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Street of Walls Guide Questions

Terms in this set (79)

What characteristics does a good LBO candidate have?
(1) Strong market position with sustainable competitive advantages

(2) Multiple avenues of growth

(3) Stable, recurring cash flows

(4) Low capital expenditure requirements

(5) Favorable industry trends

(6) Strong management team

(7) Multiple areas to create value
What are some things that can help a business maintain a strong market position and sustain its business model?
(1) High barriers to entry

(2) High switching costs

(3) Strong customer relationships
What are various ways for a business to diversify its growth strategy (achieve multiple avenues of growth)?
(1) Introducing new products

(2) Increasing number of business locations

(3) Acquiring new customers

(4) Increasing penetration of current customers (upselling)

(5) Exploring adjacent industries

(6) Expanding into new geographies
Why is having multiple avenues of growth so important for a business?
A company is able to de-risk itself when its success isn't completely reliant on one driver
What types of characteristics should we look for in a business to determine if its cash flows are stable?
(1) Highly visible (e.g. long-term contracts)

(2) Recurring (e.g. magazine subscriptions)

(3) Low exposure to seasonal fluctuations (e.g. tourism is very seasonal)

(4) Low sensitivity to cyclical fluctuations (e.g. oil is cyclical)
Why is it important for PE firms to ensure their portcos have stable / recurring cash flows?
Because LBOs rely on high leverage, PE firms want to make sure they have sufficient cash flow to service all debt requirements.
What does it mean for a business to have low sensitivity to cyclical fluctuations?
The business is relatively immune to economic downturns or fluctuations in commodity prices.
Why does it matter if a business has low capital expenditure requirements?
Provides management with more flexibility in terms of how it can allocate the company's capital and run its operations.
What kind of capex requirements do PE firms especially want to avoid in an investment?
Maintenance capex
When a PE firm has a low maintenance capex business, how can they allocate their cash instead?
(1) Invest in growth capex

(2) Make bolt-on acquisitions

(3) Grow its core operations

(4) Give back capital to shareholders in the form of a dividend
Are capital-intensive business typically valued higher or lower than non-capital-intensive businesses, and why?
Lower

Less available capital (after interest expense) and increased financial risk in the deal.
What are some industry trends that are important for a PE firm to consider before engaging in an LBO?
(1) Increasing automation

(2) Changing consumer habits

(3) Adoption of a disruptive technology

(4) Digitalization

(5) Changing demographics

(6) Increasing regulation

*Important to think about which firms are benefitted by each of these factors
Why is it important to PE firms for their portcos to invest in businesses that benefit from favorable industry trends?
(1) Stronger return on equity potential

(2) Stronger downside protection
Why is a strong management team important to PE firms?
While PE firms provide strategic guidance, they will almost exclusively rely on management to execute their operating strategy.
What must a PE firm do if a company does not have a strong management team?
Quickly find a new replacement, or have one ready before engaging in the new investment.
What are various ways a PE firm can create value in an investment?
(1) Selling underperforming assets

(2) Increasing the efficiency of operations

(3) Pricing optimization

(4) Adjusting / streamlining organizational structures

(5) Diversifying the customer base
What does a PE firm try to better understand in commercial due diligence?
(1) Company's value proposition

(2) Company's market position

(3) Company's historical performance

(4) Industry trends
What is the ultimate goal of commercial due diligence?
Assess the target's ability to achieve its forecasted proejctions
What are the five areas you want to look at in commercial due diligence?
(1) Competitive landscape and market position

(2) Industry growth / addressable market

(3) Customer base / suppliers

(4) Capital requirements of the business

(5) Financial performance (historical and projected)
Why do we want to understand a firm's competitive landscape and market position?
Important to understand how sustainable the business model is and where it is positioned relative to its competitors.
What are eight questions we should ask to assess the business' competitive advantage and market position?
(1) What is your competitive advantage, and is this a disruptive business model?

(2) What are the barriers to entry into the business?

(3) What are costs of switching to a competitor's product?

(4) Where does the company fit in the industry value chain? How has this value chain changed over the past five years, and how will it change over the next five years?

(5) Who are your main competitors?

(6) From who have you been gaining / losing market share?

(7) What firm is the biggest threat to your company / what your firm's biggest share gain opportunity?

(8) What is the market landscape, and how saturated is the market?
What are different competitive advantages a business can have?
(1) Differentiable product offerings (e.g. Apple)

(2) Technology (e.g. Boston Dynamics)

(3) Price (e.g. Walmart)

(4) Premium brand (e.g. LVMH)

(5) Geographic presence (e.g. Diageo)

(6) Fully-integrated solution (e.g. Amazon)
How do you define a disruptive business model?
One that changes the landscape of how business is done in this space in some way.
What are the different types of market landscapes?
(1) Oligopoly

(2) Fragmented market

(3) First-mover
What is an oligopoly?
A market structure in which a few large firms dominate a market
What is first mover advantage?
Occurs when an organization can significantly affect its market share by being first to market with a competitive advantage
Why would a PE firm want to do commercial due diligence on an industry's growth or a business' addressable market?
Because it is crucial to understand the market environment and factors affecting the business.
What questions should we ask to determine an industry's growth / addressable market?
(1) What is the historical / projected growth of the market?

(2) How mature is the industry?

(3) What is the total addressable market, and what segments of the industry are growing faster than others?

(4) What are the key macroeconomic drivers of the business?

(5) Have there been any significant changes to the industry landscape?

(6) What are the regulatory concerns and how can it adversely affect the business?
What are some types of "significant changes" that can happen within an industry?
(1) Disruptive new entrants (e.g. Tesla in autos)

(2) Consolidation (e.g. Marathon / OurHealth)

(3) Vertical / horizontal integration

(4) Demand / supply imbalance
What is the purpose of investigating a company's customer base / suppliers?
To better understand the "stickiness" of customers, as well as a company's reliance on its suppliers.
What questions should we ask to assess a company's customer base?
(1) How many customers does the business have, and what is the concentration of the top-50 customers?

(2) What is the typical contract length of a customer relationship?

(3) What is the typical renewal rate?

(4) What percentage of customers have multiple products?

(5) Who are the key decision-makers for the customers?

(6) What are the buying dynamics?

(7) How long is the entire sales process?

(8) What were the main reasons for your most recent customer wins / losses?
What questions should we ask to assess a company's suppliers?
(1) How many suppliers do you have?

(2) What is the concentration of your top suppliers?

(3) How large of a customer are you to your suppliers?

(4) What is the average length of a supplier relationship?

(5) How often are your supply contracts renegotiated?

(6) If you receive price increases from your suppliers, are you able to pass it through to your customers?
Why does a PE firm want to investigate the capital requirements of a business?
Must understand total capital needed to run the operations of a business, especially during difficult times.
What questions can be asked to better understand the capital requirements of the business?
(1) How capital-intensive is the business?

(2) What percentage of capex is growth capex vs. maintenance capex, and how has this trended over the last five years?

(3) What kind of lead-time is needed (e.g. purchase order to delivery) when making a purchase order? How large of a deposit is customary for new purchases?

(4) How cyclical is the business? Are there any severe seasonal changes in demand? What are the factors that drive this?

(5) How much visibility do you have in expected sales?

(6) What percentage of the COGS cost structure is fixed vs. variable? What is the breakdown of operating expenses?

(7) What is the normal working level of cash to run the business for a year?

(8) At what manufacturing capacity is the company running right now?

(9) How quickly, and to what extent, can capacity be reduced if demand falls?

(10) What would be your biggest concern in a downside scenario?
Why would a PE firm want to assess a company's financial performance?
Helps to understand how realistic the company's forecasted projections are.
What types of questions can be asked to better understand a company's financial performance?
(1) How have historical financials performed relative to management's budget for the last five years? What was the methodology for the budget and what were the reasons for beating / missing the budget?

(2) What are the KPIs the management uses to monitor the business, and how have they trended over time?

(3) What has happened to organic growth over the last five years?

(4) How does projected growth compare to expected market growth, and where will growth come from?

(5) Why are margins expected to increase / decrease compared to historical performance, and where will this change come from?

(6) What are the key assumptions around forecasted KPIs, and how do they compare to the industry average / main competitors?

(7) What are the primary risks to the forecast?
What are some was a company can achieve growth?
(1) Increase in price

(2) Increase in volume

(3) Increase in market share

(4) New products

(5) Acquisitions
What are some was a company can grow margins?
(1) Operating leverage

(2) Cost efficiencies

(3) Higher margins on products

(4) Revenue / cost mix
What are common risks to a financial forecast?
(1) New product introduction

(2) Executed expansion into new geography

(3) Customer concentration

(4) Sufficient hiring of employees

(5) R&D resources
Why do companies conduct financial due diligence?
(1) To confirm that all financial information is provided and accurate

(2) To understand some of the unique dynamics of the company from a financial reporting perspective
What are the six main areas of financial due diligence?
(1) Quality of earnings

(2) Debt and debt-like items

(3) Normal working level of capital

(4) Tax structure

(5) Information technology

(6) Human resources
Why does a PE firm need to assess the quality of earnings?
(1) To confirm that the company is excluding non-recurring costs / expenses, as they will affect the valuation of the company (especially the EBITDA figure).

(2) To ensure the information provided by the company is accurate.
What are the three main types of adjustments made when calculating an EBITDA figure?
(1) Management adjustments

(2) Business-related adjustments

(3) Pro-forma adjustments
What are management adjustments?
(1) One-time or excess owner / executive compensation

(2) Transaction costs

(3) Legal settlements

(4) Personal expenses (e.g. private jet, accounting fees)
When are management adjustments seen the most?
When purchasing family-founded businesses where compensation is flexible.
What are common business-related adjustments
(1) Accounting-related issues
-True-ups for bonuses and reserves
-Inventory valuation
-Revenue recognition
-Accrual / reserve reversals

(2) Lost customers

(3) Unsustainable margins / cost cuts
What are pro-forma adjustments?
Adjustments that occur when the company has made recent acquisitions or divestitures.
What question do pro-forma adjustments try to answer?
Given the current business structure, what would historical earnings have been, pro forma, for the acquisitions / divestitures?
What are some examples of pro-forma adjustments?
Synergies:
(1) Eliminated positions / facilities

(2) Scaled pricing

(3) Major customers

(4) Audit / tax fees

(5) Open positions

(6) Known cost increases
Why does a PE firm need to do due diligence on a company's debt and debt-like items?
The company's amount of debt-like items outstanding will impact the total amount given to sellers.
____________________ - ______________________ = cash given to sellers of a company
(1) Total enterprise purchase price
(2) Debt (and/or debt-like items)
All liabilities are categorized as either ____________________ or _____________________.
(1) Working capital

(2) Debt
Can a liability be both working capital and debt?
No.
What are sellers of a business incentivized to do with regard to debt?
Lower the amount of debt and debt-like items as much as possible.
As a response, what must buyers do as it relates to a company's debt?
Before buying the business, must make sure that the amount of debt isn't misrepresented.
Where else can debt be buried, other than traditional "financial liability" line items?
(1) Accounts payable

(2) Accrued expenses

(3) Other liabilities

(4) Deferred compensation

(5) Termed accounts payable

(6) Shareholder payables

(7) Legal settlements

(8) Tax-related liabilities

(9) Liabilities associated with certain cash transactions
Why might a company's reported capital expenditures figure not be accurate in terms of cash flow?
The company may have ordered lots of equipment but is yet to pay for the purchase, which results in a larger post-acquisition for the buyer of the company.

More broadly, this also affects the total cash available after the deal.
Why does a PE firm need to assess a company's normal level of working capital?
The normal level of working capital to remain in a business must be removed from the purchase price, so respective adjustments must be made.
What financial line items / metrics might a PE firm use to determine a company's optimal level of operations during various economic cycles?
(1) Cash flow

(2) Deferred revenue

(3) Orders

(4) Revenue recognition

(5) Business seasonality
Why would a PE firm want to do diligence around a company's tax structure?
Provides insight into the best methods and locations for tax compliance so that the company may maximize its net profit and minimize tax liabilities.
How does a PE firm evaluate a company's tax structure at the national level?
(1) Review tax assets

(2) Review company structure

(3) Review step-up calculations

(4) Review compliance procedures

(5) Identify potential tax liabilities
How does a PE firm evaluate a company's tax structure at the national level?
Evaluate the optimal locations for the company to operate in.

(1) Review payrolls

(2) Review use tax

(3) Review sales compliance procedures

(4) Assess high-level potential tax liabilities
Why would a PE firm want to do diligence around a company's information technology assets?
Because IT issues can cause significant block in a smooth transition if the systems are not reviewed correctly and comprehensively.
Why is a smooth IT system important for a business?
It is crucial to conducting accurate reviews of tax liabilities and accounting, as well as maintaining historical financial records.
Why would a PE firm want to do diligence around a company's human resources?
Because HR plays an important role in that in affects payroll, which in turn affects the taxes for which the company is responsible.

State filing requirements and income regulations are based partly on the location of the payroll.
What is legal due diligence?
Diligence that is focused on confirming the company is not subject to any future liabilities including:

(1) Regulatory issues

(2) Threatened / ongoing lawsuits

(3) Unusual / onerous contract provisions
What areas will a PE firm typically engage in legal due diligence on?
(1) Corporate filings

(2) Material contracts

(3) PP&E

(4) HR

(5) Health and welfare plans

(6) Information technology

(7) Lawsuits / litigation / patents

(8) Environmental
Why would a PE firm want to do diligence around a company's corporate filings?
To confirm all filings have been filed correctly and to understand the legal organization of the company (e.g. if there are any strange corporate structures)
What types of material contracts might a PE firm look at before acquiring a company?
(1) Debt structure

(2) Acquisitions

(3) Other liabilities

(4) Key customer, partner or supplier agreements
Why would a PE firm want to do LEGAL diligence around a company's human resources?
(1) Any HR risks need to be captured in the valuation model.

(2) The compensation structure is crucial to understanding the organizational and operational structure of the company.
When we say human resources, who are we talking about?
The target company's management team and employees.
What types of HR areas will a PE firm typically look at in their legal due diligence process?
(1) Employments terms / agreements

(2) Individual contracts

(3) Collectively-bargained agreements (CBAs)

(4) Retention / severance agreements

(5) Review of management / employees

(6) Compensation structure, especially for executives

(7) Possible severance packages, if any terminations are to occur during the deal

(7) Salaries / stock option plans for key employees
Why would a PE firm want to do diligence around a company's health and welfare plans?
To understand any regulations or legal issues surrounding the benefits BEFORE engaging in the transaction.
Why would a PE firm want to do LEGAL diligence around a company's information technology assets?
Can provide further insight ingot the company's weaknesses and strengths by assessing a company's IT and related assets.
How does a PE firm perform do LEGAL diligence around a company's information technology assets?
(1) Review software / hardware agreements with external parties

(2) Review contractually obligated product features or service level agreements

(3) Review license agreements

(4) Review any other technology-related agreements
Why would a PE firm want to do diligence around a company's lawsuits / litigation / patents?
Looking at lawsuits/litigation provides a summary of any pending litigation, history of past litigations and what may arise in the company (e.g. environmental, employment, customer or worker compensation issues).
Why is diligence around a company's IP be useful for a PE firm?
Because the company's proprietary information can help raise its value.
What are some examples of valuable IP?
(1) Patents/trademarks

(2) Domain names

(3) Trade secrets

(4) Design rights that are exclusive to the company and help drive its busienss
Why would a PE firm want to do diligence on environmental aspects of a company?
To understand any potential liabilities the business is exposed to in its environment while conducting the day-to-day processes, such as hazardous material or toxic waste.
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