine times on a trailing basis, but seven times on a last quarter annualized basis in a business that's not seasonally volatile. It's kind of back to this, you have more comfort that it's growing nicely.

[00:30:06] You can lean in

[00:30:07] Sean Mooney: and that's one of the big areas your quality of earnings people will also dig into is like, how valid are these add-backs in this kind of annualization of recent performance?

[00:30:16] Lloyd Metz: Hey Sean, you, you bring up another interesting point on this real world valuation discussion we're having. You talked about valuing a business based on ebitda, and that's frequently the convention.

[00:30:28] When you go through that exercise though of building out your DCF, you'll also see for your own self if there's a disconnect between EBITDA and cashflow, right? So is there higher CapEx? Is there increasing networking capital intensity that will be a deduct to your cash flows and put some more separation between EBITDA and free cash flow.

[00:30:54] 'cause ultimately you want to value a businesses off of free cash flow. I'm raising a point that's in the pro column for DCF, but it affects when you're actually in the process of trying to buy a business, something for you to watch out for, because oftentimes people will look for a multiple on ebitda, and if cash flow is actually equal to or better than ebitda, that tells you one thing.

[00:31:17] And if it's materially less than ebitda, that. Informs your valuation view the other way.

[00:31:22] Doug McCormick: I don't own any businesses where it's more so you are buying good software and all kinds of good stuff and all my stuff has da,

[00:31:32] Sean Mooney: but it's a great point. I think that's one of the reasons why a lot of PE firms don't use these multiples as their primary example, like EBITDA enterprise to EBITDA multiples.

[00:31:41] Warren Buffett had this great line referring to EBITDA is utter nonsense and it's, call it, its earnings before everything important. So it's the da. And what that means for our listeners, it's depreciation, it's the capital expenditures that are massive. You're paying taxes. And Lloyd, to your point, it's so right.

[00:31:59] It's like at the end of the day, it's cash money. What are you getting at the end? If you got cash money, then it's good. So maybe to frame this, you're doing these very detailed models that are as much about making sure that you understand how the business works. And so the process is as important, the outcome.

[00:32:16] You are using that to create projections of not only the income statement, but you're also putting in things like your taxes. You have a balance sheet, right? You're projecting like how your working capital, your accounts receivable, your payables. Very importantly, your capital expenditures. If you're a manufacturer, that's huge money that has to be.

[00:32:34] So you gotta buy equipment and you gotta maintain it. And then you project this forward and now you're at this point of like you're trying to figure out the price. There's some circulars here, right? And so it's one, what's your capital structure? Two, what you pay for something makes your IRR, your internal rate return at the end of the year change.

[00:32:56] And so talk to us about like now you've got your base case, and then maybe we will bridge to this. You're often doing kind of an upside case and downside case, you wanna know a full range of outcomes. How do you then triangulate into what you think the actual fair price for you as an individual willing buyer is?

[00:33:15] Lloyd Metz: So honestly, Sean, it'll come down to the buyer's psychology and emotional state at the time. It's ultimately gonna be a human decision. So you can run the numbers, you can run the LBO model, you can run dcfs, you can run scenarios, upside case, downside case, and those will often provide you with guardrails.

[00:33:38] If we're wrong on these factors on growth or wrong on this factor for cost, and we have a downside case and there's a recession, et cetera, you, you play with all of that and you're like, okay, this is how bad it might be. If that's acceptable, then you move forward. If it's not acceptable, and that's not an acceptable risk.

[00:33:56] Even if you try to stick your thumb in the air to figure out how likely that is, then you walk. So let's assume you've done all that downside case, base case, upside case, and you're still within parameters that work for you. The question you're asking is, well, where do you draw the line when you're trying to buy the business?

[00:34:14] And then it becomes a bit of an exercise in negotiation. How badly do you want this investment? How confident are you in your value creation plan? How confident are you that you can go take down the next three or four add-on acquisitions in the next six months or nine months, and then double your EBITDA or increase EBITDA 50% in the next six to nine months?

[00:34:38] All of those things that are going into your perception of the opportunity affects your valuation. And you have to have a bit of a bid strategy or a negotiating strategy. If you're cutting a deal directly with the company, how much do they want informed by your market intelligence from talking to bankers.

[00:34:57] You have a sense for what a business like this is going for an extra million dollars, an extra 2 million extra 10, an extra 15, you start to play with that in your own head with your numbers to figure out how much are my returns affected? Do I want to take more debt on this business or do I restrain the leverage I put on it and save my debt capacity for another reason, another use a year from now, two years from now, you have to go through all of that for you to make that final decision as to whether here's my final price.

[00:35:33] And when they come back to you and it's like, oh, can you do a little bit more? 'cause they always will. Well, sometimes it's just to give someone a token win in the negotiation. Other times it's a real, if you don't pay more, someone else truly will buy this business and, and get it from you. So you have to factor all those things in.

[00:35:52] It's not a, a simple black or white, yes or no kind. Answer, the answer's not always 17 or, or whatever, right? It's, it's a combination of those things. It's judgment.

[00:36:03] Sean Mooney: So a 20% IRR is not always a 20% IRR, right? And so I'm a vice president and I've got a partner staring over my shoulder and we're with the model.

[00:36:11] We've got the projection that we all feel comfortable with. We know here's the capital structure that we can use. We know what we're gonna allot to the management team. And then we're just, he's just like, okay, raise the purchase price a million. And that spits out an IRR internal rate of return. And then they're like, okay, raise it another million.

[00:36:29] Okay, raise it a million. Oh, take it down 500,000. And as you're iterating, you're like, yeah, I think the risk adjusted return that we need, given everything we've learned, it should be a 21% IRR. But there's other ones we're like, you know what? This is a slam dunk company. We're gonna take 17% and let's just win it and let's park it.

[00:36:49] I dunno if you all do that at the end of the day, like if I'm just like being card face up, that's what I would do. So there's almost this concept, and I never really thought about it until you were talking about this Lloyd, but it's like there's IRR times like an expected value quotient that you need to do.

[00:37:04] It's like 20% times 0.9 and then I never really did it that way. But it seems like you almost need to do that 'cause they're not all equal.

[00:37:13] Lloyd Metz: That's right. One of the things I personally believe that you have to be careful on and be on guard for with models is that false precision. I don't think anybody is.

[00:37:23] So good in private equity to say, this deal is a 20.0% IRR versus a 19.9 or 20.1. That's false precision. That's why I think it's better to think about ranges of returns, to be honest. But to go back to your example, you do have to iterate multiple times. So if we pay 5 million more on your price, your returns drop.

[00:37:49] So what would we need to do to get that return back? So what if we got our networking capital down two percentage points going forward, starting in year 2, 3, 4, and five, or. What if we skinny CapEx, or what if we found a way to have more salespeople in years, 1, 2, 3, 4, or whatever. Like you can start playing with the trade-offs and whether those trade-offs are reasonable or a stretch, right?

[00:38:18] Again, more judgment. To answer your question, that's how you would tackle that,

[00:38:23] Sean Mooney: and that's where the investment committee also comes in, right? They're gonna come in and they're gonna challenge you on all these assumptions in a very detailed way. There's checks and balances, but to your point, like. At some point, you start either removing some of the sand that you put in your model as like cushion to get to where you need to be.

[00:38:38] If you're getting broader and broader conviction that that's an asset you wanna own, or you're just gonna be realizing that you're gonna be taking on maybe incrementally a little bit more risk in order to get that same return. At least that's the way I would think about it. At the end of the day, there's so many variables.

[00:38:54] There's no exact science to this thing.

[00:38:56] Doug McCormick: I just wanna reinforce a couple things you guys are saying, because this gets back to like we talked about academia versus in practice on the modeling side. Let's talk about how important the modeling is. It's just one of many tools that I think drive conviction.

[00:39:11] So I really like it as a valuable way to think about the business and force the discipline, but then I translate it into real world and I make a couple points. The first is, you do all this to figure out in a status quo environment, what is the business in theory worth. Then you've gotta ask yourself, well how does that match up with what the market will pay today?

[00:39:31] Because you may conclude it's a weak process, you may conclude the CEO is exceptional and he wants to roll over 50% and you want to be his partner. And so that's a big risk element. So I think you gotta like use this as one of many things, but it, you could dramatically change your answer based on external factors.

[00:39:48] The other thing that's happening in my mind is the disconnect of what assets are worth to individual buyers is growing. Because I think the qualifications and capabilities of buyers continues to get better. Just to my own, our own circumstance. We do lots of consolidations, so in my models, we're assuming some crazy uninformed things like, I'm gonna buy a business at eight times.

[00:40:13] I'm gonna buy 10 of those in the future, yet to be determined. Then I'm gonna assume that collectively those assets traded 12 times. Right? And so you think about like some of those assumptions. Those are super powerful in the context of what it implies for the financial model, but they're kind of unknowable and so you gotta kind of like figure out how you're gonna risk adjust the execution of some of those elements of your strategy.

[00:40:36] Sean Mooney: You're betting on your skills to a certain degree as part of this exercise in which you have to, right? That's part of being a business builder.

[00:40:43] Doug McCormick: Yes. It's kind of like the LBO model, I think tells you what the market is willing to pay, and then you gotta decide what is it worth to me given the strategy I intend to employ.

[00:40:54] Lloyd Metz: That's right. And again, what is it worth to you is often shaped by not only your skill, as you've mentioned Sean, but just your broader awareness of the market that you're playing in. We bought a business and based on our understanding of the markets. And the supply chains and the customer dynamics around this business, we knew that one of their key inputs, the price was starting to tick down.

[00:41:21] So as we were going through diligence, we paid attention to it and saw that it was going down and was going to continue to go down through our first year of ownership. So when it came to preparing for that question, Hey, we like your price. We like you as a buyer. Can you move your price up? We were ready for that because we knew our profitability was going to increase each and every month, at least for the first six months of our ownership post close, if not for the first year.

[00:41:52] So we didn't have to get that question. We held our price. We didn't have to raise it, but we just held it. But it was, we had a lot of conviction because we had intelligence on where the key supply inputs, the price of that was going. Their costs were going to go down over time.

[00:42:09] Sean Mooney: Those are great points that both of you made because like your diligence is giving you what's called alpha.

[00:42:15] For our listeners, like, you know, you're gonna have up to a hundred, sometimes more than a hundred interested parties starting off on an a broad auction. They're all gonna get a data room, they're all gonna get lots of information, which makes each of you all much more informed than a public market investor usually.

[00:42:30] Right? But then you're also using the unique skills that you all have within your firms. To give yourself insights that no one else knows, which is what they'll call Alpha in the industry. Right? And that helps you kind of inform your bid. And then to your points also, you're also looking at public market comps.

[00:42:47] You're looking at comparable transactions, and there's just so much game theory as well, like what's important, right? Because there's valuation is only one of the three components that were really needed to close a deal, right? It's valuation, speed, and certainty. If you can say, I'm gonna close fast with a hundred degree certainty, you're probably gonna beat the highest dollar closer if you're in the range.

[00:43:09] There's so much complexity that's layered in what you all do, particularly when it comes to owning a business that's highly sought after.

[00:43:16] Lloyd Metz: I think that's right.

[00:43:17] Sean Mooney: One last thing, is there anything as we look forward that you're at least noodling on in terms of how to use these kind of valuation techniques, realizing the world is moving fast?

[00:43:29] Lloyd Metz: I'll throw this out to our listeners. I've been toying with the idea of Monte Carlo simulation, and so given my view that I mentioned earlier, but most of your key assumptions aren't sort of point specific. You don't have point precision on your assumptions. They're generally kind of in a range. Can you run different scenarios around the range of growth, the range of networking, capital assumptions for all the elements in networking capitals, CapEx assumptions.

[00:43:59] And all the other elements we talked about that go into your model, can you run that through a Monte Carlo simulation and get a fan, a spread, a range, a distribution of returns, and see whether you're looking at some asymmetric profiles, right? Is there a skew in the returns, positive or negative? Right?

[00:44:21] That is where I personally would like to go. And so if there's anybody out there who's listening. Who's got this figured out, hit me up on LinkedIn and I'll bring my notebook and you can come teach me how to do that.

[00:44:35] Sean Mooney: It's once again, using these advanced statistical techniques that are being kind of democratized for everyone, make a lot of sense, like how do you get more and more bringing science into the art of your business as well.

[00:44:46] How about you, Doug? Anything that you're kind of playing with?

[00:44:48] Doug McCormick: I think I'm pretty interested in tools that can be productivity tools for my team to look at these things more quickly and efficiently and replicate. I'm a little bit of the belief that because it's an observation set of one, I've got the business that I'm underwriting, it's hard to make meaningful assumptions about distributions and come up with great insights.

[00:45:10] At least for me, I'm more interested in pushing the envelope on how do we get better at bringing value to the business post acquisition. So like if there's two ways to compete, one is refining my underwriting process and the other is. Being a better business builder. I think there's more opportunity with technology there than the underwriting, at least in the context of our model and how we're thinking about it.

[00:45:36] Sean Mooney: I think that's right. As I kind of distill everything that I've learned from you all today, I think the takeaways that I have are. P valuation. It's not like a point on a map. It's the scatterplot on this multidimensional plane, and you're really trying to figure out where the right answer is and from that.

[00:45:53] And so it's not just X times Y equals Z, right? And then these models that you're using, it's the processes as important as the output. It's the insights that you're learning, that you're putting into them that are really what ultimately gets you there. And your competitive advantage not just comes from paying the highest amount.

[00:46:12] It's the proprietary insights, it's the edge, the alpha that you have that's gonna enable you to turn that company into something that was fundamentally probably it wasn't intended to be a year ago. And then you have some tools that are coming on that are gonna help you get better at it. But at the end of the day, it's the process that really gets to the right outcome.

[00:46:31] Doug McCormick: As always, you packaged it nicely, Sean.

[00:46:33] Lloyd Metz: Masterful.

[00:46:35] Sean Mooney: All right, gentlemen, another great PE MBA class here. So I appreciate both of you.

[00:46:39] Lloyd Metz: Thanks, man. Thanks, Doug. Thanks Sean.

[00:46:44] Doug McCormick: A special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies by partnering with family and founder owned manufacturing services and distribution companies.

[00:46:59] Learn more. At HCI equity.com, ICV Partners, an innovative, lower middle market private equity firm, supporting management teams of leading companies at the lower end of the middle market. Learn more about IC v@icbpartners.com and finally, BluWave. The Business Builders Network connecting the most proactive business builders in the world with the best of the best service providers for critical variable, on point and on time due diligence and value creation needs.

[00:47:31] Learn more about BluWave at BluWave. Net for further information on H-C-I-I-C-V and BluWave and relevant topics discussed here in the episode. Please see the episode notes or links.

[00:47:44] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities, including those referenced here.

[00:47:54] End. No representations, warranties, financial, legal, tax, or other advice are made herein. Consult your advisors regarding any topics discussed during this episode.

Join Doug McCormick from Oridian Capital Partners, Lloyd Metz from ICV Partners, and Sean Mooney from BluWave as they explore timely private equity topics and offer their seasoned perspectives on crucial areas of focus within the industry. Gain valuable insights from these industry experts in this engaging podcast tailored for PE professionals.