Shifting from Banking to Private Equity
Top investment banking and consulting analysts tend to follow a standard path; two years grinding on pitch decks, CIMs and models and then jump to a private equity firm. I followed a similar path (although it took me a little longer) and joined a private equity firm as an associate about a year ago. As a top performing analyst, I thought I would have a relatively easy transition to the buyside until I sat in on my first investment committee meeting. Everyone on the deal team, from partner to associate, was getting peppered with questions working toward the conclusion of “should we give this company [ ] million dollars?” I left with my head spinning and zero confidence in my ability to give real answers to those questions. As a banker, I would be able to bullshit my way through the questions and give sales-y answers but when its your money, the dynamic changes.
Banking is like watching poker on TV. You are an omniscient observer. You know everyone’s hand, odds of winning, pot equity etc. From this position, it is easy to see what everyone’s best move is.
Private equity is like sitting at the table. You only know what is in front of you. You use your best judgement to glean any additional information and you take calculated risks. You have pocket queens, a pretty good hand, but the person to the left could have pocket aces or kings. There’s $15 million in the pot and I only put in $5 million so my upside outweighs the downside significantly and the odds of the other guy having pocket kings/aces AND flopping one more are pretty low. All signs say you should make this bet, however, a king on the river can happen. Do you take this bet? The answer is “yes” but my butthole would still be puckered with $3 million at stake.
Anyways, this thought a simplistic analogy to how firms make investment decisions. Asses the downside risks, the growth potential and what you are willing to pay for the business. In banking, this process qualitative whereas in private equity, there is more of a quantitative aspect that has helped me immensely.
Assessing Risks & Growth Potential
Anyone should be able rattle off the five threats to a business from Michael Porter’s Five Forces, all of which matter, but the most important one is new entrants. How easy or hard is it for another company to enter the market? If the market is hard to enter, the Company will be able to continually invest money in the business at a positive rate of return. If the market is easy to enter and competitors see that there is opportunity to make a positive return, that is exactly what they will do at a slightly cheaper rate to win market share. This, in turn, lowers return on invested capital for all players in the market. This is why Investment Highlight pages in CIMs always have something about barriers to entry. The formula shown below is used to calculate ROIC but is less important because it is a point-in-time metric. You need to be confident in the direction that ROIC is going not what it was.
ROIC = (EBIT * (1 - Tax Rate)) / (Total Debt + Total Equity)
The other aspect to look at is the company’s reinvestment rate. What is the company doing with the cash generated? The formula shown below is used to calculate reinvestment rate.
Reinvestment Rate = (Capex - Depreciation + Inc in NWC) / EBIT * (1 - Tax Rate)
Required reinvestment rates can vary widely depending on the industry. Is the business a trucking company that has to spend millions each year in capex to buy new trucks? Or is it a SaaS platform that only needs to hire additional sales people and increase their server rack space?
Coupling reinvestment rate with ROIC, here is how to calculate growth rate of a company.
Growth Rate = Return on Invested Capital * Reinvestment Rate
Here you can see why barriers to entry and capital requirements are so important. Are new entrants decreasing ROIC over the next five years? Does the company need to spend significant amounts on capex? It is impossible to predict the future with certainty but understanding how ROIC and capital requirements, reasonable outcomes for both and understanding how they affect growth helped my assessment of investment opportunities.
Determining Price
M&A transactions are quoted in multiples but have you ever thought about how investors arrive at multiples? It’s not because precedent transactions say it should be 10.0x EBITDA. Crazy. There is a formula to determine enterprise value shown below. From there, divide by whatever metric you are using to get the multiple.
Enterprise Value = Free Cash Flow / (Weighted Avg. Cost of Capital - Growth Rate)
This formula is essentially a simple one year DCF that assumes everything stays constant. If the company has limited capex requirements and/or high growth, the enterprise value is much higher driving higher multiples.
Now that you know how growth rates, enterprise values and multiples are derived and affect purchase prices, I find it much easier to assess investment opportunities and take calculated risks. Is there a competitor that can take my top 10 largest competitors? Yes, but unlikely. If that happens, how much will ROIC decrease? Will I have to lower my prices to win back market share? Is my current ROIC high enough where I am comfortable reinvesting in the company? These are all questions you are now much more comfortable answering now that you understand the inner workings.
Coming from a non-traditional background, I never saw this stuff in a classroom or in training. Maybe you guys have and I am an idiot but maybe this helps someone understand why there are doing their job (lol). Let me know if you guys like the more technical / analytical content opposed to lifestyle content and I will change it up a little. As always, happy hunting.