Month: April 2015

Five Thoughts As We Learn Finance

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thoughtsToday, I’m not going to discuss any Finance topic, but share with you some of the methods I adopted while learning the subject. Coming from a Computer Science background, Finance was a new subject for me. Having graduated from the college in 2003 and then working in the corporate sector for eight long years completely into computer technology and its related field, it was very difficult for me to absorb the contents. Moreover, trying to learn the things on my own was a big challenge (and change) that demanded tremendous amount of effort and dedication from me. Today, after gaining a good understanding of this subject, I realized that I should have done it in early part of my life, but nevertheless, somebody says, “Everything happens when it has to happen”. So, I’m sure it was for good.

I’ll keep this article short and simple, and at any moment you feel you should ask questions, or share your experiences, ideas and thoughts with me and others in this blog, please do not hesitate to leave your suggestion(s) in the “Comments” section below. Let’s get started!

(1) Always Keep a Paper and Pen/Pencil Beside You

Franklin Allen, Nippon Life Professor of Finance, The Wharton School says, “It’s important to realize that Finance is not a subject where you can just simply read things and understand them. You have to absorb the material over time and be able to apply it, which is somewhat different than understanding the concepts.”

So, in my opinion, the best way to learn this subject is through practice, practice and practice.

Before you pick up that finance text and start reading it, ensure that you have a cool mind. As you read, try to understand the fundamentals to the core. Always keep a paper and pencil/pen beside you, and take notes as you learn the concepts. After understanding the concept, practice a few problems in that area, and then try to solve “real-life” problems (using case studies) so that you can apply the concept. Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, Opportunity Cost of Capital, Annuity and Compounding are few of the concepts that will find its play in any aspect of finance. So, learn them in depth and apply them real-time. Also, do not confine yourself to one book. Read other authors’ compositions so that you understand the subject from every angle. Make a habit of reading finance related topics every day.

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Leveraged Buyout (LBO): Key Participants

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ParticipantToday, let’s discuss the key participants involved in an LBO transaction and the role they play in leading the LBO to its success. But before proceeding further, you may want to take a glance at the following parts that highlight my previous write-ups on LBO.

Part1: Leveraged Buyout: An Overview

Part2: Leveraged Buyout: What makes a Strong LBO Candidate?

I’ll start this article with the financial sponsors and investment bankers, and offer insights in detail, followed by a note on investors and target’s management. As you read through it, you will unearth each of the stakeholder’s activities and how they look at the transaction. You will also discover that the sponsor, I-Banker and target management drive the deal.

(1) Financial Sponsors are the private equity firms (PE), merchant banking divisions of investment banks, hedge funds, venture capital (VC) funds and special purpose acquisition companies (SPACs). PE firms, hedge funds, and VC funds raise majority of their investment capital from third-party investors such as pension funds, insurance companies, endowments and wealthy families / individuals (also known as HNI).

This raised capital is organized into funds that are usually established as limited partnerships, in which the General Partner (GP) – the sponsor – manages the day-to-day activities of the fund and are compensated with 1-2% of the committed fund as management fee, besides 20% “carry” on the investment profit.

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Cost Cutting: A Case Study

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CostCuttingThis is an extension of my previous article on cost cutting. I thought of publishing it to offer my insights on how I arrived at the precautions (in my previous article), especially the three of the four thoughts I presented under “Precautions”. I’ve also provided the hyperlink to each of these two articles so that readers can easily steer and read them one after the other. Read my previous article on “Cost Cutting: Steps, Strategies and Precautions” here.

Precaution #1: If the CEO is not leading the project, it’s not worth pursuing it

In the past 2 years, I have helped organizations (up to US$ 50 million) improve performance, execute growth strategy and maximize their business value. In one of my assignments in India, I had the opportunity to serve one of my clients in the IT sector which had concerns with declining sales and operating margins. The President and CEO of this $33 million organization made a strategic move to expand their business to cloud computing, focusing on SME, USA. He made a directive to his Finance Manger to lead the cost cutting initiative and give him the updates on the progress such that he can concentrate on his business expansion project. Unfortunately, the Finance Head resigned to pursue opportunities outside the company, thereby forcing the Owner, President and CEO to delegate the cost-cutting project to his oldest employee, the next Finance Head. Being new to the job, the new Finance Head showed enthusiasm, commanding his team to meet the expectations of his new boss. But he committed mistakes on various lines, leading to a situation which the entire organization suffered.

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Leveraged Buyout: What Makes A Strong LBO Candidate?

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In this article, I’ll discuss the characteristics that define a strong LBO candidate, but before proceeding further, you may want to review my previous article on “Leveraged Buyout: An Overview”.

During the due diligence process, the financial sponsor evaluates the characteristics of an LBO candidate (including its strengths and risks). Most of the time, an LBO candidate will be one or combination of the following, but irrespective of the situation, the target becomes a LBO opportunity only if it can be acquired at a price and using a financing structure that generates acceptable returns with a viable exit strategy.

  • Non-core or under-performing business unit of a large enterprise
  • Distressed company with a turnaround potential
  • A public company that is perceived as undervalued
  • A public company that is considered as a high growth potential but not being exploited by its current management
  • A solid performing company with a compelling business model, defensible competitive position and strong growth potential. This may also tally with the above point
  • Companies in fragmented markets that can be consolidated into a single entity with higher size, scale and efficiency. This is called roll-up strategy.

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Leveraged Buyout (LBO): An Overview

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LBOIn the past two weeks, I have written 22 articles, covering finance concepts, business strategy and advanced finance. This week onwards, I’m thinking of dedicating my articles to advanced finance, spending the next few weeks on one of my favorite topics in finance, the Leveraged Buyout (LBO), which is nothing but an acquisition of a target by some smart investors using debt to finance a large portion of the purchase price.

While it’s unclear about its history, it’s generally believed that LBOs were carried out in the years following World War II. Back in 1970s and 1980s, firms like Kolberg Kravis Roberts and Thomas H. Lee Company saw an opportunity to profit from companies that were trading at a discount to their net asset value through bust-up approach – buy the company, break them up and sell off the pieces (what is called the corporate raiding).

In this article, I’m going to present an overview on LBO, followed by a series of articles, discussing its characteristics, sources of capital, financing structure, economics and exit strategies. After reading this post, do leave your sincere thoughts in the comments section below.

As briefed above, a leveraged buyout is an acquisition of a company, business, division or asset that is financed with a combination of equity and borrowed funds (also called debt). The equity portion contributes 30 – 40% to the purchase price and debt portion 60 – 70%. This disproportionately high level of debt is secured by the target’s projected free cash flow (FCF) and asset base which enables the sponsor to contribute a relatively small portion of equity to the acquisition price. The ability to borrow such high levels of debt based on a small equity investment is vital to the financial sponsor to earn an acceptable return. This high level of leverage also provides a tax shield – they save on the taxes because interest expense on debt is tax deductible. The image above depicts the flow of funds and how it works. Pay attention to the arrows.

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What is Enterprise Value? How do you calculate it?

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EVEnterprise Value (EV) or Firm Value is an economic measure that indicates the total value of a company. It measures how much an acquirer needs to pay to buy a company. It’s one of the fundamental metrics used in business valuation and portfolio analysis.

Enterprise Value is considered to be more comprehensive and accurate than market capitalization while valuing a business. It takes into account not only the equity value of the company, but also its debt, cash and minority interest. Market capitalization, on the other hand, includes only common equity (leaving out important factors like company’s debt and its cash reserves.)

Calculating Enterprise Value of a firm

Simply put, Enterprise Value is the sum of market capitalization and net debt of a company. Mathematically,

Enterprise Value = Market Capitalization + Debt + Preferred Stock + Minority Interest + Pension Liabilities and other debt-deemed provisions – Cash and cash equivalents – “Extra Assets” – Investments

Where,

  • Market Capitalization is the price of each share  x   number of common shares outstanding. So, if a company has 100 common shares outstanding with each share selling at $10, its market capitalization will be $1,000.

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