It’s interesting to learn about the dynamic you guys have with the US-based analysts. Also, can you elaborate on what the IP concerns are? Do they relate to the financial models or something else, and how are they protected? For your question about getting a “modeling certification,” I don’t think that’s necessary. It’s much more important for you to be able to answer questions about models and show them that you know how to build one. I think if you can speak intelligently about modeling, that’d be fine. I’m not aware that anyone really cares about Bloomberg, Wall Street Prep, or whatever other certification there is out there – I sure don’t. The experience matters a lot more than your certification, so you should get as much hands-on modeling experience as you can. As a start, learn how to build a fully-integrated three-statement model from scratch.
numi Wrote: ------------------------------------------------------- > Good assumptions about a potential investment > drive the financial model, not the other way > around. agreed - important observation > That being said, the > model is still absolutely essential in order to > pinpoint valuation. it may be a matter of semantics - but ‘pinpoint valuation’ is sorta an oxymoron. intrinsic valuation by nature is a range concept, not a specific value. but yes, i think what you’re saying is a good model will allow you to identify a confidence interval more effectively.
Intrinsic valuation may be a “range concept,” since it’s as much an art as it is a science. That being said, when you’re submitting a bid for a company or a stock, you don’t say, “Well, I think I’d like to buy the asset in the range of $X-Y.” No – when you agree on a price, the amount you pay for something – anything – is a defined number. Maybe that’s in your valuation range, as it should be, but the number you’re paying is unambiguous, and that’s what I meant about “pinpointing” your valuation. There’s nothing self-contradictory about that.
Are there any outside programs/certifications I could look into for modeling? I saw “The Analyst Exchange” program on WallstreetOasis.com; I was curious as to some of your opinions on programs like that.
numi: That was really informative. Thanks.
bchadwick Wrote: ------------------------------------------------------- > Numi, that’s very enlightening. But I’m still a > little foggy on how “transactional” modeling > differs from “operational” modeling. Is it that > you’re making a decision about whether to do pure > equity, convertible debt, etc., and so you are > running a number of future scenarios to figure out > which has the best risk/reward? Or is it > something else. I realize I didn’t answer this particularly thoroughly, but since Ill be in the office till midnight and need to take a break anyway, I’ll tackle it now. Basically, the transactional model does like you said – we run a variety of scenarios to figure out which type of financing situation can give us the most reward while appropriately managing risk. As an example, let’s take a leveraged buyout (LBO) model. Assume that we already have the operating portion of the model built out (i.e. the part of it that tries to project the company’s operating performance in the form of P&L, balance sheet, and cash flow), we then want to evaluate how different financing considerations will affect IRR, the internal rate of return. Essentially, as a private equity investor, our objective is to get as high an IRR on our investment as possible, and laying on a transactional framework, namely the LBO structure, enables you to test how the IRR changes depending on your transactional or operating assumptions. There are several fundamental drivers of value to a private equity investor, namely (1) multiple expansion, (2) top-line growth and/or margin expansion, and (3) leverage. Our model reflects our assumptions for factors #1 and #2, and factor #3 is based on what we’re able to get from lenders as well as what the business can tolerate in terms of debt capacity. If you look at a private equity model in terms of these three aforementioned factors, it’s quite intuitive. Multiple expansion is probably the hardest to attain or even predict, but basically it refers to buying a company at some multiple of EBITDA and selling it in the future for a higher multiple thereof. You can do this by either getting a great deal on the company when you buy it, or through growth in the industry that makes the industry more attractive at the time you exit the investment. Even if EBITDA remained the same, an increase in multiple makes the exit valuation higher than the entry. Top-line growth and margin expansion are fairly self-explanatory as well – you want to have a business that’s expanding its earnings in some fashion so that even if the EV/EBITDA multiple is the same at exit as it is at entry (i.e. no multiple expansion), you can sell your investment at a greater price than what you paid for it. Finally, leverage, or the amount of debt, is your third and arguably the most critical element of your transaction. Obviously, the more debt you can use to finance the company, the better off you are as a PE investor – if you can service it and pay it down. But that is a big “if” – clearly, your equity value has more opportunity to expand if your initial equity injection is smaller, but you also need to carefully monitor how much debt you’re loading onto the business. And that’s where the financial model is so critical – it’s a representation of how much cash flow the company is generating, and helps you understand how constrained the business is going to be when you load debt on it. Plus, there are many different types of debt as well as management incentives that you have to take into consideration, and your model should be robust enough that you can test all these different transaction scenarios and see what your returns will look like. In a nutshell, these three key factors all help determine what your IRR is, and ultimately the private equity firm’s goal is to maximize IRR while being able to address its debt responsibilities. Thus, the whole purpose of your LBO model is to allow you look at how IRR changes as these variables change. Hope this helps…again, a long-winded response to how transaction models differ from operating models, but hopefully my “LBO Model 101” was useful.
Numi wrote: "Can you please go into more detail about the extent of your modeling responsibilities, and what you guys actually do as “outsourced modelers”? I have actually worked at not one, but two of the companies you mentioned above – and at least in my personal experiences, I felt that the modeling we outsourced overseas tended to be more mechanical in nature, i.e. setting up a model template, populating it with data from 10-Q and 10-K, and so forth. And while our counterparts overseas did a good job in this area, we (the analysts and associates in the US) typically retained responsibility for building the projections. " I do work on projections and key drivers. My PM goes through these and then asks me to make changes if he feels there is a need to do so.
Very enlightening post numi, greatly appreciated for those of us working on the sell-side ER departments of this world. Transaction work is definitely something I will look into a couple of years down the road.
btw, totally unrelated, what would be typical hours in PE? Similar / slightly less than IB (that’s my guesstimate)?
Numi, I’m curious if PE people use their model to help negotiate terms of their Credit agreements or are “market terms” just used. I’ve seen some companies come back to the table pretty quickly for amendments in order to do some basic liquidity transactions such as a sale-leaseback. Obviously these things can be overlooked or not anticipated. However, I know in HY analysis, CA agreement provisions are modeld in such as covenants or restricted payment baskets, etc. Are these thinsg considered when PE firms negotiate terms?
Numi, thanks a lot for the enlightening and knowledgeable posts. Its indeed helpful for us and will serve as a good tutorial for future reference. To answer your questions about IP protection and IP concerns, following is the explanation. IP concerns - These are concerned with both IP around financial models as well as IP around any other technology or intangible asset. For example, many I-Banks and Hedge Funds have their captive centers based in Outsourcing locations (mainly India, China, Latin America and Central and Eastern Europe) and they share their models with the support team, as far as my knowledge goes, many such teams help validate the models (for volatility and other major concerns) developed by the Mathematics gurus (PhDs and global mathematics scholars) sitting at the research centers of the banks and funds. Also, there are many technology or other patents shared with the support teams. As in my case, I am working with a technology venture group (they invest in various technologies and license it) of a major conglomerate firm based in US, and we help the client in finalizing the deals, so, for example, if the client is trying to acquire a specific portfolio of IPs of a company and wants to monetize the same by licensing it to other industry participants throughout the value chain (as they are a bigger firm and are in a better position to license the patents given their wide contact spectrum), at times they share the IPs with us and then we look at the market attractivess and the expected licensing revenues to be generated from the patents by licensing it out to a specific set of licensees in future. It involves going throug the market research reports, analyst reports and other secondary and primary sources to find the global market for that particular technology and then finding out the revenue on the basis of various assumptions and forecasts. It also sometimes involves generating the forecasted PnL, Balance Sheet and Cash Flow Statements for the new company formed (in case the client wants to have a major share in the company by aquiring the patents) and the expected revenue generated till the time (5 - 10 years) the client wants to move out. IP Protection - For protection, as I mentioned the companies have NPA with the clients and also there are various standards like ISO for data protection and confidentiality. I like the work I am doing now, but I want to move out of outsourcing, as the rewards and recognition here are very low. You can’t imagine the fees charged for the work done, its many times lesser than that charged in developed nations. The whole concept of outsourcing is based on cost arbitrage. I want to move to a good I Bank or a PE/VC firms but am not able to as my work experience is less (I have just completed a year) and I have a bachelors of technology in Aerospace Engineering, though I am a CFA, level 2 candidate (8th June 2008). Also, the major reason being that I lack contacts, the alumni base of my institute is strong, however, many of them are in big software firms in the US (many students from my insitute migrate to good universities in the US for MS and in the 90s there were many alumni who entered Silicon Valley). Some of them are in PE/VC firms and I banks, but then its a handful and they might not be having enough time to take into consideration the requests large pool of their juniors seeking their help. Again, thanks a lot for the insights about the PE firms and the work done there, and I shall be delighted to answer any further clarifications required.
Immense pleasure to read about difference in operational and conventional financial modeling. Being a novice in field of finance - especially financial modeling, how can I acquire on LBO modeling skills. Needless to mention, i am working on Level 2 books and also using damodar website. Currently Level 1 candidate and reading Level 2 books (purchased it ) - hope not violated any CFA code. Please kindly suggest me any resource (possibly free) with material of LBO modeling.
numi Wrote: ------------------------------------------------------- > Intrinsic valuation may be a “range concept,” > since it’s as much an art as it is a science. That > being said, when you’re submitting a bid for a > company or a stock, you don’t say, “Well, I think > I’d like to buy the asset in the range of $X-Y.” > No – when you agree on a price, the amount you > pay for something – anything – is a defined > number. Maybe that’s in your valuation range, as > it should be, but the number you’re paying is > unambiguous, and that’s what I meant about > “pinpointing” your valuation. There’s nothing > self-contradictory about that. it looks like your shop likes to use one number, but when we (strategic investors) put in a bid, also when the VC fund i used to work at previously offered a term sheet, we have a range in mind based on the model we use, and we’d offer up the low end of that range initially, and if necessary negotiate up to the top end of that range.
Great post, numi, thanks!
Hi guys - glad you found my posts informative. As for your questions… Alayle Wrote: ------------------------------------------------------- > Very enlightening post numi, greatly appreciated > for those of us working on the sell-side ER > departments of this world. Transaction work is > definitely something I will look into a couple of > years down the road. You’ll definitely learn a lot in your role in sell-side research, but it’s also cool that you find the transaction side interesting. I’m sure when and if you decide to make the transition, you’ll be able to transfer a fair amount of your research knowledge to the new role. For me, one of several reasons why I wanted to move to PE was because I was more interested in transactions and I saw myself more as a project-oriented person, and I just wasn’t as interested in the stock markets as some of my colleagues. I think it’s hard to be truly good at something unless you really like what you do, so that was a big factor in my decision to move to PE. As for my hours, I usually get in around 9AM and if things aren’t too busy, I can leave work by around 7:30PM. On a decent week, I’m here from around 9AM to 8PM Monday through Friday, and then work a few hours on the weekends too – so you’re looking at about 60 hours. However, if there’s a lot of deal-related stuff going on, then all bets are off – for example, I was here from 9AM to 1AM yesterday (16 hours). It really just all depends on the workload, but I do like that the day-to-day happenings in the stock markets don’t dictate my lifestyle, and I have pretty good control over my schedule outside of meetings and conference calls. People here care a lot more about just getting the job done and doing it well as opposed to face time, and I find this to be true of many PE firms. accountant23 Wrote: ------------------------------------------------------- > Numi, > > I’m curious if PE people use their model to help > negotiate terms of their Credit agreements or are > “market terms” just used. I’ve seen some > companies come back to the table pretty quickly > for amendments in order to do some basic liquidity > transactions such as a sale-leaseback. Obviously > these things can be overlooked or not anticipated. > However, I know in HY analysis, CA agreement > provisions are modeld in such as covenants or > restricted payment baskets, etc. Are these thinsg > considered when PE firms negotiate terms? It’s really a combination of both – what goes on in the market as well as our negotiations that are particular to the deal are both major determinants on the amount of leverage we can get as well as the terms of the deal. Back in 2006-2007 when the credit markets were frothy, you could get 5x EBITDA in senior debt; now, you’re probably looking at more like 3-3.5x senior debt depending on the deal. Lenders are just much tighter on their loans across all markets. As far as the terms of the loans, it can be very deal specific. For example, if you’re looking at a company that’s generating stable and predictable cash flows, you may get better interest rates or more lenient terms from the lenders. However, if the target business is less predictable, you as a buyer would want to consider more sub debt instead of term loans (so that you have more flexibility on your amortization payments), and also look for terms on loans where the repayment is more loaded towards the future as opposed to the present. The important thing though is that as PE investors, we definitely share with the lenders the investment memorandum that the bankers sent us, and also give them a print-out of our model. For the most part, lenders are on the same side as us – if they believe in the investment, they’ll want to put their money in, but they just want to make sure they’re on the same page as us and they use our models to build their models. All those things you mentioned above are things that lenders care about, and we will use anything that we can in order to negotiate better terms. geranimo Wrote: ------------------------------------------------------- > Immense pleasure to read about difference in > operational and conventional financial modeling. > > > Being a novice in field of finance - especially > financial modeling, how can I acquire on LBO > modeling skills. Needless to mention, i am working > on Level 2 books and also using damodar website. > Currently Level 1 candidate and reading Level 2 > books (purchased it ) - hope not violated any CFA > code. Please kindly suggest me any resource > (possibly free) with material of LBO modeling. I think WallStreetPrep and Training the Street are good ways to learn how to build an LBO model. I haven’t seen a free model on the web that I’d recommend wholeheartedly as a way to learn – they’re either too basic or too complex – but you might also want to check the Damodaran site as I’m sure there’s something on LBO’s there too.
gauravku - thanks for your insightful post. It looks like you actually deal with some real technology there. For some reason I’d thought that the modeling was just the basic Excel financial models that most people use. That sounds pretty intense. Do you think that if you moved to another country, you’d be able to do the same role and get paid a lot more, or are the job markets elsewhere for technology and programming more competitive? Or are you just looking to change fields into a more financially analytical role? It’d seem like it’s pretty competitive already in your side of the world, but it appears that cost arbitrage as it relates to outsourced work will take a while before it ever disappears.
Thanks Numi for the appreciation and further insights about the PE work. I could very closely relate the work which my client is doing at her end with the explanations given by you about the deal structuring and negotiations. However, the lenders in your case is mirrored by their commercial finance team in the case of my client, the models which we prepare is shared with the finance team by the client and the finance guys use these numbers and their own models in conjunction of ours to come to the final conclusion. However, the sad part is that we are sitting here and have no direct interactions with the equity people, we just talk to our client over the call. Other point is that I lack good mentor ship, there are not any CFAs in my vertical, most of them are MBAs from normal B-schools in India (the top in India stands at around 93 in the world except for ISB which is at 20 as per economist, so you could imagine where the normal schools in India stand on the global basis, however, in terms of graduates they only hire from top engineering colleges), so, they don’t have in depth knowledge of the front end work and even they are a bit ignorant towards adopting those, they are satisfied with their work and don’t want to innovate or move ahead. I really want to join an organization where I could get more experienced people to work with and develop my career in a better fashion. But again I lack contacts. In my believe moving to some developed country, is always a good option because those are the places where there are opportunities. Also, I am open to relocation, however, many companies which I tried ask for working VISA which I don’t have as will require the employer (once I am in) to sponsor and acknowledge the VISA owing to the fact that I lack that amount of capital and that the VISA guidelines for the US are really strict. You are very correct, the level of competition is intense here and the cost arbitrage is never going to be eliminated, owing to the population. However, for ITO the cost arbitrage was eliminated in the early 2000 and there were many software captives and outsourcing companies which had to close their operations in India. However, in the near term, there are very less chances of that happening in the financial sector. As far as the packages are concerned, there is a huge difference. You will be astonished to know that the charge rates for a single analyst in financial outsourcing might be close to $45,000 (very rough estimate, on the basis of my knowledge, there can be huge differences from firm to firm), out of which around 20 - 25% is given to the analyst. Also, as I mentioned in the earlier posts around 90% of the work involves simple data punching exercise, data collection, data mining, data representation, secondary research and primary research. Only a small portion of the outsourced work is what I had mentioned in the posts (in which we are currently involved). Hope to see some enlightening posts from you again and hope to get a push in my career. Once again thanks for all your explanations and enlightening posts.
Solid post , Numi. Very informative. I have a couple questions. 1.) You mentioned IRR as the primary number you guys seek to maximize. How do you guys account for the short comings of IRR e.g. assuming intermediate CFs will be invested at IRR. Use MIRR? 2.) Did not see to much about DCF. Do you guys make use of DCF methods when establishing bids or are valuations completely multiple driven? 3.) Lastly, related to question 1, do you guys typically assume there will be no intermediate cash outflows between the initial investment and eventual exit. If not, how does this factor into your IRR forecast? I’d appreciate your insights.
Hi, Numi and others, may be very silly questions to post but given curiosity i still take liberty to request following queries: 1. How you incorporate value enhancement in your model. I mean to ask, some qualitative factors of value enhancement e.g. team resources and post acquisition management practices. 2. Where risk analysis comes into play for financial modeling. Do you use probability distribution - for instance generating your confidence interval for particular value. Or do you develop multiple IRRs based on probability distribution. 3. Do you also conduct post acquisition financial modeling. For instance, in case of high variance of revenues do you go back and amend your model. 4. How financing styles change your model. In particular, mezzanine financing has anything to do with financial modeling. Apologies, if some question doesn’t make any sense.
Numi… Excellent posts! +50! @Original poster Yes…You definitely need to learn financial modelling to cut it in Finance!