There are some private equity interview questions that you’re almost certain to get asked. Practicing case studies and LBO model tests is critical, but you also make sure you cover your bases on high-likelihood questions.
Here we’ll cover the key questions you’re most likely to get asked. I’ll eat my most recent deal toy if you don’t get at least one of these in your next process.
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This question can appear in various forms, either standalone, as part of a mini-paper LBO, or in relation to a past deal. Here are the key points to hit on with your answer:- Determine the purchase price of the target, plus and transaction fees or financing fees (transaction fees to investment banks, diligence providers, QoE, and lawyers, with financing fees related to your debt used in the acquisition). This is known as your Uses.- Determine how you’ll finance the transaction (your Sources), typically including a mixture of your equity, debt, and possibly rollover. Make sure your Sources exactly equals your Uses.- Project out the target’s financials for the hold period, typically five years. Determine how much cash is generated and how much debt you can pay down over this period. – Model out the sale of the company at the end of the hold period (LTM EBITDA (x) Exit Multiple). Subtract your net debt (debt at the end of the projection, less cash balance) to arrive at your equity value. Determine your returns from the investment by calculating your Multiple of Invested Capital (MOIC) and Internal Rate of Return (IRR).
EBITDA growth – The sponsor and management will aim to grow the portfolio company’s EBITDA from the time they enter to the time they exit. This will create value equal to the additional EBITDA (x) the exit multiple when the business is sold. This EBITDA growth can be delivered either via revenue growth, cost reductions, or both.
Multiple Expansion – An increase in the exit multiple vs. the entry multiple will have a direct impact on returns. Every dollar of EBITDA generated is more valuable, so multiple expansion can generate a return even if the business doesn’t grow at all (though you’re unlikely to actually see any multiple expansion without growth).
Leverage – The ratio of debt to equity in the sources and uses can have a significant impact on returns. Increased leverage can juice returns up to a point. You just need to ensure that the company is able to meet its mandatory repayment and interest obligations.
There are a number of different items that will impact this decision, and the importance of each will depend on the specific situation. Below are a few key considerations:
Debt capacity of the target based on market leverage multiples and debt service ability.
Financing environment – how easy or hard is it to get debt financing on attractive terms for the deal? Different deals will have varying success based on market appetite, and will also be exposed to broader economic conditions.
Appetite for significant add-on M&A over the near-term. Sponsors may enter an investment with a specific inorganic growth gameplan that will require near-term financing. As such, they may elect for more conservativeness at entry to leave room for additional debt financing later, if needed.
Appetite to put dollars to work. Occasionally a fund will choose to contribute more equity than they otherwise would because they want to deploy more capital. They don’t make money and their LPs don’t make money if the capital isn’t invested. As such, they may choose a slight discount in projected returns for the opportunity to put more cash to work.
Desire to offer co-investment opportunities to LPs. Some firms make an effort to invite their LPs into specific deals and offer them fee-free, carry-free co-investments on the same economic terms as the sponsor. This can be attractive to LPs as they avoid fees that would normally be paid, plus have the opportunity to deploy more capital.
Rollover Equity refers to a capital that is “rolled” from before the current transaction. This usually takes the form of proceeds to the prior owner and management team that they’ve elected to re-invest, rather than receive as cash.
Sponsor equity is new capital contributed from the private equity firm completing the transaction. Both rollover and sponsor contributions are sources of equity within the sources & uses. They are also usually on the same economic terms (meaning rollover equity isn’t worth more or less than sponsor equity, it’s all the same).
You pay enterprise value. However, it’s important to note that your actual cash out the door (your uses) is going to be higher after you account for transaction expenses, financing fees, and any cash to the balance sheet.
The target and it’s shareholders (or owners) will receive equity value. Existing debt will be repaid upon the change of control, allowing you to refinance with your debt from the Uses.
Trick, gotcha — it doesn’t. Assuming the management rollover is substituted one-for-one with sponsor equity (additional management rollover reduces sponsor equity in the sources & uses), there won’t be any impact as it’s exactly equivalent. The only difference is who receives the return for the specific incremental dollar contributed.
The private equity firm will contribute fewer dollars to the transaction, so overall dollars returned will decrease. This can be a negative if the firm is trying to put as much money to work as possible.
The only other consideration is the mixture of debt vs. equity. If additional sponsor rollover reduces the amount of debt, and leverage, that may have a negative impact on returns.
Transaction fees don’t flow through the three statements and are only a component of the sources and uses. They’ll increase your cash needed to complete an acquisition, and will reduce your shareholder’s equity on the pro forma balance sheet.
Financing fees, on the other hand, do flow through the three statements. They’re also counted within your sources and uses, but are then held on the balance sheet as a contra-liability and amortized over the life of the loan. Amortization reduces net income, is added back on the cash flow statement, and reduces the contra-liability each year until it reaches zero at the end of the debt’s term.
Consider the quality of revenue, resilience of margins, growth opportunities, competitive position, and cash flow profile when evaluating a business
– Ideal target companies generate long-term, recurring free cash flows that support debt service. Cash conversion is important, with strong targets having low working capital and capital expenditure requirements.
– Recurring or re-occurring revenue is key. Long-term contracts, SaaS or subscription-based services, or predictable revenues are critical. Non-cyclical and defensive industries or services are preferred.
– Strong management teams are important. It can either be the current team, or the ability to easily replace them with top performers.
– Defensive or non-cyclical industries are ideal. You want something that will survive the next recession, not go bankrupt.
– High barriers to entry. Your target’s offering and industry should be difficult for new entrants to establish themselves in. This can be achieved via proprietary technology or processes, significant required investment, specialized knowledge, or scale.
– Don’t forget price. A perfect target is probably expensive and may not make the best investment. An alternative target with some shortcomings might be much cheaper and actually provide significantly higher returns. Neither price nor any specific characteristic is a be-all end-all. Everything must be evaluated in conjunction with one another.
Check out our more fulsome discussion on what makes a good LBO candidate.– Pursue up-sell and cross-sell initiatives to realize growth within the existing client base.
– Install strong management teams and professionalize the organization’s human capital capabilities.
– Explore opportunities for organic revenue growth, including new product lines, new geographies, or acceleration of sales and marketing efforts.
– Pursue add-on acquisitions and take advantage of multiple arbitrage, revenue synergies, cost synergies, and increased scale, among other benefits.
– Optimize cost structure, including supplier negotiations,
– Improve internal systems and capabilities across key functional areas, such as technology/analytics/cybersecurity, sales and marketing, finance, and operations.
There’s not necessarily a correct response here because operating leverage isn’t considered good or bad. The interviewer simply wants to see if you understand the concept and how you think through a response.
For background, operating leverage refers to a company’s ratio of fixed vs. variable expense. If revenue increases, fixed costs remain the same while variable costs increase.
This means that growth for businesses with high operating leverage can be very profitable (revenue growth and fixed expenses), while declines in revenue can be a big issue (the same fixed expenses, less revenue to cover them).
Consider noting that, while neither option is necessarily better, you would most prefer a business with stable, recurring, and predictable revenue with a high degree of operating leverage.
Customer concentration – Generally, any single customer or client representing more than ~10% of revenue is cause for concern. Without mitigating factors, I’d start to question viability of the deal at 25 – 30% customer concentration range. Note there are ways to structure around this, but it makes things more difficult and riskier.
Management – In a high-rate environment, the interest burden could be too high. You should also confirm that this is a common equity investment that is pari-passu with other equity, as variations in structuring could make this an unattractive opportunity for you despite the EBITDA growth.
Client/customer churn – Any excessive recent churn is a big cause for concern. Beyond the immediate hit to revenue, you’ll need to understand what the underlying drivers of the churn are. Is there a highly competitive new player in the industry that’s taking share? Has standard of service slipped? Is there some kind of negative shock to demand?
Declining margins – Has there been a sustained downtrend in margins over the past 2-3 years? Have there been any significant drops to a new, lower level? You’ll want to understand if the driver is pricing declines or cost increases. Pricing declines could signal new entrants and commoditization, while cost increases present their own challenges when assessing the long-term sustainability of the business model.
Cyclical revenue – Looking at prior periods of deteriorating economic conditions, how responsive was the target’s revenue? Significant drops are cause for concern. Seasonality or other non-economic cyclicality can also be an issue.
Management turnover – Has there been upheaval within the C-suite? Any critical departures (key sales, operations, divisional leadership, etc.)? If so, you’ll want to understand reasoning, confirm replacements are strong performers, and confirm there’s no long-term impact.
Multiple Arbitrage – Typically smaller add-ons will be available at a lower multiple than what your larger platform would trade at.
This gives you an opportunity to buy something for a low multiple and then turn around and sell it at a higher multiple.
E.g. buy a $10M EBITDA add-on at 5.0x for $50M, sell your larger platform at 10.0x, and realize a $50M increase in value on the add-on component without changing a thing.
Cross-Sell – There may be an opportunity to sell your platform’s existing products and services into the clients of the add-on, as well as the reverse.
The ability to cross-sell will be a key component of your add-on diligence.
Cost Synergies – The potential to reduce duplicative expenses, either headcount or non-headcount.
For example, your add-on may come with its own finance, legal, and HR departments which will no longer be needed as part of the combined organization.
Increased Scale – This point partially combines elements of the other items.
Increased scale may allow you to negotiate better contracts with both your clients and your suppliers (fewer options for clients and increased volume for suppliers).
Similar to the multiple arbitrage point, a more built-out platform may sell for a higher multiple than something smaller.
The most important thing with a question like this is that you provide a well-thought out answer, as there are multiple ways of attacking this.
The suggested response would be to ask for projected 5-year revenue CAGR, LTM EBITDA, and the cash conversion percentage.
From here you’ll be able to create a very high level LBO analysis with summary returns based on your own assumptions for entry, exit, and financing.
Specifically, you can project out revenue for the following 5 years, assume a constant EBITDA margin to arrive at your 5-year EBITDA projection, and then apply the cash conversion rate to understand where your net debt will be at exit.
Estimate purchase price based on LTM EBITDA, your knowledge of market conditions and the specific industry vertical, and the company’s near-term growth (based on provided CAGR).
Financing can be based on LTM EBITDA and your knowledge of lender appetite for this type of deal
Exit can either assume a simple static multiple vs. entry, or a slightly more nuanced view based on the specific situation.
On questions like this, don’t be afraid if the interviewer probes your answers and acts like they disagree. Often they’ll want to test you to see your level of conviction, calmness under pressure, and whether you are able to articulate follow-up responses beyond guide memorization
Deferred revenue is money collected from customers in advance for goods or services that have not yet been provided. It’s a liability on the balance sheet. When the goods are delivered, the revenue is recognized and the liability falls off. Accounts receivable is an asset resulting from goods or services that have been provided to the customer but not yet paid for.
TCV is total contract value, referring to all revenue generated over the life of a contract, potentially spanning multiple years.
ACV is annual contract value, referring to the amount of revenue generated in a single year from a specific contract.
ARR is annual recurring revenue, referring to subscription-based contracts/products that recur every year.
The two primary types of debt covenants are maintenance covenants and incurrence covenants.Maintenance – A maintenance covenant requires the borrower to maintain specific levels of performance to ensure compliance. For example, most commonly you’ll see a net leverage covenant (net debt to EBITDA less than a certain amount, such as 6.0x).Incurrence – An incurrence covenant covers and prevents specific actions taken by the borrower. For example, the company may not incur additional debt or divest a certain business line.
You would prefer either $1 in revenue driven by price or a $1 decline in expenses. Both of these options pass the entire $1 through to the bottom line, whereas the $1 in revenue from increased volume has additional COGS associated with it.
Differentiating between the price increase and expense decrease will vary on a case by case basis. Would the business in question be relatively more attractive with higher revenue growth or higher margins?
An early-stage tech company would probably benefit more from higher revenue growth, while a more established business with a steady growth trajectory would probably prefer the margin improvement.
The choice between the two options has ramifications for hypothetical multiple expansion. Which option would make the business more attractive to potential acquirors?
This one isn’t rocket science – talk yourself up while being reasonably honest and lightly acknowledging any constructive feedback you’ve received if asked.Emphasize ability to work independently to drive tasks to conclusion, operating at a level above your current role, ability to “go beyond the numbers” and think like an investor, and that you’re a positive contributor to team morale regardless of how late you’re stuck at the office.Don’t tell blatant lies or anything unrealistic because it’s a small world and chances are someone at the firm you’re interviewing with has a contact at your bank that they may ask about you.
Also not rocket science, but a frequent question so one that should be prepared forIt’s best to take legitimate areas for improvement and spin them in a positive light. Don’t say that you haven’t received any feedback because your interviewer will either think you’re lying or unaware“In my initial check-in, my VP told me that my modeling and technical abilities are very strong and I’m ahead of where I should be as an analyst. We’re working together to start practicing operating at a level above where I’m at and tackling some associate responsibilities, such as leading client calls, sketching out deck outlines, and thinking through helpful diligence analyses on one of our buy-side mandates. The key thing I’m working on now is my ability to independently drive entire workstreams to conclusion, freeing up capacity for my associates and VPs.”
If you’ve got this list covered you’ll be in a great spot, regardless of how crazy the recruiting process gets. Any VP looking to make a fool out of you is going to need to work harder than usual.
This is an excerpt from our full list of private equity interview questions within the Finance Homie private equity recruiting guide. Check it out to make absolutely sure that you’re the one dunking on any smug VP trying to trip you up, not the other way around.