Entrepreneurial Finance, Luigi Zingales
I pledge my honor that I have not violated the Honor Code
during this examination.
1. Under the assumptions of the proposed deal structure in exhibit 7, what are the economics of the
deal for MDC? i.e. what IRR and value can MDC expect to earn?
Adjusted Present Value Analysis: To calculate MDC’s expected return, I have performed an APV analysis.
Using the long-term Treasury Bond rate of 6.4% as the riskfree rate, I have assumed a risk premium of 6.5%
because that is the amount by which the market exceeded T-bonds over the last 50 years according to Kaplan’s
article. The appropriate discount rate for valuing the cash flows is rUe = rf + βU*(rm - rf) where rUe is the appropriate
discount rate for an all equity firm, βU is the unlevered (or asset) beta for the firm, and rm - rf is the market premium
over the riskfree rate of 6.5%. We do not have betas for Cady, Dialplus or Datacom. However, APAC and SITEL
are good analogs for these businesses as both exclusively provide telemarketing services similar to MDC’s
acquisition targets. I have used an unlevered beta of 1.111, the median of these two analogs, to calculate an
overall discount rate of 13.6%. Assuming a terminal growth rate of 3% (in line with inflation) and a tax rate of
41% (blended pro forma rate per exhibit 8 footnote b), the present value of the cash flows together with the present
value of the debt tax shield is roughly $100M.2 The actual APV value will be less than this because the $100M
does not take into account the present value of the cost of financial distress which in this case is non-zero and
potentially quite large. Given that these costs are difficult to measure, we can compute MDC’s present equity
value assuming the cost of financial distress is $0. MDC’s equity stake is 21,150/41,900 or a little more than
50%.3 The present value of MDC’s 50% stake amounts to $24.5M. That is, MDC must invest $21M to receive an
equity stake worth $24.5M, for an overall return of 16%.4 This is not quite up to the 20% return a private equity
firm would generally look for in an LBO. If the debt tax shield is discounted at the riskfree rate, a less realistic
assumption, rather than the unlevered cost of capital, the enterprise value only goes up to $103M5 leading to a
slightly better return of 24%.6
IRR Based on Terminal Value: As is to be expected, the IRR based on an exit at the perpetuity value
depends heavily on the value used for the terminal value of the free cash flow. For all reasonable levels of
terminal value this deal has also has a decent IRR. For example, if we simply use the FCF at the end of year 2000
of $3.5M, without zeroing out depreciation, changes in NWC and capital expenditures, the IRR based on
perpetuity value is negative because MDC must invest $21M to receive $9M in year 2000 resulting in a very
negative IRR.7 However, there is a very large change in networking capital in Year 2000 that is getting blown out
in the terminal value. Therefore, if we zero out capital expenditures, depreciation and changes in NWC and use
the resulting free cash flow of $11M, the IRR is a more impressive 21% based on the $21M investment leading
to $44M in year 2000.8 Therefore, IRR based on terminal value suggests the deal is not the greatest ever but could
IRR Based on Exit at Multiple: When calculating the IRR based on an exit multiple the investment looks
more attractive. The two public comparables, APAC and SITEL, currently have Enterprise Value/EBITDA
multiples of a whopping 40x and 14x.9 Using the average EBITDA multiple of these comparables (i.e. 27.4x), the
IRR for MDC would amount to 112% based on Year 2000 EBITDA of $33M.10 This amounts to MDC cash on
cash of 20.4x.11 If MDC is able to secure participating preferred common stock, the IRR goes up slightly to
114%.12 Even using a more conservative multiple of 7.2x (i.e. the purchase price multiple in the proposed deal)
the IRR is still 45%.13 This amounts to 4.5x cash on cash.14 Both of these would be sufficient to cover the
required return on the investment of 13.6%. The pro forma projections for the combined company do not have
cash in 2000 so there is no need to calculate an IRR based on exit multiple + cash. Therefore, IRR based on exit at
multiple appears very attractive at most levels of multiple and operating performance.15
2. Assuming Hellman can get Cady to agree to sell, would you recommend that Hellman and McCown
De Leeuw (MDC) proceed with the negotiations for the deal? i.e. is this an attractive opportunity
for MDC? Why or why not?
While the quantitative numbers make this deal appear moderately attractive on balance, particularly when
looking at IRRs based on exit multiples, I would not recommend that Hellman and MDC continue with the deal. A
qualitative analysis (OUTSIDE-CUPID) of the deal weighs heavily in favor of not pursuing the deal.
Competition: Competition for the deal is likely to be fierce. An industry observer noted that the SITEL and
APAC IPOs would encourage the remaining top ten telemarketing firms to undergo a capital structure
transformation by either going public, recapitalizing, or being acquired in a private transaction. Therefore, the
wider market is aware of the opportunity in telemarketing. Additionally, the telemarketing market has already
been looked at by numerous other private equity firms, including TA Associates, Summit Partners, and Golder
Thoma Cressey Rauner some of whom have already made large investments in the space. Even the large
telemarketing agencies have made acquisitions in this space and could create more competition for deals like these.
Hellman is aware that each of his target companies have “several other options” in addition to closing a deal with
MDC. Therefore, competition for the deal is likely to be high driving up the price of the deal overall.
Additionally, competition in the deal (e.g. within the telemarketing space) is also high. Barriers to entry in the
industry are low. Deregulation is likely to increase competition and put downward pressure on margins. Labor is
the largest component of product cost which makes emerging markets with lower labor rates a credible and
frightening mid- to long-term threat. Even in the US, competition for new campaigns has been “increasing
rapidly”. Therefore, telemarketing is a very competitive place making it difficult to maintain high margin rents.
Unique: In addition to stiff competition, there is nothing incredibly unique about the acquisition targets. The
primary assets of the targets are employees and contracts. These assets are not sticky because there are very few
switching costs for workers and customers. Cady has some unique experience with joint ventures in foreign
markets (low telemarketing penetration and high market potential) but has not created entry barriers in this area.
DialPlus has a unique focus on selling long distance services (over 70% of revenue came from a single long
distance reseller). However, this is likely a bad thing given the upheaval in this industry once the impending
deregulation takes place combined with the threat of competing technologies like cellular.16 And finally, Datacom
has developed a “sophisticated psychological screening test” that has reduced turnover, but this can hardly be
considered an insurmountable differentiator.
There is also nothing incredibly unique about MDC as the buyer. MDC does not provide unique value add to
the deal. MDC has never invested in a telemarketing company before. Its partners do not have domain knowledge
in telemarketing. MDC does not have a long rolodex of contacts in the telemarketing space nor can they provide
good strategic guidance for corporate decisions. Therefore, it does not appear crucial that these companies get
their investment capital from MDC as opposed to other sources. MDC does not provide strategic value.
Price: Per the discussion in question 1 above, the price is more attractive based on EBITDA multiple than with
an APV analysis. However, the price of the deal will likely get pressured upward as competition for the deal heats
up among private equity firms and other telemarketing organizations. This will make it more likely that MDC
overpays for the deal.
Improvements: MDC plans to improve the company through cost savings, improved margins, and economies
of scale. However, these improvements are likely to be fairly limited. MDC is not planning on major cost-cutting
reductions which would be the most reliable way of improving the combined company. Moreover, MDC hopes to
improve margin by bringing in more sophisticated new management (e.g. CEO). However, this might upset the
old management and make them less productive. Additionally, MDC seeks to leverage economies of scale to
purchase the latest IT solutions for managing the business that the smaller companies could not afford. However,
MDC is not particularly well-positioned to provide guidance in this area as they have no experience in high
technology. While economies of scale at the sales and marketing level might also be a possibility, it is unclear
how valuable these synergies will be.
Distress: While financial distress can be difficult to measure, the probability of the combined company
becoming distressed is fairly high. While the market for telemarketing is large and growing, the revenues are not
as stable as in other industries. Competition for outbound telemarketing contracts is steadily increasing while
switching costs are very low, making revenues more volatile. DialPlus, the most expensive part of the deal for
MDC (at $46M), derives 70% of its business from a single company selling long-distance services. If this
company were to fail due to the impending deregulation of telecommunications, due to the reduced need for long-
distance in an increasingly cellular world, or for any other reason, MDC’s investment would be devastated.
Therefore, the probability the combined company will default or otherwise become distressed is fairly high.
In addition to the probability of distress being high, the costs of financial distress are also high. Financial
distress would destroy a large percentage of the combined company.17 The primary assets of telemarketing
businesses are its employees and its contracts, both of which will be incredibly difficult to retain in financial
distress. Workforce retention in the industry is difficult under ordinary circumstances, let alone when a business
can’t pay its bills. There are few switching costs for employees and there are plenty of other growing
telemarketing companies that would be ready to hire them. Customers will likely flee. Revenue is highly
concentrated in a few customers which if lost would be devastating. For inbound telemarketing in particular, no
customer will be willing to sign a contract with a firm if there is risk the company will go out of business. There
are large upfront costs and difficult switching costs associated with choosing an inbound telemarketer. Even
companies looking for outbound telemarketing services will likely flee to other providers if it appears the
combined company has entered financial distress. Therefore, if the combined firm becomes distressed, a large
portion of the value of the combined firm is likely to be destroyed if the firm becomes distressed.
Uncertainty: There is a large amount of uncertainty in this deal. Two of the targets focus on
telecommunications which is in the middle of deregulation. The largest portion of the deal is for DialPlus, a
company that gets 70% of its revenue from a long-distance provider whose days might be numbered. Low cost of
entry and the importance of cheap labor for the business suggest that the industry will quickly migrate to emerging
markets. Therefore, vast uncertainty exists around the telemarketing industry.
Team: The new management team will probably be less effective after the buyout than before. First, their
skills may not be transferable. The current CEO’s skills and value add in running their smaller companies may not
help them add value in their new, undefined roles in the larger organization. Second, the CEOs may not work well
together. They have never met and may be more competitive with each other (e.g. positioning for the CEO
position, etc.) than collaborative. They may also not like their new roles, particularly the prospect of not being
fully in charge. Third, the incentives of the old managers may not be aligned with the goals of the combined
company. Collectively, target company shareholders (likely highly concentrated in the hands of the existing
CEOs) are set to receive $58M in cash in the transaction. Receiving $10M to $20M in cash while simultaneously
having their salaries reduced will likely cause them to work less. Cady, for instance, has already said he wants to
step outside daily management but retain access to the financial upside of the combined business. Therefore, the
management team will probably be worse after the buyout than before the buyout.
Strategy, Investment, Deal, and Exit: MDC’s strategy for making money is not impressive. They expect to
make money through growth opportunities, in particular through future acquisitions. They expect to make
improvements, but as discussed above, these are unlikely to be substantial. The investment of $21M is substantial
given that the majority of what MDC is acquiring is human capital (e.g. labor) that may fell the new company.
Competition for deals in the space is high driving up the price. While there are decent exit opportunities (IPO,
Recapitalization, M&A) and good industry multiples, the deal as a whole does not create good incentives for the
Therefore, an OUTSIDE-IMPACTS analysis suggests that MDC and Hellman should not pursue this deal.
3. In what ways (if any) do MDC and Hellman create value in this transaction? Are there ways in
which they can create more value?
At a pure transaction level, MDC and Hellman do not create much value. They don’t have much experience in
telemarketing. While they have plans to improve cost savings, margins and leverage economies of scale, as
discussed above these improvements are likely to be limited. Additionally, MDC is not best positioned to provide
these improvements given their lack of experience. Moreover, MDC is not planning on major workforce
reductions which would be the most reliable way of cutting costs for the combined company. MDC plans to bring
in a new CEO, but they currently don’t have a candidate in mind. Moreover, a new CEO might destroy value by
making the rest of the management team less productive. Therefore, MDC and Hellman do not create much value
in the initial transaction.
MDC might be able to create more value by providing experience and expertise in future transactions. MDC
has assisted its portfolio companies in the completion of almost 60 strategic growth acquisitions. In particular,
MDC has experience with initial and follow on acquisitions in consolidating markets (e.g. the DIMAC acquisition
in the media space). MDC could leverage this experience by helping the combined telemarketing firm identify
solid future acquisition targets and take advantage of future growth opportunities in the telemarketing industry. In
many circumstances, the ability to act quickly on follow-on deals can be critical to creating momentum in the
industry and MDC provides this skill. Given the high degree of fragmentation in the telemarketing industry, these
skills could potentially become very valuable as industry dynamics begin to force consolidation.
Therefore, Hellman and MDC provide very little value in this transaction but could provide additional value by
helping the combined firm identify future acquisitions enabling it to take advantage of growth opportunities in the
4. If you were Cady, would you sell? Why or why not? Should Hellman go ahead with the deal if Cady
From a financial perspective, if I were Cady I would probably not sell. Cady is selling at a discount because
current management has been unable to extract the same levels of margins as competition in the market. Cady’s
total operating expenses as a percentage of sales are much larger than both DialPlus and Datacom despite
comparable gross margins. This is despite the fact that DialPlus and Cady have similar ratios of Full-Time TSRs
to Part-Time TSRs. These large operating expenses, in particular the high cost of its employees, are destroying
Cady’s bottom line numbers. For example, in 1995 Cady had net income of $545k on $46M of revenue while
DialPlus had $3.5M net income on $29M in revenue. Despite representing over 50% of the revenue of the
combined firm, Cady would contribute less than 30% of the EBITDA. As a result, the price MDC is willing to pay
for Cady is depressed. MDC is offering to purchase Cady for about half what it has offered DialPlus, a company
with $17M less in revenue. Moreover, under this deal Cady shareholders will only be receiving $4.5M in cash and
4.5M in equity in the new business. Cady would be better off spending the next year or two improving the daily
management of the business to improve margins and then be able to command a higher set of multiples from the
market (revenue, EBIT, or EBITDA). At that point, Cady could sell at these higher multiples to a strategic
investor or could IPO. The IPO market for telemarketing companies appears to be very favorable based on comps.
From a personal perspective, however, Cady’s CEO might be ready to sell at this low price. Cady is being
poorly managed, most likely because the CEO is disengaged. The CEO is not interested in a daily management
role. A strategic sale at this time would enable him to step out of a daily management role, enable him to liquidate
some of his equity, and enable him to participate in the financial upside of the combined firm. Therefore, spending
a couple years time trying to improve operating performance in preparation for an IPO that would still require him
to work afterwards may not be what the CEO is looking for. Therefore, he may be interested in selling now, even
at a depressed price. Therefore, from a financial perspective Cady should not sell but from a personal perspective
he may do it anyway.
If Cady pulls out, Hellman should not go through with the deal. Based on the qualitative analysis (OUTSIDE-
IMPACTS) in question 2, Hellman probably shouldn’t go through with the deal in the first place. Moreover,
losing Cady would make the deal less attractive. Cady represents the greatest opportunity for MDC to provide
value through cost-savings and improved efficiency (reducing the operating costs at Cady through better
management). Additionally, a large part of the strategic value of the deal for MDC is to become one of the top 3
largest telemarketing companies in the industry to position it more effectively to take advantage of future
acquisition opportunities (in addition to leveraging economies of scale). Without Cady, the new combined
company would lose over 50% of its revenue and therefore would not be a dominant player in the space.
Moreover, the new company would have an even higher probability of financial distress because DialPlus’s single
long-distance customer would represent almost 50% of the combined companies revenue. Losing this account
would be devastating.
5. Based on the information in the case, would you have invested in MDC’s third private equity fund?
Would Swensen? Why or why not? To answer this, you will need to evaluate MDC’s strategy.
I would not have invested in MDC’s third private equity fund. The fund appears to lack focus and their
strategy could be easily imitated by other private equity firms. Their list of “opportunities” (e.g. prior owners have
not fully supported the company with management or capital, management team is solid but underperforming due
to misaligned incentives, and significant acquisition opportunities due to industry consolidation) are very general
and represent what all private equity firms are looking for. Therefore, MDC does not appear to have effectively
differentiated itself in the market nor articulated a clear vision for why they are better positioned to identify these
middle market companies and add value.
Swensen would not invest in MDC’s third private equity fund. Swensen liked working with a small number of
properly incented investment managers with specialized knowledge in particular industries. Swensen believes that
these managers, with intelligent and clearly articulated investment strategies, can consistently outperform the
market in their areas of expertise. Similarly, in private equity, Swensen prefers organizations that provide “added
value” rather than mere financial engineering skills so that they can maintain their competitive advantage over time
and generate good returns regardless of market conditions. Swensen selected a few small high-end private equity
partnerships and built long-term relationships with them.
MDC does not fit into this type of investment strategy. MDC does not have specialized industry knowledge.
They have invested in lumber, gas supply, building materials, shoes and sneakers, the paper industry, airlines, pet
stores, restaurants and more. Swensen would not believe that MDC could have specialized knowledge of each of
these varied industries nor that they could provide “added value” in each of these areas. Swensen would think that
in the face of increasing competition in private equity, MDC does not provide good long-term strategic value to
Yale’s investment portfolio without a core differentiator that enables them to provide value add to their portfolio
Calculating Asset Beta and EBITDA Multiple from Public Comparables
The following chart shows how I calculated the average asset beta of our two public comparables. The median value of
1.11 was used as the unlevered beta in calculating the discount rate for the APV analysis.
APV Analysis in which Debt Tax Shield is discounted at the Unlevered Cost of Capital
Capitalization Table for the Proposed Transaction
IRR Based on APV Analysis
APV Analysis in which Debt Tax Shield is discounted at the Riskfree Rate of 6.4%
IRR Based on APV Analysis With DTS Discounted at Riskfree Rate
Exit at Perpetuity Value Using FCF from 2000 without Zeroing out Depreciation, NWC and CapEx
Exit at Perpetuity Value Using FCF from 2000 w/ Zeroing out Depreciation, NWC and CapEx
Public Comparable Multiples for APAC and SITEL
IRR Based on Exit at Multiple Using Public Comparables APAC and SITEL
Cash on Cash Analysis at 27.4x EBITDA Multiple
MDC Returns Based on Participating Preferred Stock
Cash on Cash Analysis at 7.2x EBITDA Multiple
Returns Matrix for MDC Based on Different Exit Multiples and Different Levels of Operating Performance
Long-distance services are likely to become obsolete as cell technology became more prevalent. This would destroy 70%
of DialPlus’ revenue stream.
Pro Forma projections have DialPlus providing over 50% of the EBITDA. Therefore, loss of their largest customer (which
represents 70% of their revenue) could reduce the value of the combined company by 35%, even before considering the
other impacts of losing the customer (e.g. fleeing customers, fleeing employees, etc.)