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Investment Banking - Middle Market M&A Origination, Process, Financial Modeling & Valuation

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Investment banking - Middle Market M&A Origination, Process, Financial Modeling & Valuation

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Investment Banking - Middle Market M&A Origination, Process, Financial Modeling & Valuation

  1. 1. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 1
  2. 2. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 2 Michael Herlache MBA Doctor of Business Administration Candidate VP, M&A at AltQuest Group Investment Banking M&A Origination, Execution, Financial Modeling & Valuation Investment Banking University Publishing www.InvestmentBankingU.com
  3. 3. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 3 For my wife, Svitlana, whom is my treasure.
  4. 4. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 4 About the Author: Michael Herlache is the VP of M&A at AltQuest Group, a middle market boutique investment bank located in Fort Lauderdale, Florida. He lives in his home in Florida with his wife, Svitlana. Michael has an MBA in Finance from Texas A&M University and is getting his Doctorate in Business Administration with a focus on finance. To learn more about AltQuest Group, please go to www.AltQuest.com. For those interested in going through a formal investment banking training program associated with this text, the Investment Banking University (www.InvestmentBankingU.com) course’s syllabus is based upon the content of this book.
  5. 5. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 5 Contents PERPETUITY SCIENCE: Part I: Perpetuity Methodology Chapter 1: What You Learn in Business School vs. What You Should Learn in Business School Chapter 2: What is Business? Chapter 3: What is a Perpetuity? Chapter 4: Perpetuity by Industry & Sub-Industry Chapter 5: Capitalism as a Perpetuity Game Chapter 6: Playing the Perpetuity Game FOUNDATIONS OF VALUATION: Part I: Tracking Value (Accounting) Chapter 4: Tracking Value with Accounts Part II: Analyzing Value (Finance) Chapter 5: Analyzing Value with Finance Part III: Modeling Value Chapter 6: Finance with Excel Chapter 7: Financial Statement Modeling Part III: Valuation Methodologies Chapter 8: Valuation Principle Chapter 8: Valuation Build Up Chapter 8: Valuation Methodologies BUILD-SIDE: Part I: How to Build a Perpetuity? Chapter 9: How to Build a Benefit Stream? Chapter 10: How to De-Risk the Benefit Stream? Chapter 11: The Value Perpetuity Part II: Perpetuity Analysis Chapter 12: How to Be a CEO? Chapter 13: How to Be a Consultant? Part III: Perpetuity Modeling & Valuation Chapter 14: Framing Valuation Part IV: Perpetuity Engineering Chapter 15: How to Be an Engineer? Chapter 16: Knowledge Engineering Chapter 17: Content Engineering
  6. 6. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 6 Chapter 18: Platform Engineering Part V: Perpetuity Management Chapter 19: Perpetuity Management Chapter 20: Index Building & Benchmarking Chapter 21: Financial Data Sources Part VI: The Market for Perpetuities Chapter 22: The Market for Perpetuities SELL-SIDE: Part I: How to Sell a Perpetuity? Chapter 23: Investment Banking Chapter 24: How to Become an Investment Banker Methodology Part II: The Middle Market Chapter 25: Middle Market Breakdown Chapter 26: Buyer Profile: Individuals & Search Funds Chapter 27: Buyer Profile: Lower Middle Market Private Equity Chapter 28: Buyer Profile: Middle Market Private Equity Chapter 29: Buyer Profile: Strategics Part III: M&A Multiples Chapter 30: M&A Multiples Part IV: Investment Banking Coverage Methodology Chapter 31: Investment Banking Coverage Methodology Chapter 32: Index Building & Benchmarking Chapter 33: Financial Data Sources Chapter 34: Industry or Sector Newsletter Chapter 35: Industry or Sector Report Chapter 36: Rolodex Building Chapter 36: Industry & State Level Coverage Part V: M&A Origination Methodology Chapter 37: M&A Origination Methodology Part VI: Mandate/Target Matching Methodology Chapter 38: Mandate/Target Matching Methodology Part VI: M&A Fee Methodology Chapter 39: M&A Success Fee Chapter 40: The M&A Engagement Letter Part VI: Buyer List Methodology Chapter 41: How to Build a Buyer List Chapter 42: Outreach to the Buyer List Part VII: Deal Structuring Chapter 43: Deal Structuring
  7. 7. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 7 Part VIII: M&A Process Chapter 44: M&A Process Chapter 44: Dealing with Sellers Chapter 44: Dealing with Buyers Part IX: Investment Bank Management Chapter 45: How to Build a Boutique Investment Bank? Chapter 46: Running the Boutique Investment Bank Part X: Investment Banking Deliverables Chapter 47: Investment Banking Deliverables Chapter 48: Adjusted EBITDA Chapter 49: Valuation Chapter 50: Teaser Chapter 51: CIM (Confidential Information Memorandum) Chapter 51: Purchase Agreement Chapter 51: Minimum Financials to Do a Deal BUY-SIDE: Part I: How to Buy a Perpetuity? Chapter 52: The Principle of Investing Chapter 53: How to Be a Warren Buffett? Chapter 54: The Operating Model Chapter 55: The Financial Buyer aka Private Equity (LBO) Chapter 56: The Strategic Buyer aka Corporation (Merger) Chapter 57: Perpetuity Science & Portfolio Theory Chapter 58: How to Start a LMM Search Fund? CASES: Part XVIII: Build Side Cases Chapter 59: AltQuest Group Chapter 60: Investment Banking University Chapter 61: CI Institute Chapter 62: M&A Nexus Part XVIII: Sell Side Cases Chapter 63: Sigma Solve Chapter 64: Aesthetics Institute Chapter 65: Esco Fasteners Chapter 65: Guiliante Machine Tool Chapter 65: Toledo Jet Chapter 65: Martens Farm Part XVIII: Buy Side Cases
  8. 8. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 8 Chapter 66: Asiansbook Chapter 67: FameLinked Chapter 68: DegreeLinked
  9. 9. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 9 Preface There are many investment banking texts out there that claim that financial modeling and valuation is the core work of the investment banker. This is simply not the truth. The core work of the investment banker is origination, mandate/target matching, and deal structuring. It should follow that a text/course on investment banking should be based upon the same. It is the good fortune that the reader has encountered such a book/course. Investment Banking: M&A Origination, Execution, Financial Modeling & Valuation explains origination, mandate/target matching, and deal structuring (i.e. how investment bankers actually make their money). For those new to investment banking you are first going to want to clarify whether you would like to work on the sell side for a few years or pursue a career in investment banking. The skills that you will need to get started in investment banking are different than those that you will need to have a long and successful career in investment banking. The role in investment banking transforms from one that is research, financial modeling & valuation based into one focused on origination and facilitating the M&A process. M&A (Mergers & Acquisitions) is the core product of investment banking, and the other products, advisory & capital- raising, simply support this. We founded Investment Banking University (www.InvestmentBankingU.com) to prepare students for both bulge bracket and middle market investment banking career opportunities. We see a paradigm shift occurring in the field of investment banking. The idea that you need to spend three years of your life as an analyst doing 80+ hour workweeks building financial models to become an investment banker is a faulty paradigm. The real value add of an investment banker is not financial modeling & valuation, but rather origination, mandate/target matching, and deal structuring. You don’t need Goldman Sachs’ permission to be an investment banker just like you don’t need McKinsey’s permission to be a consultant. Investment banking for private companies in the middle market is a great way to build your initial coverage and career as an investment banker without sacrificing a family life or your health.
  10. 10. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 10
  11. 11. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 11
  12. 12. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 12 Perpetuity Science Perpetuity Science is the body of knowledge and optimization models associated with the building, selling or buying of perpetuities, the core work of the capitalist system.
  13. 13. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 13
  14. 14. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 14 Part I: Perpetuity Methodology Consistent with Perpetuity Science, the Perpetuity Methodology is broken down between the three aspects of the perpetuity and also has the foundations of valuation to tie it all together:
  15. 15. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 15
  16. 16. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 16 Chapter 1: What You Learn in Business School vs. What You Should Learn in Business School The standard MBA curriculum at most business schools is broken down along siloed subjects such as accounting, finance, management, operations, and marketing and attempts to teach students how to be a mid-level manager at a large corporation for the rest of their lives. Unfortunately, these jobs are mostly gone, having been shipped overseas or automated. This MBA curriculum is thus outdated and not appropriate for the 21st century when most individuals will have multiple jobs and roles throughout their careers and lives. The more appropriate field of study which has yet to make it to business schools is known as Perpetuity Science. Perpetuity Science is the body of knowledge, methodologies, and optimization models related to the building, selling, and buying of perpetuities. It explains how perpetuities can be built, managed and exited from to create wealth. Perpetuity science is a paradigm shift in business and finance education in that it replaces the siloed subjects traditionally taught in undergraduate and graduate business schools with a holistic methodology that integrates industry and the capital markets into one framework. Instead of a disparate business taxonomy along the lines of economics, finance, accounting, marketing, etc., we have an initial taxonomy broken down in relation to the perpetuity, namely: Build-side – the building of perpetuities (entrepreneurs, corporations)
  17. 17. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 17 Sell-side – the selling of perpetuities (investment bankers, wall street) Buy-side – the buying of perpetuities (private equity, corporate M&A) Within each of the three, we have various methodologies and optimization models that may touch on various subjects such as accounting, finance, economics. By starting with perpetuity science however, the student can better synthesize the various moving parts of industry and the capital markets. When first learning about industry and the capital markets, one should first understand the nature of the perpetuity, which is the basis for industry & the capital markets. The perpetuity can be modeled with the following formula: Perpetuity value = CF / r Where CF represents the benefit stream associated with the perpetuity and r represents the discount rate associated with the perpetuity’s risk of receiving the benefit stream.
  18. 18. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 18 After understanding the nature of the perpetuity in general, we can then analyze the nature of the perpetuity within each industry. The nature of the CF, r, value chain, and value being offered will be different. We investigate each industry according to these variables by building an index for each industry and then sub-sector within the industry. After building the index and sub-sector indices we can then begin analyzing the value chain and leaders in each part of the value chain. We then build financial statement models for the leaders in each section of the value chain and understand the drivers of performance. We analyze each leader or target in relation to the phases of perpetuity in terms of where they are now and the next steps that they can take to move to the next phase. In doing so, one begins to think in terms of being a CEO. The CEO’s role is to bring the company/opportunity through the stages of the perpetuity by building recurring benefit streams (i.e. cash flows) and at the same time de-risking those benefit streams. In doing so, the valuation of the perpetuity moves from backward looking towards forward looking and the valuation is thus maximized (based upon a multiple of future earnings).
  19. 19. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 19 The CEO should thus be familiar with Perpetuity Science and the phases of the perpetuity. As the perpetuity changes, the formula for valuing the perpetuity changes as well. There are five phases of perpetuity building. As we move through the phases, the role of the owner of the perpetuity becomes more passive and the valuation becomes larger due to size of EBITDA increasing, EBITDA multiple increasing, and the discount rate decreasing. The perpetuity becomes less dependent on the owner to exist and run as an organizational structure is formed coinciding with the division of labor, processes are automated, and revenue becomes recurring. Phases of the Perpetuity: I. Syndication (Getting to PMT) II. Job Shop (From PMT1 to PMT2, PMT3, etc) III. Perpetuity (From PMTi to CF/r) IV. Growing Perpetuity (From CF/r to CF/r– g) V. Diversified (Perpetuity 1 + Perpetuity 2) The goal of Perpetuity Science is the building, growing, management, exit and buying of perpetuities, so ultimately, while learning about Perpetuity Science itself, we are also actively looking for:
  20. 20. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 20 1. Perpetuities to create 2. How to advance a perpetuity to the next phase 3. Perpetuities that should be exited from 4. Perpetuities that should be purchased Ultimately, Perpetuity Science transforms the individual from a one- dimensional functional worker into a multi-dimensional value-creator able to execute on either of the three sides of the perpetuity; build side, sell side, or buy side. The Perpetuity Scientist vs. The Functional Specialist The Perpetuity Scientist builds assets that generate passive benefits whereas the functional specialist uses labor to generate active benefits. The quality of life of the perpetuity scientist is thus higher than the functional specialist. It is the perpetuity scientist that drives the primary value with functional specialists simply serving a role in the process of building or operating a perpetuity. The Perpetuity Scientist has the three capabilities associated with the key question of each side of the perpetuity: Build-Side: Key Question: How to Build a Perpetuity? Capability: The capability to build a perpetuity Sell-Side: Key Question: How to Sell a Perpetuity? Capability: The capability to sell a perpetuity
  21. 21. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 21 Buy-Side: Key Question: How to Buy a Perpetuity? Capability: The capability to buy a perpetuity Capabilities that each business student should have are associated with the 3 key questions of Perpetuity Science: Perpetuity Science: I. Build side: How to build a perpetuity? II. Sell side: How to sell a perpetuity? III. Buy side: How to buy a perpetuity? The key questions are associated with capabilities to be built learning perpetuity science.
  22. 22. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 22 From this methodology, Investment Banking University has built a body of knowledge which turned into the course, How to Become an Investment Banker. The book, Investment Banking, is meant to accompany the course which can be taken online, in the weekend workshop, or in the month-long training.
  23. 23. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 23 When asking the key question, “How to Become an Investment Banker?”, we are really asking four questions simultaneously: 1. How to use finance to model the concept in a perpetuity format? 2. How to physically build the perpetuity? 3. How to sell/exit the perpetuity? 4. How to buy a perpetuity? For each question, Investment Banking University has developed proprietary methodologies which are the basis for building a capability which is the ultimate answer to the question. When the individual implements these models and builds the capabilities in finance, the build side, the sell side and the buy side, one may claim to have become an investment banker.
  24. 24. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 24 Currently, in business school you learn in a siloed manner about the various support functions in business, namely; accounting, finance, management, marketing etc. without an integrated framework for industry and the capital markets. The idea being that you would become a functional specialist within an existing perpetuity and fulfill your role. Contrary to this, we believe that an integrated understanding is important and that understanding the perpetuity itself is important allowing the individual to play different roles according to the opportunities available. This integrated understanding is what we are calling Perpetuity Science. Perpetuity Science: 1. Nature of the Perpetuity 2. Sides of the Perpetuity 3. Phases of the Perpetuity 4. Perpetuity Analysis 5. The Market for Perpetuities 6. Perpetuity Modeling & Valuation 7. The Perpetuity Game
  25. 25. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 25 Chapter 1: What is Business? Business is the bringing together of demand with a product in order to build a benefit stream. The demand can be purchased and the product can be built, purchased or merely sold. As demand transacts to obtain the product, the benefit stream grows. The goal of the businessman is to broaden and deepen the pipeline of demand while improving the product until it is irreplaceable to consumers and moves from discretionary to a necessity. As transactions grow, the division of labor can occur within the business in order to make the ownership of the benefit stream more passive for the owner amounting in an organizational structure. As demand becomes recurring, additional products may be built, bought, or merely sold that are complementary/synergistic to the original. The pattern goes from broadening and deepening the demand pipeline for one product to broadening and deepening the product pipeline itself so that ultimately you have an infinite loop of demand and product bringing the benefit stream to ever increasing valuation. Business goes through phases of development including: I. Syndication – initially bringing together of demand purchased via Google Adwords or Facebook ads or built via databases cultivated in platforms like Salesgenie.com with the initial product being, purchased or sold. II. Job shop – division of labor initially with owner actively involved in day to day. Initial pipeline of demand and products matched in one off jobs III. Perpetuity - organizational structure takes over fully for the owner. Pipeline of demand becoming recurring in nature. IV. Growing perpetuity – pipeline of demand recurring and growing (broadening and deepening demand pipeline) V. Diversified – additional benefit streams built or purchased forming a portfolio.
  26. 26. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 26 When thinking about business we have to acknowledge the sources and uses associated with a corporation where sources represent the capital markets and uses represents the asset mix of the corporation. Business can be thought of as a process where the output is a benefit stream with a given level of variability. This benefit stream with a given level of variability is known as a perpetuity. Thus, the model for business is the perpetuity. Since we know that a perpetuity is the model for business (the integration of industry and the capital markets), we can then build a body of knowledge around the perpetuity which serves as the basis for the science of the perpetuity (Perpetuity Science):
  27. 27. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 27 The body of knowledge known as Perpetuity Science can be broken down in the following manner:
  28. 28. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 28
  29. 29. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 29 Chapter 2: What is a Perpetuity? Nature does not provide for man, so he must use reason to obtain value. Since his task is both survival and pleasure, man must use philosophy and science to determine what is valuable and then to build something to obtain said value. That which he builds should not require the same work continually to operate; this is the basis for the perpetuity. A perpetuity is an asset that generates a benefit stream continuously into the future. Perpetuity is the basis for intrinsic value. All of mans progress is towards the creation of assets that add value on behalf of the human on a continuous basis into the future without the human having to replicate previous work to receive benefits. This phenomena is referred to as the perpetuity. This speaks to the advancement from the active benefit stream towards the passive benefit stream (perpetuity). The perpetuity is both a philosophical and scientific phenomena which embodies mans progress in both philosophy and science.
  30. 30. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 30 Perpetuity can thus be broken down into: 1. Perpetuity Philosophy 2. Perpetuity Science For the purposes of this book, we will be focusing on Perpetuity Science. Standard of Living: Perpetuities The Goal To increase standard of living without sacrificing quality of life. How to Get the Goal In order to increase standard of living without sacrificing quality of life, one is to build, sell or buy perpetuities.
  31. 31. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 31 Perpetuity Perpetuities increase standard of living without sacrificing quality of life by possessing recurring revenue and automated work processes to achieve the revenue. I. Building Perpetuities The building of perpetuities is known as being on the build-side; commonly referred to as entrepreneurship or corporations. II. Buying Perpetuities The buying of perpetuities is known as investment or being on the buy-side. The players here are Private Equity (PE) or Corporate M&A Departments for major corporations. III. Selling Perpetuities The selling of perpetuities is known as the sell-side. The players here are investment bankers (Wall Street). The Lab of Perpetuities The experimentation and optimization tool of finance is known as Excel. Excel Is the scientific computational tool of finance to aid us in the modeling and valuation of perpetuities. Demand for Perpetuities There is always demand for perpetuities and especially by institutional investors which means that the market for corporate control more closely mirrors the DCF (intrinsic value) of the perpetuity (corporation). Institutional investors can pay higher multiples in order to realize returns over longer periods of time. Types of Perpetuities Perpetuities can be created from companies that possess some aspect of recurring revenue and automated work processes associated with product creation. At a high level, types of perpetuities include: I. Commodity a. Durables b. Non-durables II. Platform a. Digital
  32. 32. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 32 b. Physical III. Content a. Educational b. Entertainment IV. Service a. Analysis b. Allocation c. Engineering d. Logistics e. Management f. Advocacy g. Relationship V. Infrastructure a. Private i. Real estate b. Public Business: The Science of the Perpetuity Introduction to Business Business is the science of the perpetuity Perpetuity value = CF / Discount rate As you can see we can increase value by increasing CF (increasing revenues, decreasing COGS, SG&A) or decreasing the discount rate. The Corporation’s Goal 1. Become a perpetuity - as characterized by recurring revenue as automated work processes. 2. Become a growing perpetuity Value of growing perpetuity = CF / r – g g decreases the discount rate One should make the distinction between a perpetuity and a commodity. A commodity is associated with a single benefit (cash flow) or a finite benefit stream, whereas the benefit stream of a perpetuity is continuous into the future. What is Intrinsic Value?
  33. 33. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 33 Something is intrinsically valuable inasmuch as it is a perpetuity. Perpetuity provides certainty that the benefit stream will be recurring in the future and is thus, the basis for intrinsic value. Perpetuities allow us to improve our standard of living while not sacrificing quality of life by continually dealing with a problem/opportunity in nature and yielding passive benefits. How to Become Wealthy? The secret that the wealthy know and the middle class is unaware of is the perpetuity. A perpetuity is an asset that generates a benefit stream continuously into the future. This yields passive benefits rather than active benefits of which the middle class works for. The wealthy know Perpetuity Science which is the science of building, selling & buying perpetuities. There are three sides to the perpetuity: 1. Build-Side - How to Build a Perpetuity? (entrepreneurs, corporations) a. How to Build a Benefit Stream? i. Case for Value Perpetuity and Financial Perpetuity ii. MVP iii. Value Perpetuity iv. Financial Perpetuity v. Growing Financial Perpetuity vi. Diversified b. How to De-Risk the Benefit Stream? i. Customer Concentration ii. Owner Dependence iii. Recurring Revenue 2. Sell-Side - How to Sell a Perpetuity? (investment bankers, wall street) 3. Buy-Side - How to Buy a Perpetuity? (private equity, corporate M&A) Ultimately, the wealthy teach their children how to be 21st century perpetuity scientists rather than 20th century functional specialists that will remain in the middle class. In terms of order, the process is usually: 1.Begin on the build-side building a perpetuity which will take 3 to 5 years (initiate coverage and syndicate within a vertical & sub-vertical)
  34. 34. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 34 2.Enter the sell-side and begin in investment banking after university/business school (within existing investment bank or start own boutique investment bank) From the sell-side, take advantage of strong opportunities and leverage this into a LMM search fund
  35. 35. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 35 Chapter 3: Perpetuity by Industry & Sub-Industry When thinking about business we have to acknowledge the sources and uses associated with a corporation where sources represent the capital markets and uses represents the asset mix of the corporation. Business can be thought of as a process where the output is a benefit stream with a given level of variability. This benefit stream with a given level of variability is known as a perpetuity. Thus, the model for business is the perpetuity. From the types of perpetuities, when applied to the main value themes of human existence we arrive at industries associated with the perpetuities (according to Aswath Damodaran at NYU):
  36. 36. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 36 When looking at the different industries in which perpetuities are located, it becomes helpful to understand the nature of the perpetuities including risk (as represented by the discount rate in the perpetuity formula), return, growth, margins, multiples, and cash flow: Risk (discount rate) on the following page:
  37. 37. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 37 Return: Growth:
  38. 38. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 38 Margins (Cash flow): Multiples:
  39. 39. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 39 Chapter 4: Capitalism as a Perpetuity Game In order to build benefit streams (wealth), individuals engage in the perpetuity game by building or buying perpetuities. In order to build a perpetuity, a single benefit stream must be created first and then that benefit stream is to be de-risked. After de-risking that benefit stream and continuing to grow it, the individual may build another benefit stream that is synergistic with the initial benefit stream so that capabilities and functionality may be taken advantage of. Due to existing capital that is accumulated desiring passive returns from already built perpetuities, a marketplace for perpetuities emerges where the benefit stream itself is valued in a multiple capacity meaning that it is worth more than the work put into the creation of it. This marketplace means that there are those that seek to enter and exit perpetuities in order to generate passive benefit streams for themselves and thus the perpetuity game emerges. This is the essence of the capitalist system that we live in whether you are aware of it or not. Within the perpetuity game, there are different sides of the perpetuity that emerge including the build side, sell side and buy side that have different players within each category with various hurdle goals. On the build side, the perpetuity scientist seeks to build a benefit stream with the largest multiple in order to then exit the perpetuity. This means getting the benefit stream to qualify for the most liquid marketplace by going from a private perpetuity to a public perpetuity (“going public”). These players include entrepreneurs and corporations.
  40. 40. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 40 On the sell side, the perpetuity scientist seeks to aid those that have already built perpetuities in exiting them at a strong multiple and take a fee for doing so. These players include investment bankers and Wall Street. Finally, on the buy side, the perpetuity scientist utilizes an existing or borrowed pool of capital to enter and exit perpetuities to create a passive benefit stream for themselves at some hurdle goal (“hurdle rate” or IRR). By entering perpetuities, operating them and then exiting them five to seven years later, the financial or strategic buyer is able to generate the new benefit stream and the rate of return in relation to the capital invested.
  41. 41. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 41 Chapter 5: Playing the Perpetuity Game The name of the perpetuity game is to build as large and passive a benefit stream as possible. There are three sides that one can engage in in order to do so as mentioned in the last chapter; the build side, sell side and buy side. Though there are different sides to the perpetuity, the perpetuity scientist should understand the entire process of playing the perpetuity game including mastering the capabilities and knowledge necessary to play the game. Process of Playing the Perpetuity Game The perpetuity scientist uses the valuation methodologies to determine a valuation range for a target perpetuity that is less than its DCF value (positive NPV project) via using the two valuation methodologies of: 1. Comp companies 2. Comp transactions The perpetuity scientist then uses an LBO or merger structure for the purchase (syndication on build side) of the perpetuity utilizing a deal structure (cash, stock, cash & stock) and goes through the syndication or M&A process to build or buy the perpetuity.
  42. 42. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 42 The perpetuity scientist then operates the company, focusing on debt paydown if there is any and then in five to seven years exits the perpetuity receiving a 25%+ return on capital invested. The perpetuity scientist understand the buy side perspective to every deal, the perpetuity marketplace (multiples), the process and thus he knows the perpetuity game. The perpetuity scientist knows how to pull comps from a coverage database such as Mergr (www.mergr.com) as well as comp transactions to get an understanding of the multiples in a sector and then sub-sector. He then knows how to spread these comps into his valuation model to obtain a mean and median multiple for the sector and sub-sector to value his own target. The perpetuity scientist then knows how to collect financials and calculate adjusted EBITDA (proxy for cash flow) including addbacks (also called Total Owners Benefit in the lower middle market). The perpetuity scientist then knowns how to perform a DCF valuation in excel based upon the adjusted EBITDA and compare the NPV valuation to the multiples of comp companies and comp transactions. This gives an understanding if an investment actually exists (if DCF value > comp multiples). The perpetuity scientist then knows how to procure financing of various sorts to fund the transaction including various types of equity, debt or hybrid from their different sources (can be found in Mergr). He builds a financial model that incorporates these sources of capital along with the corresponding uses of capital in the perpetuity itself and runs an analysis according to what type of buyer he is (strategic with a merger model or financial with an LBO model) in excel to understand the returns from an IRR perspective. The perpetuity scientist then knows how to originate the M&A opportunity in terms of approaching the target and issuing an IOI in order to do a deeper dive with management and how to have a buyer/seller meeting. The perpetuity scientist then knows how to obtain longer period and more detailed financials of 3 to 5 years and confirms the analysis from before to see if still meeting the hurdle rate and performs various sensitivity analysis.
  43. 43. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 43 The perpetuity scientist then knows how to issue an LOI then purchase agreement to begin due diligence and then ultimately takes ownership of the perpetuity.
  44. 44. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 44 FOUNDATIONS OF VALUATION In order to understand the role and work of the investment banker, we need to first have a strong understanding of the foundations of valuation. This helps us to understand why it is that the investment banking industry exists and where investment bankers fit into the bigger picture.
  45. 45. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 45 Part I: Tracking Value (Accounting) As a perpetuity is built, it becomes necessary to track the financial existence of the perpetuity through time. Accounting is the set of concepts, methodologies, and models that allows us to do exactly that.
  46. 46. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 46 Chapter 4: Tracking Value with Accounts Value The formula for value is: Perpetuity value = CF / Discount rate Accounts and Accounting In order to track valuation performance of the perpetuity (i..e business), companies create accounts for each item of it’s financial existence. These accounts are the basis of valuation. Valuation is the basis of actions taken in a capitalist economy. Accounts, Accounting & Excel Excel is the software used to model the accounts of the enterprise and determine the valuation of the perpetuity (i.e. business). Account Filings & Public Data 10-K annual 10-Q quarterly Account Statements: P&L Income statement (P&L): Revenues COGS Gross Profit Operating Expenses
  47. 47. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 47 EBIT Interest Cost EBT Taxes Earnings Account Statements: Balance Sheet Assets = Liabilities + Shareholder’s Equity Total Assets = Total Liabilities + Shareholder’s Equity Current Assets + Long Term Assets = Current Liabilities + Long Term Liabilities + Value of Shares Previously Issued + Retained Earnings – Treasury Stock Account Statements: Statement of Cash Flows CF from Operating CF from Investing CF from Financing Statement of Cash Flows is the linkage between the income statement and the balance sheet. Get D&A from SCF (CF from Operations) and CAPEX from SCF (CF from Investing) The following is a 10-K from Berkshire Hathaway: The following is a 10-Q from Berkshire Hathaway: The following is the IS from Berkshire Hathaway: The following is the BS from Berkshire Hathaway: The following is the SCF from Berkshire Hathaway:
  48. 48. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 48
  49. 49. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 49 Part II: Analyzing Value with Models (Finance) As the economic existence of the perpetuity continues to grow, one becomes interested in the value of the perpetuity. Enter finance, whose concepts, methodologies, and models allow us to understand the valuation of the perpetuity.
  50. 50. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 50 Chapter 5: Analyzing Value with Models Analyzing Value Strategics, financials, and entrepreneurs undertake investment with the expectation of NPV & IRR. They accept projects that have positive NPV and IRR higher than the cost of capital. They actively find and structure positive NPV projects and then match financial products to them. The positive NPV project is ideally a perpetuity with the value of the business being the perpetuity value: Perpetuity value = CF / Discount rate Calculating NPV & IRR is the main analytical work of finance. *Growth statistic CAGR (Compound Annual Growth Rate) is yearly IRR From Accounts to Models To go from accounts (accounting) to a finance number we use models. We only use Free Cash Flow to determine valuation for major transactions in a capitalist economy including restructuring, growth, M&A, and capital raising. To go from account filings to models, we need to “clean the numbers”, “scrub the financials”, “normalize the financials”. This amounts to recasting accounts to get to a finance number. We try to get to a finance number to get to a valuation. We get to a valuation to then take actions in a capitalist economy. *We want more add backs to get to a higher valuation
  51. 51. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 51 Modeling After getting valuation, we can then model the different actions we can take in a capitalist economy to increase the valuation of the strategic, financial or entrepreneurial firm. Modeling in Excel Just like our account statements, our models are built and exist in Excel Analysis of Account Statements Analysis of account statements (ratio of analysis) has various uses including from a liquidity perspective, commercial bank perspective, activity perspective, profitability perspective, and growth perspective. Ex. 4x-7x debt multiple for lending purposes The following is the adjusted financials for Berkshire Hathaway:
  52. 52. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 52 Part III: Modeling Value Continuing deeper into the field of finance we now discuss the actual work associated with understanding the value of a perpetuity. The work is done by modeling the perpetuity in Excel.
  53. 53. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 53 Chapter 6: Finance with Excel Finance with Excel Express your decisions using Excel. Excel is the premier business computational tool Implement financial analysis using the tool for financial analysis, Excel Valuation process Heart of finance is time value of money and discounting Excel Concepts Needed for Finance Write down variables (defining the parameters of the decision) Absolute or relative values copying (=A1) (=$A$1) and formulas Functions (=fx( )) Data tables (“sensitivity tables”) Express Decisions with Excel Implement financial analysis with Excel
  54. 54. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 54 Using a Financial Model for Decision Making: The Investment Decision Ability to get financing from financial institutions depends on ability to make a financial model for the new or existing business The financial model projects future earnings from the organization Predict the future performance of a firm. Accounting statements report what happened to the firm in the past. A financial model predicts what the firm’s accounting statements will look like in the future. Start by taking the initial accounting statements and inputting them into Excel Difference between accounting and financial model is in the current assets and current liabilities. In financial model we are concerned only with operating assets and operating liabilities. We exclude financing related Financial model has three components: Model parameters (value drivers) Financing decision assumptions (i.e. Mix between debt and equity, what does firm do with excess cash? Repay debt, payments to shareholders, or as cash balance) Pro forma financial statements Cash in the financial model is a plug. The plug is so that the balance sheet balances. Cash = total liabilities and equity – current assets – net fixed assets The plug is the balance sheet item that guarantees the equality of the future projected total assets and future projected total liabilities and equity. Every financial model has a plug and the plug is almost always cash, debt, or stock. Financial Model and Valuation Process: Assumptions (value drivers) Existing accounting statements (IS and BS) Projected financial statements Free cash flow calculation (FCFs) Terminal value calculation Valuation calculation Sensitivity table for major value drivers to see range of valuation
  55. 55. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 55 Once the financial model is complete (i.e. accounting statements have been projected), we can use the model to: Value the firm by projecting free cash flows (FCFs) Determine ability of firm to pay it’s debts (i.e. credit analysis) Using a Financial Model for Decision Making: The Financing Decision All companies must decide how to finance their activities Proportion of debt and equity The discount rate should be appropriate to the riskiness (i.e. variability or beta) of the cash flows being discounted. Discount rate is also called interest rate, cost of capital, opportunity cost. Compute annualized IRR The cost of capital of an investment is related to the risk of the cash flows of the investment. The relationship of individual asset returns to the risk is called the security market line (SML). You can use SML to get the discount rate for individual investments. The SML is used for private companies. The cost of capital of an organization is related to the risk of the combined riskiness of the investments in the portfolio. The relationship of portfolio returns to the risk is called the capital asset pricing model (CAPM). You use CAPM to get the discount rate (i.e. cost of capital). When the investment is a public security, you use CAPM since the buyer of the security will have a portfolio to diversify away risk. Portfolio risk is associated with statistics. Wealth Maximizing Decisions Investment decision – What is it worth? NPV of strategic alternative Financing decision – What does it cost? IRR of financing alternative Cash is King Wealth maximization has to do with maximizing cash. Cash in the context or organizations is known as cash flow. Return is a word for cash flows
  56. 56. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 56 Cash Flow Definition (FCF) Profit after taxes + Depreciation (noncash expense) + Change in net working capital (- increase in current assets and + increase in current liabilities) Capital expenditures (CAPEX) + After-tax interest payments = Free Cash Flow (FCF) Role of the Finance Professional The role of the financial professional is to quantify the cash flows and risk of strategic alternatives available to the individual or organization. Investment bankers compute the IRR and NPV of strategic alternatives. Capital Markets The capital markets is made up of cash flows and discounts Capital Markets and Information Information is valuable in determining investment and financing decisions in the capital markets. Overall, markets are weak form efficient meaning that their valuations reflect previous stock price performance (i.e. stock price data) and are sometimes semistrong meaning that valuations incorporate all public information. Capital markets are not strong form efficient meaning that valuations do not reflect private information. Multiple Investment and Financing Decisions: Portfolio When there is multiple investment and financing decisions, we have something called a portfolio. The discount rate can be decreased by diversifying with a portfolio. When the discount rate is decreased, the valuation of the portfolio increases as cash flows have maintained more value. A corporation/organization is simply a portfolio of sources and uses Modeling a Strategic Alternative Put all variables (“value drivers”) at the top of the spreadsheet Never use a number where a formula will also work Blue for hard codes Black for links and outputs Finance: Exchanging Value Through Time
  57. 57. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 57 Assets have a time dimension Future value function =FV( ) Value in the future of a sum of money compounded into the future Present value =PV( ) Value today of future payments discounted to present Net present value (NPV) =-First payment + NPV( ) Incremental wealth increase earned by a strategic alternative. NPV tells you economic value of an investment today. Always use NPV in the investment decision. Internal rate of return (IRR) =IRR( ) Compound rate of return earned by a strategic alternative VIII. Rate of Return vs. Cost of Capital What is the asset’s IRR? Compare to the cost of capital (Effective annual interest rate – which is the annualized IRR used to compare financing alternatives aka Compound Annual Growth Rate (CAGR)) Cost of Capital Calculate IRR of financing alternatives to determine cost of capital Need to get IRR in annual terms to facilitate comparison. May have to start with monthly IRR then annualize Annualized IRR = (1 + Monthly IRR)^n-1 Finding a Value in a Financial Model When we want to find a value by setting a particular value to another cell, we use: Goal seek – Alt, A, G Financing Alternatives: Loan Amortization =PMT( ) To calculate the debt payment per period
  58. 58. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 58 =IPMT( ) To calculate the interest portion of the payment of debt =PPMT( ) To calculate the principal portion of the payment VIII. Financing Alternatives: Direct Comparison IRR of differential cash flows tells you the cost of the option IRR tells you the cost of the financing alternative CAGR is Effective Annual Interest Rate (EAIR) to allow for comparison Analyzing the Strategic Alternative: Sensitivity Table Data Table is Alt, A, W, T Tells you how output changes with incremental changes in the inputs (i.e. variables) The Financing Alternative: Nominal vs. Real Cost In determining the true cost of a financing alternative, it is important to use the real rate of interest which incorporates inflation. The real rate of interest is determined by using the real cash flows. Inflation acts as a discount rate Strategic Alternatives Analysis For each strategic alternative, compute the NPV and IRR, then have decision rules for investing including: Minimum NPV Hurdle rate (IRR) You are using NPV and IRR to make investment decisions but you need the discount rate. The discount rate is associated with the financing decision Cash Flows and Risk Are cash flows riskless (i.e. treasury bills) or are they risky (i.e. market portfolio) Cost of Capital and Opportunity Cost The returns of similar investments should be used as the cost of capital The Discount Rate
  59. 59. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 59 An organization’s discount rate is the cost of equity and cost of debt. The cost of the total capital structure is known as the Weighted Average Cost of Capital (WACC): WACC = rE* (E/(E+D)) + rD (1-Tc)*(D/(E+D)) Value of Equity The value of equity is the present value of all future dividends Sources & Uses Uses Sources Free Cash Flows WACC CAPM to get cost of equity Accounting Statements: Statement of Cash Flows The purpose of the statement of cash flow is to explain the increase in the cash accounts on the balance sheet as a function of the firm’s operating, investing, and financing activities. Valuation Methods: Total Enterprise Value (TEV) vs. DCF Market valuation: Total Enterprise Value (TEV) = MVE + MVD + Preferred – Cash 2. DCF Method (intrinsic value) = PV(FCFs) @ WACC + liquid assets Accounting Value vs. Finance Value Accounting value of firm is backward looking and thus incorrect to use in valuation. Finance value is forward looking and consistent with the fact that the owner of an organization or security has claims on the future cash flows of the business. FCF and DCF Free cash flow (FCF) calculations is DCF Portfolio Analysis and the Capital Asset Pricing Model (CAPM) Discount rate is a measure of risk associated with: Horizon Safety Liquidity
  60. 60. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 60 We get the discount rate by analyzing the distribution of an investment’s returns. We get the standard deviation which is a measure of variance in returns. Standard deviation is a component to finding the discount rate: =STDEVP( ) What does the frequency distribution look like? Determine risk measure known as beta and plug this into CAPM to get the discount rate of equity. Derive the cost of debt and then calculate WACC to get the discount rate of the firm. Ex Ante vs. Ex Post Returns Ex Ante is the expected return Ex Post is the actual return VIII. Statistics for Portfolios =Average( ) To get mean return =Varp( ) To get variance of returns =Stdevp( ) To get standard deviation of returns =Covar( ) To get covariance between two sets of returns =Correl( ) To get correlation between two sets of returns Trendline (regression) – click on points of XY graph and right click to Add Trendline with linear regression and display equation and R-squared on chart Portfolio Returns and The Efficient Frontier Statistics are used to determine acceptable and unacceptable portfolios Diversification lowers standard deviation of the portfolio Are the returns correlated? If no, then add security to the portfolio (i.e. diversify)
  61. 61. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 61 The efficient frontier is the set of all portfolios that are on the upward-sloping part of the graph starting with the minimum variance portfolio (i.e. the market portfolio). Choose the portfolio that is on the efficient frontier. The Efficient Frontier and the Optimal Portfolio The best investment portfolio is made up of the risk free asset and a risky asset representing the market (i.e. the market portfolio) Determine the market portfolio (the portfolio with the highest attainable sharpe ratio) Market portfolio is the best combination of risky assets available to the investor Security Market Line & CAPM The security market line says that the expected return of an asset is a function of the asset’s beta (i.e. sensitivity to the market). Only relevant risk is systematic risk since the investors will all be diversified Security Market Line & Investment Performance The security market line says that the expected return of an asset is a function of the asset’s beta (i.e. sensitivity to the market). Only relevant risk is systematic risk since the investors will all be diversified Security Market Line & Investment Performance The security market line says that the expected return of an asset is a function of the asset’s beta (i.e. sensitivity to the market). Only relevant risk is systematic risk since the investors will all be diversified VIII. Security Market Line & Investment Performance Continued Investment performance: Risk adjusted performance; excess returns? Risk Adjusted Performance Market portfolio proxy is S&P 500 Beta is measure of riskiness of security Alpha measures excess return
  62. 62. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 62 Market portfolio proxy is S&P 500 Beta is measure of riskiness of security Alpha measures excess return It is about investment performance versus the risk involved in the investment CAPM & Investment Performance Use CAPM to get the discount rate of equity and compare to cost of financing alternatives Is there risk adjusted overperformance or underperformance? Is performance commensurate with risk? Excess Return Excess return is the investment’s spread over the one year treasury (i.e. risk free rate) Use regression equation to determine if underperformance (negative alpha) or overperformance (positive alpha) When regressing asset’s returns against the market portfolio, alpha measures excess returns over the market portfolio Beta & R^2 High beta is an aggressive stock Low beta is a defensive stock R^2 is percentage of variability that is market related risk when returns are regressed on the market portfolio Diversification increases R^2 of the portfolio and decreases nonsystematic risk Alpha and Efficient Markets In efficient markets, there is no alpha and investments earn their risk-adjusted return CAPM and the Cost of Capital
  63. 63. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 63 CAPM = rf + Beta [ E(rm) – rf] In CAPM, use Beta of asset to calculate cost of equity WACC is the discount rate based upon the capital structure of the investment Valuing Securities in Efficient Markets Market efficiency and the role of information in determining asset prices Publicly available information should be reflected in market price Chapter 7: Financial Statement Modeling Financial statement modeling refers to the creation of a standalone operating model for a company. The operating model is built using historical performance (i.e. historical financial statements). We use the operating model to see pro forma performance of a company given certain assumptions. These pro-formas are the basis for decision making within the corporation. Financial statement modeling best practices: Blue is hard codes, black is formulas Be consistent with millions and billions (keep conventions the same) Footnote everything in presentation Keep your model simple (1,000 cells is better than 10,000 cells) Financial Modeling Steps: 1. Spread historical financial statements a. 3 to 5 years history for IS, BS, and SCF b. Public information for company 10K, 10Q c. If private company, get audited financial statements provided by company 2. Adjust for non-recurrings
  64. 64. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 64 3. Build cases into the operating model a. Best case b. Base case c. Worst case d. Disruption case 4. Build assumptions based upon historical trends in assumptions tab (margins and growth rates) 5. Project LIBOR and interest rates a. Spread over LIBOR b. LIBOR is the base that banks use to price spread their loans to make money (called “L”) c. 3 month LIBOR is the standard reference 6. Project IS and BS & two items on SCF (D&A and CAPEX (before gross PPE on BS)) a. Maintenance CAPEX vs. Discretionary (growth) CAPEX 7. Separate debt and interest schedule (calculate debt and interest schedule before calculating BS items for revolver, term loan, and unsecured debt) 8. Project Working Capital a. Days payable & Days receivable (360 day method) 9. Project rest of SCF (all items pulled from IS or BS) a. AR goes up, need negative sign on SCF b. AP goes up, need positive sign on SCF c. BS cash is ending cash position on SCF 10. Calculate paydown/drawdown for revolver as minimum (Min function) of CF before revolver and beginning revolver balance 11. Operating model is done when you finish SCF. Operating model check (zero for Assets – (Liabilities + Owners Equity) NEXT STEP IS TO USE THE OPERATING MODEL FOR VARIOUS ANALYSES INCLUDING ORGANIC GROWTH & INORGANIC GROWTH (STRATEGIC ALTERNATIVES). THE KEY QUESTION TO ASK IS: WHAT IS THE BEST STRATEGIC ALTERNATIVE FOR THE CORPORATION (I.E. HOW TO BE A GROWING PERPETUITY OR PARENT COMPANY OF MULTIPLE GROWING PERPETUITIES)? The following is a financial statement model for Berkshire Hathaway:
  65. 65. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 65
  66. 66. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 66 Part IV: Valuation Methodologies Continuing on through foundations of valuation, we arrive at the actual valuation methodologies used in investment banking & private equity.
  67. 67. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 67 Chapter 8: Valuation Principle Large institutional investors and corporates need to deploy large amounts of capital at reasonable rates of return. This large amount of capital is ideally to be deployed into perpetuities. Thus, the larger the perpetuity, the greater the scarcity of it and larger the demand, coinciding with a larger multiple.
  68. 68. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 68 Chapter 8: Valuation Build Up A company is a perpetuity in a financial sense. The valuation for a simple perpetuity is: Perpetuity Valuation (Intrinsic) = CF / r CF = Adjusted EBITDA (proxy for CF from NI on financial statements P&L) r = Discount rate for phase of perpetuity To determine the r, we look at the discount rate for each phase of the perpetuity as demanded by the source of capital: I. Syndication = 45%+ (VC) II. Job Shop = 35% (LMM PE) III. Perpetuity = 25% (PE) IV. Growing Perpetuity = 15% (Strategic) V. Diversified Perpetuity = 7% to 10% (Mature Strategic) We then take the proxy for cash flow, EBITDA, and divide by the discount rate of the phase of the perpetuity to get a base line valuation build up for the perpetuity. This should give you a high level simplified understanding of valuation of the corporation as if its cash flow behaved like a perpetuity for the rest of its existence.
  69. 69. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 69 Chapter 8: Valuation Methodologies 1. Public Company Valuation 2. Comp Companies – Also known as trading comps. Management team gives you 1 to 2 years projections or equity research comp reports to get forward multiples (x Revenue or x EBITDA ) which may be used as the basis for this valuation. You can get comps from the general overview as it will discuss the target’s comps in the 10K. Find comps with good multiples to then tell your story to the marketplace to then get a certain valuation. a. Select the universe of comparable companies – Choose 7, 8, 10 comps, need their 10K, 10Q, analyst reports to get TEV for each comp then divide by line item to get multiple. b. Locate financial information on comp companies – Information must come from latest filing (10K or 10Q). Print out 10K, 10Q, analyst reports. c. Spread key financial information, ratios and multiples – Calculate TEV (in comp spread tab). To get MVE, use TSM method. TSM = Exercisable options outstanding x (share price – strike) / share price. d. Benchmark comp companies – Get the multiple that the company is trading at for each metric for each comp and get mean and median of comps for the metrics (ex. TEV/EBITDA) e. Determine implied valuation – Multiply mean and median multiple x the revenue or EBITDA to get the valuation range for your target company.
  70. 70. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 70 Notes: The better the company, the higher the multiple and the better valuation you get. In IB/PE/CorpFin, you need to know comp companies and transaction comps. “Here are the comps in your sector…” Higher multiple because… Operating in better markets, better operations The multiple tells you which company is better, margin analysis tells you why they are better. Sell side key question: “Which comp would you use to guide potential buyers?” 3. Precedent Transactions – comp transactions a. Select universe of comp transactions b. Locate deal-related and financial information – Need press release of the deal, 8K, 10K, and 10Q. Type of payment: cash, stock, cash & stock. c. Spread financial information, ratios and multiples – Get transaction TEV (implied) & transaction MVE (implied) d. Benchmark precedent transactions e. Determine implied valuation Notes: 20% to 25% control premium paid with the transaction multiple being an implied one based upon the valuation. Determine whether the market is good or bad based upon whether people are paying good premiums (control premiums). When a transaction occurs, update client on the latest transaction to show them impact on the control premiums being paid and implied multiple as well. Point to the transaction comps that have the highest control premium. 4. Discounted Cash Flow (DCF) a. Spread historical financial statements (input historicals) and derive historical ratios, trends and variables (drivers of future performance; margins and growth rates). Project financial statements (proforma). Revolver modeling to link IS, BS, and SCF
  71. 71. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 71 b. Project free cash flow (FCF) c. Determine Weighted Average Cost of Capital (WACC) – Discount rate Cost of equity: Rf = 10 year treasury Market risk premium = Rm – Rf. Refer to Ibbotson. Ultimately this is S&P returns over 70, 80, or 90 years Beta = Levered beta of comps to unlevered median and mean of comps (unlevered beta); should be .5 to 2.5; 2 year to 5 year betas (taking out capital structure and relever to actual capital structure. With beta, we are putting capital structure on unlevered beta mean and median of comps to calculate WACC of own company. Cost of debt: weighted average of tranches of debt tax effected; found in 10K. Rates from the notes. If private company, get from clients the tranches and to get rates, go to DCM to get approximation. Cost of equity 20% to 25% in private markets. No use of debt is an inefficient use of capital. Trying to optimize the D/E ratio to minimize cost of financing. d. Determine terminal value – EBITDA multiple which is going to be almost 80% of the company value. Terminal value = LTM multiple from comps x EBITDA. Perpetuity growth rate should be 2.5% to 3% and should not be larger than the size of the GDP of the country e. Calculate net present value (NPV) and determine implied valuation Notes: Need the valuation date; this determines stub year fraction (i.e. period left in the year). Stub year fraction – investor does not have claim on revenues before that. DCF value always moving through time consistent with valuation date.
  72. 72. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 72 IB interviews test you on DCF. Everything else that you know is a bonus. Do DCF to find yield to decide whether or not to invest principal. Creating value: $ dollars of value increased by… Changing multiple on valuation Decreasing the discount rate
  73. 73. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 73
  74. 74. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 74
  75. 75. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 75 BUILD-SIDE Related to the intentional creation of perpetuities following a methodology, we have what is known as the build-side. The build-side is associated with the creation and management of perpetuities. Participants on the build-side include startups, growing businesses, and established corporations.
  76. 76. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 76 Part I: How to Build a Perpetuity? The process for building a perpetuity is the following: 1. Challenge/opportunity and case for value perpetuity & financial perpetuity (total addressable market that exceeds hurdle) 2. Key question associated with challenge/opportunity 2. Methodology that answers key question 3. Platform architecture consistent with methodology 4. MVP (Minimum viable product) of platform 5. Value Perpetuity 6. Financial Perpetuity 7. Growing Financial Perpetuity 8. Diversified Perpetuity
  77. 77. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 77 Perpetuity Science & The Perpetuity Scientist Within Perpetuity Science, there are definite phases of the perpetuity corresponding to levels of development of the perpetuity including: 1. Levels of customer concentration where: a. high levels of customer concentration correspond with a lower EBITDA multiple and low levels of customer concentration correspond with a high EBITDA multiple 2. Levels of recurring revenue where: a. high levels of recurring revenue correspond with a high EBITDA multiple and low levels of recurring revenue correspond with a low EBITDA multiple 3. Levels of owner dependence where: a. a high level of owner dependence corresponds with a lower EBITDA multiple and low levels of owner dependence correspond with a high EBITDA multiple The perpetuity scientist (CEO or consultant) is not only responsible for growing the benefit stream (CF), but also these de-risking factors that determine the discount rate (r). In doing so, the perpetuity scientist builds a highly sought after perpetuity for both strategic and financial buyers corresponding with a premium valuation. When providing coverage to a target perpetuity and originating an engagement, the perpetuity scientist should follow these steps: Stage of the Perpetuity: 1. Syndication: (Getting to PMT) Initial revenue generation The key here is taking a concept that has a large enough total addressable market and turning it into a single sale as represented by PMT. This demonstrates product market fit between the minimum viable product/platform and allows the owner to invest additional time/energy/resources into turning the syndication into a perpetuity. The syndication’s value to the owner will be related to the NPV/DCF value, however, since there is an inefficient market for syndications, the value is going to be discounted at a high rate, in the 80% to 100% range. The syndication is entirely reliant on the owner’s active involvement. If the owner no longer works in the syndication, the syndication will cease to operate.
  78. 78. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 78 The market here is inefficient. 2. Job Shop: (From PMT1 to PMT2, PMT3, etc) The initial efforts create a job shop The key here is taking a syndication that has demonstrated product/market fit and turning it into a job shop with multiple projects as represented by PMT1, PMT2, PMT3. This demonstrates product market fit between the minimum viable product/platform and allows the owner to invest additional time/energy/resources into turning the syndication into a perpetuity. The job shop’s valuation is based upon a multiple of its EBITDA and is usually in the range of 3x to 5x. The job shop is not entirely reliant on the owner’s active involvement and there is thus a larger, albeit still inefficient market for the prospective perpetuity with likely buyers being individuals and LMM strategic and financial buyers. The owner’s primary responsibility is to first turn the company into a project or job shop (PMT representing a given job). The company is looked at solely as the sum of the value of its projects/jobs meaning that the valuation of the company is backward looking. 3. Perpetuity: (From PMTi to CF/r) Transitioning from a job shop to a recurring revenue stream The key here is taking a job shop with disparate projects (PMT1, PMT2, PMT3) and turning it into a perpetuity with a predictable if not recurring benefit stream. The perpetuity’s value is based on a larger EBITDA multiple since there is a semi- strong efficient market for perpetuities with likely buyers being middle market strategic and financial buyers. The perpetuity is almost entirely not reliant on the owner’s active involvement. From here, the owner is to turn the company into a perpetuity as characterized by predictable, preferably recurring revenue. This can be done by building an organizational structure with division of labor, automated processes with technology, and a business model that is recurring by nature. When this is accomplished, the valuation becomes forward looking. 4. Growing Perpetuity: (From CF/r to CF/r– g)
  79. 79. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 79 Going from recurring revenue stream to a growing perpetuity The key here is taking a perpetuity with a durable benefit stream (CF) and reasonable amount or variability in that benefit stream (r) and turning it into a growing perpetuity with a corresponding growth rate (g). The perpetuity’s value is based on an even larger EBITDA multiple since there is a weak form efficient market for growing perpetuities with likely buyers being middle market strategic and financial buyers and some public strategic and financial buyers. The growing perpetuity is almost entirely not reliant on the owner’s active involvement. This can be accomplished by building a scalable platform as part of the core business. The valuation of the company now has to incorporate a growth factor. 5. Diversified: (Perpetuity 1 + Perpetuity 2) From one growing perpetuity to growing another perpetuity organically or purchasing one to grow inorganically Finally, the owner is to diversify either organically (new product, new business) or inorganically. If the diversification is organic, the new product/business will naturally move through the phases of: 1. Syndication 2. Project/job shop 2. Perpetuity 3. Growing perpetuity Since the valuation is forward looking, it has to incorporate the new product/business’ financial performance. Since the parent company is now becoming diversified, the discount rate will now decrease which adds value to the parent company.
  80. 80. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 80
  81. 81. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 81 Chapter 9: How to Build a Benefit Stream? The CEO’s role is to bring the company/opportunity through the stages of the perpetuity by building recurring benefit streams (i.e. cash flows) and at the same time de-risking those benefit streams. In doing so, the valuation of the perpetuity moves from backward looking towards forward looking and the valuation is thus maximized (based upon a multiple of future earnings). Reasoning to Platform The ultimate conclusion of reasoning applied to a challenge/opportunity in nature is the building of a platform which in turn can be turned into a perpetuity. 1. Opportunity/challenge in nature 2. Key question associated with challenge/opportunity 3. Develop methodology that answers the key question 4. Build platform around the methodology 5. Perpetuity Existing Platform to New Value Theme A common way to begin on the build-side is to take an existing platform and apply the concept to a new value theme. We will discuss this in great detail in the cases portion of this text. Platform vs. Mod
  82. 82. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 82 Platform is associated with network and is the core value, the connecting of individuals in an integrated platform. Platform is ultimately the basis for becoming a perpetuity. Mod is associated with a specific functionality. The Value of Technology & Science Technology and science have value inasmuch as they are associated with a perpetuity. Technology and science in isolation has no value. Ecommerce The new science (product) ultimately needs ecommerce to be built around it including: 1. Marketing 1. Database (Salesgenie & InfoUSA) 2. Adwords 3. SEO 2. Platform 1. Wordpress 1. Form 2. Login/profile 3. Cart (Woocommerce & Paypal) 3. Fulfillment & Delivery The Consumption Process & Growth Hacking It is important to have appropriate expectations regarding growth and returns. One does not simply build an MVP and turn on users with a switch. Brands are built one person at a time and consumption follows a definite process which is the following: 1. Awareness of methodology via being advocated to directly on a social network or via email 2. Methodology adds value for individual (based in reason) and thus the user decides to be a follower
  83. 83. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 83 3. Followership of brand adds value enough so that when the 'ask' is made, the individual is willing to experiment with usage 4. Usage adds value enough so that the user becomes an active user 5. Active usage adds value enough so that individual is willing to recommend others to become users 6. Active users willing to pay for usage Since there is a definite process to consumption, one's growth hacking methodology should be consistent with this fact. The Growth Hacking Methodology means manually connecting with individuals on various social networks including Instagram, Facebook, & Twitter to first advocate the startup's methodology: 1. Develop thought leadership (methodology) 2. Advocate methodology and first contact 3. Acquire followership 4. Convert followership into users 5. Convert users into active users The key here is to advocate the startup's methodology and then show traction on the methodology which will be used to gain followership from influencers and turn them into evangelists for the methodology. Mechanisms like social proof can be helpful as they accelerate willingness to participate in followership or experiment with usage, but they are not a replacement for one by one advocacy of a methodology. Social proof kicks in incrementally as the startup hits an extra zero at the end of its followership and user numbers (ex. 100, 1000, 10000, 100000, 1000000).
  84. 84. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 84
  85. 85. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 85
  86. 86. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 86
  87. 87. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 87
  88. 88. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 88 Chapter 10: How to De-Risk a Benefit Stream? The CEO’s role is to bring the company/opportunity through the stages of the perpetuity by building recurring benefit streams (i.e. cash flows) and at the same time de-risking those benefit streams. In doing so, the valuation of the perpetuity moves from backward looking towards forward looking and the valuation is thus maximized (based upon a multiple of future earnings).
  89. 89. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 89
  90. 90. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 90 Chapter 11: The Value Perpetuity Commodity -> Finite Benefit Job -> Active Benefit Perpetuity -> Passive Benefit Perpetuity How to Build a Perpetuity Methodology: 1. The Case for a Perpetuity 2. MVP 3. Value Perpetuity 4. Financial Perpetuity 5. Growing Financial Perpetuity 6. Diversified Perpetuity
  91. 91. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 91 Part II: Perpetuity Analysis On the build-side, we are ultimately concerned with the creation and management of perpetuities. We first explore the perpetuity analysis, perpetuity building process/timeline (including sources and uses) and then move towards a methodology for perpetuity management. The goal of Perpetuity Science is the building, growing, management, exit and buying of perpetuities, so ultimately, while learning about Perpetuity Science itself, we are also actively looking for: 1. Perpetuities to create 2. How to advance a perpetuity to the next phase 3. Perpetuities that should be exited from 4. Perpetuities that should be purchased Perpetuity analysis is performed with an understanding that a perpetuity’s ideal course of action at any given time is related to one of the three sides of the perpetuity (Build-side, Sell-side, Buy-side) which depends on the phase that the perpetuity is in: I. Industry and sub-industry indices made up of public comps II. Benchmark comps into Perpetuity Phases III. Build financial statement models for each IV. Determine DCF, Comp Companies & Precedent Transactions valuation football field V. Compare peers in Perpetuity Phase to intrinsic value to determine if this is a Buy-Side, Sell-Side or Build-Side deal (where are peer multiples at in relation to intrinsic value?)
  92. 92. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 92 a. If Build-Side: What needs to be done to get to the next phase of the perpetuity? b. If Sell-Side: How to exit the perpetuity? c. If Buy-Side: How to acquire a target perpetuity? Perpetuity science explains how perpetuities can be built, managed and exited from to create wealth. As such, it inherently has an owner focus rather than simply a capital markets focus which is manifested by the dual goals of decreasing the owner’s active involvement in the day to day of the business and the maximizing of valuation. Perpetuity Analysis can occur at three levels: 1. Vertical (Industry) At the level of the industry, we can take the public comps as place them on the Market for Perpetuities chart: For example, we can take a look at the Oil & Gas vertical and see where the various players at:
  93. 93. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 93 2. Sub-Vertical At the level of the industry, we can take the public comps as place them on the Market for Perpetuities chart:
  94. 94. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 94 For example, we can take a look at the Oil & Gas machine manufacturing sub- vertical and see where the various players at: 3. Corporation As discussed, a corporation is merely a portfolio of perpetuities. As such, we can map the corporation in terms of its perpetuities and see the stage of each individual perpetuity:
  95. 95. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 95 An example of Perpetuity Analysis at the corporate level would be Berkshire Hathaway, which we have mapped below: Perpetuity science is where entrepreneurship, strategy & finance come together. It a field of study complete with a body of knowledge,
  96. 96. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 96 methodologies, and optimization models towards improving the individual's quality of life by the building of a perpetuity that accomplishes two dual goals: 1. ever decreasing involvement of the perpetuity owner in the perpetuity 2. ever increasing valuation of the perpetuity Perpetuity science is ultimately about maximizing quality of life rather than just wealth by building perpetuities with recurring revenue streams that are not reliant on the daily participation of the owner of the perpetuity. We can take a look in a visual format of what we are trying to accomplish: As you will notice, the owner’s direct involvement in the perpetuity decreases as the perpetuity moves through the phases of development. Also, valuation increases as the perpetuity moves through the phases of development for three reasons; EBITDA increase, EBITDA multiple expansion, decrease in discount rate. The key question is: How to build a perpetuity that minimizes the daily involvement of the owner and at the same time maximizes it’s valuation.
  97. 97. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 97 Though applicable to all industries, the focus industries of perpetuity science are thus those that do not require significant capital outlays which could otherwise be used to invest in a diversified portfolio. These industries include: 1. Technology 2. Media 3. Education 4. Business Services As you will notice, these industries have to do with knowledge working and benefit from information arbitrage and/or network arbitrage. While it is possible to structure arbitrage in other industries by preselling various products and services, knowledge working industries offer genuine information/network arbitrage as well as allowing for recurring revenue business models rather than being one time commodity or project-based. You will also notice that margins are much larger in knowledge working industries which translates into larger EBITDA multiples. Thus, the owner of the perpetuity is rewarded multiple times more for the value that their perpetuity creates than they would for commodity or project-based syndications. Given that the human has a limited amount of time on earth and limited resources within which to invest (energy, capital), one should invest their time in knowledge working industries and build perpetuities there first. Only after a perpetuity has been built in a knowledge working industry should the owner explore other non-knowledge related industries. One should thoroughly understand these industries overall and their sub- sectors when syndicating a new perpetuity. We will go into these industries in detail after explaining the perpetuity building process, the perpetuity management process, and perpetuity exit process. The science of the perpetuity can be broken down into three sequential categories including: I. Perpetuity Analysis II. Perpetuity Building III. Perpetuity Management Perpetuity Exit
  98. 98. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 98 Market Analysis GDP Industry Spend Sub sector spending Sub sector spending by product Value Chain Analysis
  99. 99. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 99 General Industry Sub-sector Sub-sector by product Gap Analysis General Industry Sub-sector Sub-sector by product Product/Platform Analysis Base Mods Perpetuity Science: A methodology that synthesizes industry and the capital markets in relation to the perpetuity. The science of building, selling and buying perpetuities. I. Nature of the Perpetuity II. Phases of the Perpetuity III. Sides of the Perpetuity IV. Perpetuity Analysis: Industry and sub-industry indices Determining where leaders are at in Perpetuity Phases Build financial statement models for each Compare Perpetuity Phase to intrinsic value
  100. 100. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 100 Determine if this is a Buy Side, Sell Side or Build Side deal (where are multiples at in relation to intrinsic value?) What needs to be done to get to the next phase of the perpetuity?
  101. 101. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 101 Chapter 12: How to Be a CEO? The CEO’s role is to bring the company/opportunity through the stages of the perpetuity by building recurring benefit streams (i.e. cash flows) and at the same time de-risking those benefit streams. In doing so, the valuation of the perpetuity moves from backward looking towards forward looking and the valuation is thus maximized (based upon a multiple of future earnings). The CEO should thus be familiar with perpetuity science and the phases of the perpetuity. As the perpetuity changes, the formula for valuing the perpetuity changes as well. There are five phases of perpetuity building. As we move through the phases, the role of the owner of the perpetuity becomes more passive and the valuation becomes larger due to size of EBITDA increasing, EBITDA multiple increasing, and the discount rate decreasing. The perpetuity becomes less dependent on the owner to exist and run as an organizational structure is formed coinciding with the division of labor, processes are automated, and revenue becomes recurring. Phases of the Perpetuity: I. Syndication (Getting to PMT) II. Job Shop (From PMT1 to PMT2, PMT3, etc) III. Perpetuity (From PMTi to CF/r) IV. Growing Perpetuity (From CF/r to CF/r– g) V. Diversified (Perpetuity 1 + Perpetuity 2)
  102. 102. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 102
  103. 103. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 103 Chapter 13: How to Be a Consultant? The consultant’s role is to aid in the building, selling, or buying of a perpetuity. Since the consultant’s value is in relation to the perpetuity, the consultant’s core methodology/body of knowledge is Perpetuity Science. Perpetuity Science is the set of methodologies related to building, selling, and buying of perpetuities which is referred to as the build-side, sell-side, and buy-side respectively. The key questions related to each side of the perpetuity are: The consultant uses methodologies related to each one of these key questions which serve as the basis for a consulting engagement: 4. Build-Side: How to move a company/opportunity to the next stage of the perpetuity building process? The methodology for the phases of a perpetuity is the following:
  104. 104. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 104 5. Sell-Side: How to obtain a valuation higher than the NPV of the perpetuity? The methodology for doing so is to get a buyer to price in the next phase of the perpetuity into the current valuation (ex. if the perpetuity is at the perpetuity phase, get the buyer to pay for a growing perpetuity) 6. Buy-Side: How to locate and take ownership of a perpetuity that is being valued at less than its NPV? The methodology for doing so is to get the seller to accept a price for the previous phase of the perpetuity (ex. if the perpetuity is at the growing perpetuity phase, get the seller to sell for at a perpetuity valuation) What Should You Learn in Business School? Since the perpetuity is the basis for both industry and the capital markets it follows that business school thus focus on educating individuals on: 1. The Nature of the Perpetuity 2. The Phases of the Perpetuity 3. The Different Sides of the Perpetuity The standard MBA curriculum at most business schools is broken down along siloed subjects such as accounting, finance, management, operations, and marketing and attempts to teach students how to be a mid-level manager at a large corporation for the rest of their lives. Unfortunately, these jobs are mostly gone, having been shipped overseas or automated. This MBA curriculum is thus outdated and not appropriate for the 21st century when most individuals will have multiple jobs and roles throughout their careers and lives.
  105. 105. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 105 The more appropriate field of study which has yet to make it to business schools is known as Perpetuity Science. Perpetuity Science is the body of knowledge, methodologies, and optimization models related to the building, selling, and buying of perpetuities. It explains how perpetuities can be built, managed and exited from to create wealth. Perpetuity science is a paradigm shift in business and finance education in that it replaces the siloed subjects traditionally taught in undergraduate and graduate business schools with a holistic methodology that integrates industry and the capital markets into one framework. Instead of a disparate business taxonomy along the lines of economics, finance, accounting, marketing, etc., we have an initial taxonomy broken down in relation to the perpetuity, namely: Build-side – the building of perpetuities (entrepreneurs, corporations) Sell-side – the selling of perpetuities (investment bankers, wall street) Buy-side – the buying of perpetuities (private equity, corporate M&A) Within each of the three, we have various methodologies and optimization models that may touch on various subjects such as accounting, finance, economics. By starting with perpetuity science, the student can better synthesize the various moving parts of industry and the capital markets. 1. The Nature of the Perpetuity: When first learning about industry and the capital markets, one should first understand the nature of the perpetuity, which is the basis for industry & the capital markets. The perpetuity can be modeled with the following formula: Perpetuity value = CF / r Where CF represents the benefit stream associated with the perpetuity and r represents the discount rate associated with the perpetuity’s risk of receiving the benefit stream. 2. The Phases of the Perpetuity: After understanding the nature of the perpetuity in general, we can then analyze the perpetuity within each industry. The nature of the CF, r, value chain, and value being offered will be different. We investigate each industry according to these variables by building an index for each industry and then sub-sectors within the industry:
  106. 106. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 106 3. The Different Sides of the Perpetuity:
  107. 107. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 107
  108. 108. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 108
  109. 109. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 109 Part III: Perpetuity Management On the build-side, we are ultimately concerned with the creation and management of perpetuities. We first explore the perpetuity analysis, perpetuity building process/timeline (including sources and uses) and then move towards a methodology for perpetuity management.
  110. 110. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 110 Chapter 14: Perpetuity Management The Purpose of the Company Companies exist to create value How Companies Create Value Companies create value by investing capital at rates of return that exceed their cost of capital. This is the principle of value creation. The only thing that differs across companies is the implementation (i.e. different asset and capitalization mix) Strategy & Finance Valuation Drivers
  111. 111. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 111 The Role of the CEO Perpetuity Management Valuation
  112. 112. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 112 Perpetuity Management with Discounted Cash Flows Growth or Restructuring Perpetuity Management Process
  113. 113. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 113 Measuring Value Added: ROIC vs. Market Return Measure return on invested capital (after-tax operating profits divided by capital invested in working capital, PP&E) and compare it with stock market returns Measuring Value Added: Economic Profit & NPV Economic profit = ROIC spread % over cost of capital x invested capital The objective is to maximize economic profit. When the company is larger, one should use Net Present Value (NPV) which calculates economic profit in a more robust and flexible fashion. Valuation in the Public Markets Valuation in the public markets has investors paying for the performance they expect the company to achieve in the future; investors ultimately end up paying more since their valuations are not based upon the past or cost of the assets. The CEO should endeavor to have his company in the public markets since the largest multiples are applied in valuation Real Markets & Financial Markets When a public company, the CEO has to both maximize the intrinsic (DCF) value of the company and manage the expectations of the financial market Differences between actual performance and market expectations and changes in these expectations drive share prices. The delivery of surprises produces higher or lower total shareholder returns Perpetuity Planning & Control (i.e. Management) Planning & control system should be put in place to monitor the NPV of every business unit and summed to get the NPV of the corporation. Economic profit (i.e. NPV) targets set annually for next three years, progress monitored monthly and managers’ compensation tied to economic profit against these targets Value Metrics Metrics are to drive decisions and guide all employees toward value creation.
  114. 114. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 114 Perpetuity Planning & Control (i.e. Management) in Practice Corporate management sets long-term value creation targets in terms of market value of a company or total returns to shareholders (TRS) Strategic alternatives valued in DCF (i.e. NPV) Intrinsic value of chosen strategic alternative translated into short and medium term financial targets and then targets for operating and strategic value drivers Performance assessed by comparing results with targets on both financial indicators and key value drivers. Managerial rewards linked to performance on financial measures and key value drivers Value Metrics: Market Value Added & Total Return to Shareholders Market Value Added is the difference between the market value of a company’s debt and equity and the amount of capital invested. Measures financial market’s view of future performance relative to capital invested in business. Total Return to Shareholders measure performance against the expectations of financial markets and changes in these expectations. TRS measures how well a company betas the target set by market expectations Value Metrics: DCF vs. Earnings Multiple DCF is intrinsic value. Earnings multiples are market values. Earnings alone is inadequate without understanding the investment required to generate the earnings. Should know ROIC Cash Flow Cash flow equals the operating profits of the company less the net investment in working capital and fixed assets to support the company’s growth. Perpetuity Management Capability 1. Analyze where perpetuity is currently at (which phase) 2. Determine which phase is the goal 3. Determine steps to get to next phase of the perpetuity 4. Build Work Breakdown Structure (WBS) to get to next phase working backward from the next phase 5. Execute the plan
  115. 115. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 115 Perpetuity Lifecycle:
  116. 116. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 116 Chapter 15: Framing Valuation We are not looking at each valuation methodology in isolation but are ultimately using the methodologies together to frame the valuation in a valuation summary format. We use a “football field” (valuation summary) to frame the valuation which looks like the following: Regarding the football field, we add control premiums to comp companies and DCF (% addition that is equal to the control premium average for the transaction comps) if doing valuation for selling the company. Footnote everything (assumptions) in the football field. The football field takes one day to a few days depending on how easy it is to obtain the precedent transactions data. Banker should know what valuation the client expects to be at; 10% to 15% spread of range of valuation (“tighten” the range if needed by eliminating comps that skew the range) For each valuation methodology we are going to do a sensitivity analysis to determine a valuation range:
  117. 117. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 117
  118. 118. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 118 Chapter 16: The Market for Perpetuities The market for the perpetuity at its initial stages is inefficient, but as it moves through the stages of a perpetuity, the market becomes more efficient. You can observe the coinciding cost of capital move from almost 100% going all the way down to 3.5%. You can observe the EBITDA multiple for the perpetuity increasing as the perpetuity moves through the phases of the perpetuity.
  119. 119. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 119
  120. 120. INVESTMENT BANKING: M&A ORIGIINATION, EXECUTION, FINANCIAL MODELING & VALUATION 120 SELL-SIDE As perpetuities continue to grow, the builder of the perpetuity seeks to grow the perpetuity inorganically or exit the perpetuity. This is the primary role of the sell- side, which is to aid in the buying and selling of perpetuities. Investment bankers now enter the picture as this is their core work.

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