Is this ROI good or not for an average PE firm?

Finance Investment Private Equity
New answer on May 01, 2020
3 Answers
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Anonymous A asked on Apr 21, 2020

Hi PrepLounge community,

I was not sure about a case answer regarding the evaluation of an investment for a PE firm

Simplified Scenario:

  • Up-front cost: -8M (beginning of year1) - CAPEX lasting 5 years
  • Cash Flow: +2M every year for five years
  • ROI over 5 years: (2M * 5 - 8M)/8M = 2M/8M = 25%
  • Profitability: - Annual Revenue: 2M - Annual Cost: 8M/5 = 1.6M --> Profit Margin = 0.4M / 2M = 20%
  • Time-value is not considered
  • No synergies / extra-revenues / extra-costs

Doubts

Is ROI 25% over 5 years enough? I don't understand if I can say that annual ROI is roughly 5%, nor if this is a good benchmark.

More in detail:

1. What should a PE fund do with this investment? (Of course, generally speaking)
2. What should an industrial company do? The annual profit margin is solid (20%)

Thank you so much

Anonymous

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Anonymous replied on Apr 23, 2020

Hello,

Just to give a ballpark figure, typical Buyout-focused PE firms target +20% IRR over a period of 5 years, implying a Multiple on Invested Capital (MoIC) of at least 3.0x. Notice that the profitability of the underlying asset is not so important; it's more of an input to achieve that.

On the case you presented:

  • ROI of 25%, thus MoIC of 1.25x is way too small
  • A key driver of profitability is the exit value, which you are not considering.. and what is the entry price? or is it a greenfield investment? (usually a PE firm acquires an established company)
  • Difficult to imagine a situation of annual cash flows of $2M and profits of $0.4M
  • Aren't you mixing CapEx and annual costs? Or is it a coincidence they are the same? And CapEx of 4x revenues is huge

In a nutshell, I would not invest in this deal and I believe you are making too simplistic assumptions.

Best,

Francisco

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Emily
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Content Creator
replied on Apr 30, 2020
BCG Project Leader | 3+ years interview experience for BCG SEA recruiting | Kellogg MBA, NTU, Peking University

Hi,

Agree with Francisco that the 25% ROI over 5 years would be way to low for PE investment. It doesn't sound like a good investment.

As for the company itself, 20% might sound solid, but you really need to compare with other players in the industry to test whether 20% is good or bad.

Best,

Emily

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Francesco
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replied on May 01, 2020
#1 Expert for Coaching Sessions (3.700+) | 1.300+ Reviews with 100% Recommendation Rate | Ex BCG | 8+ Years of Coaching

Hi there,

the answer depends on the goal of the company which you should clarify at the beginning, but a 25% return in 5 years seems low for a PE.

Not sure what you mean with What should an industrial company do?, as from what I understood the client is a PE firm and not an industrial company.

Best,

Francesco

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