AI for Private Equity: Using Claude to Analyze Deals Like a Pro

0:00As an analyst, as you say, previously you'd have spent time extracting this, analyzing the earnings, analyzing the opportunity. And Claude is going to do all of that or has done all of that already, has it? Back in our day, it wasn't automated. You couldn't just dump an IM into Claude and have it write the memo for you. And by the way, I'm not suggesting that you should just do that now, but the results you get are pretty interesting. Well, it only did the analysis on a standard basis, so we're going to push back on that, ask it to rerun the analysis, including a platform build. I didn't even prompt Claude for this, but this is such a common analysis.

0:32We've got some of that just built in here and ready to go. Welcome to this week's episode of What's the Big Deal? Graham, what are we going to be talking about this week? What is the big deal?

0:43Debs: So this week, we're going to use Claude Fable to put together an IC memo, and we're going to look at an old deal. We've got some information that's available in the public domain, which is not that easy to find for transactions like this. but we're going to use this as the basis of let's say you are a first-year associate sitting in a private equity firm this is a this is relevant or indicative of a screening type memo that you pull together in a job so you get a call from say a sell-side advisor they say hey have I got this deal for you and the first thing you've got to do is take that memo digest it pull out the key risks the key investment highlights and then pull together some kind of indicative financing model to see what your early view on returns is going to be.

1:25Debs: And you kind of use this as a, just as an early test to figure out, does this deal have any interesting characteristics? Is it worthy of our time as a firm to invest some time and pursue on diligence? Or do we just want to say, say no at this stage? And this is, I'd say, you know, I pulled together a lot of these, you know, more from a credit investment perspective in my Aries days than equity investment perspective. They're basically the same kind of thing and talk about the same factors. And you'd spend a reasonable amount of time pulling this kind of information together because back in our day, it wasn't automated.

2:04You couldn't just dump an IM into Claude and have it write the memo for you. And

2:09Debs: by the way, I'm not suggesting that you should just do that now, but the results you get are pretty interesting. So we wanted to run a test and see what kind of results we get and have a discussion about this now dated, but also kind of interesting deal. So this sounds really interesting because actually there's lots we can learn from this, not just the AI angle, but also learn a little bit more about deal flow in private equity. And you mentioned a few acronyms there, Graham. So let's just dig into those. I want to hear more about SIMs. You said that we're going to dump a SIM into Clawed and use that to extract investment committee memo.

2:45Can you tell me a little bit more about that? What are SIMs? Why are they used?

2:50Debs: Yeah, actually, you know, it's funny. There's a European-American distinction on this too. Americans say SIM. In the UK, we'd usually say I am. So SIM is Confidential Information Memorandum. I am is just Info Memorandum. You say I am in the UK. In the US, you say SIM. It's a little bit funny to me because ultimately everything in this world should be confidential. but the sim is the only thing that gets it in the actual title. So I don't know, should we be saying confidential term sheet, confidential indication of interest and all this other stuff? But no, sim is the doc that gets that title. And a sim or an IM, whatever your favorite term is, is basically a sales pitch for a business.

3:34Debs: Think about it like a really short form S1. If an S1 is your public company prospectus where a company is coming to market and you're learning about it for the first time. An IM or a sim is basically the same thing for a private company. Now, it's not a few hundred pages long like an S1 tends to be. They're usually 30 to 60, 70 pages, depending on how complicated the business is. And the idea is it's a document put together by a sell-side advisor that's designed to give you enough information on a business to get you interested, hopefully enough to put a basic model together, but it's nowhere near enough to form a full investment hypothesis.

4:12Debs: It's really the start to the whole process if you indeed want to learn more. It's also preceded by, there's the notion of a teaser as well. So a lot of times you think about the way processes work in this kind of world, the first thing you get is a teaser. It's like a one or two page, just really high level doc with some bullet points on a business basically saying, is this something you're interested in at all? if you are, sign the CONFI, the NDA, non-disclosure agreement, and then we'll send you the SIM or the confidential information memo. So it's kind of like, it's like the first real piece of info you get on a private business, and in particular, one that is being sold in some kind of, usually some kind of auction process.

4:55Okay. So as you said, it's a bit like an abbreviated S1. So presumably it has financials, an overview in business, a bit about the management team, maybe a little bit about the market that it operates in. But that goes to all the investors, doesn't it?

5:10Debs: Well, it goes out to anyone, really anyone who wants it and anyone who's willing to sign up to an NDA to actually get the document. It's not like an S1 where literally anyone who's interested can go on to SEC Edgar and just pull it. This is private market confidential info, and you only get it if you're really invited to view it. That's also why finding precedence even to put together episodes like this is really, really tricky because a lot of the stuff just tends to stay private. I mean, I've read thousands of these, but I don't actually have any of them because they still sit on the respective repositories, on network drives, on whatever else, but they stay confidential.

5:54Okay. And then you mentioned the investment committee memo that we're going to generate using Claude. So I guess, so the private equity firms, private credit firms, they take the SIM and then they have to kind of extract what they need to come up with the investment recommendation, I presume. Can you tell me a bit about that investment committee memo?

6:13Debs: Yeah, and this is going to look different at every investment house, but most places follow a similar kind of structure in that there are multiple phases of investment committee. So the first thing, I mean, thinking about back in my investing days, we'd have kind of three real stages, a stage that looks a little bit like the one that we'll look at today, although the output of that would be even more condensed to just be a one pager just with highlights, key risks, and just a bit of information on the business just to have a quick discussion around the team table and just say, hey, what do we think?

6:49Debs: Is this really worth our time? then we'd have the first proper IC stage where most likely by that point you would have had but by the time you do that discussion analysis you might not even have had the IM yet that might have just been off the back of a teaser as an example certainly by the time you go to your first stage investment committee you would have had the IM most likely there's some kind of diligence pack that's produced as well you've got diligence especially common in the UK and in Europe you have vendor diligence where if you are selling a company, you also pay for financial diligence, for commercial diligence that gets basically stapled along the IM and sent to the prospective buyers.

7:31Debs: Of course, prospective buyers are not going to trust just the vendor diligence, so they're going to do their own work as well. So by the time you go to first stage investment committee, you've probably seen some combination of that work. And usually the way it works is you approach your investment committee, you will get a green light to proceed subject to. You'll have a bunch of questions that you have to come back and answer by the time you get to final investment committee. And that's really the whole purpose of diligence is to answer all the questions that you've got kind of open items on just to figure out, is this something you really want to do?

8:06Debs: And then by the time you go to your final investment committee, that's when you get actual sanction and sign off to go do the deal or you don't, or you get a decision which basically says, you know what, we like this deal. As documented here, we don't like it enough. If you, the deal team, go out and change these few things, then come back and we'll give you sanction and sign off. So it looks different at every place, but I think everywhere follows about the same kind of process. You have multiple stages of formal investment committee. And of course, pretty much everywhere will have like a weekly WIP or work in progress meeting where you're talking about stuff that's going on at that period of time.

8:47And everyone's just going to be constantly updated on the moving pieces and all the deal the firm is looking at at that point in time. Okay. Gosh, it's so interesting to hear all this, Graham, because as outsiders, we don't get to see all of, hear about all this process that goes on behind the scenes. And you mentioned actually that all of this is confidential information. You know, only people who have signed or parties that have signed an NDA have access to this information. So it does make it really hard to learn about how deals work and some of the documentation. So how on earth have you managed to find a deal sim for us to use in this episode?

9:28And what exciting deal is it that we're going to be using?

9:32Debs: So I, no surprised, I used the help of AI to pull together some public precedents and see what we could find because finding these is not necessarily that easy. The one we came up with this morning is for a, this is a 2010 IM for a hospital business. It was at the time a not-for-profit hospital business in Massachusetts called Morton and being sold in a process that would result in it being a for-profit hospital. And I'm not any expert with the Massachusetts regulator, but as I understand it, the Massachusetts regulatory body basically says if you're converting a not-for-profit hospital to a for-profit one, you have to put all the information from the sale process out in the public domain.

10:21Debs: So this came from the Massachusetts district attorney or something like that. I don't remember the exact source, but a proper publicly available source just because the regulator said, hey, this has to be public. And ultimately, it looks to be kind of a small subscale private hospital provider. There's some plenty of tricky aspects to the business. There are unfunded pension liabilities. There's a big EBITDA bridge. When I say EBITDA bridge, I'm usually talking about the actual LTM EBITDA businesses generating to the EBITDA that the sell side process is trying to get you to buy into to bid off of.

11:03Debs: It's kind of a, on the one hand, it sounds a little bit boring and dull, just private hospitals. But on the other, there are actually some interesting financial aspects to this transaction that we'll talk about as we take a look at the memo that Claude has pulled together this morning. Absolutely. So this is a real deal that happened. we're going to use the real sim to get Claude to extract an investment committee memo. And as you say, even the most boring deal can come to life when you actually have the numbers, you run the analysis. So let's have a look. What has Claude produced for you? Our financial and valuation modelling certification programme is the self-paced version of what we teach inside investment banks.

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12:06Debs: So if you can see my screen, we've got a, I want to say this is a, where's our page count? Seven page Word doc. This would be realistically indicative of, like, if I translate this back to the process that we used to use, this would be somewhere between that, like, very first and very second phase. Again, this is going to look different depending on your actual firm. But most of these are going to follow a similar kind of cadence. We've got an executive summary. We've got our entry valuation, investment thesis, value creation plan, a couple operating cases, sources and uses, returns analysis exit considerations and some some notes on diligence um so you know as a and by the way my prompts my prompt for this was really was really simple like if i go back to i did this in the in the clod app i first did this memo from a private credit perspective and then did this did the same thing from a private equity perspective literally the prompt was i'm looking at the following opportunity from a private credit perspective summarize the opportunity the credit highlights and risks, identify any key diligence items, propose an indicative financing structure based on this analysis.

13:15Debs: And it pulled together all that stuff. I said, hey, compile this in a quick memo. And then my prompt to get this document was literally, I'll scroll back down, literally, can you pull this memo together and model from a private equity investment perspective? That was it. Basically do the same thing and replicate it for private equity. okay so let's let's have a quick chat about morton so we've got this you know here by the way here is the here is the im for morton it's a 43 page pdf and it doesn't look great because this came from the this came from whatever public body we pulled it from it's a little bit it's a little bit grainy it's not you know it's not the most interesting interesting document in the world but again most of these IMs follow a similar kind of cadence.

14:03Debs: I've got a table of contents here. Executive summary, investment considerations, market dynamics, overview on the company, financial overview. It's going to have some kind of information on the company, its management team, its position within the market, and then some information on financials. So if I go to, let's just go to the financial overview and just get a quick look at what exactly this business looks like. So we've got a really short form P &L for the business. As you can see here, we've got actual EBITDA in 2011 of$4.5 million. And then if you go all the way down to the normalized EBITDA down at the bottom, we're at$9 million.

14:44Debs: And the adjustments we've got are, let's see, adding back professional fees related to the transaction, some management incentive add backs, a few expense adjustments. A big part, by the way, a big part of the work that any analyst or associate in this world needs to go through is actually figuring out what EBITDA is. It's really funny. We all think about EBITDA as earnings for interest, tax depreciation, and amortization, but it's used in so many aspects of finance and it's used as the number you bid off of, it's used as a number you leverage off of, actually figuring out exactly what it is EBITDA is or what you believe it to be is a huge part of the work.

15:26Debs: So a big thing that the analyst or associate on this deal will be doing is trying to figure out, okay, of these adjustments that are getting me from four and a half to nine, how many of these do I actually buy into and what's the real EBITDA that I'm either leveraging off of or bidding off of. And that's something that takes obviously a lot of time and work. That's something called a quality of earnings analysis, if that's a term that people have heard before. Absolutely. Because if you're doubling EBITDA by making those normalizing adjustments, you're effectively halving the multiple that you're paying for it.

16:04So if you're using Preston's transactions and saying, well, actually, prepared to pay, you know, five times EBITDA, knowing what that actual EBITDA is and whether you actually believe it, you know, it's a difference between whether or not it's, you know, overpaying or paying a fair price for this hospital. So yeah, really important. Okay. So as an analyst, as you say, previously, you'd have spent time extracting this, analyzing the earnings, analyzing the opportunity. And Claude is going to do all of that or has done

16:34Debs: all of that already has it 100 so let's just let's take a quick look at what the what the output of this of this memo is we don't have time to go through necessarily all seven pages in in detail but we've got our see entry valuation let's see illustrative enterprise value 43 42.3 million uh we're saying 4.7 times normalized 2011 EBITDA actually okay really really important here when we've got a really big bridge from actual to LCM. We're also reporting our actual multiple as well. And to your point, you're having a multiple, right? It's 4.7 times 2011 normalized or 10.4 times 2010 reported EBITDA.

17:19Debs: We've got some initial outputs on structure and returns. We'll flip back in the model and take a look at how we're actually building those returns. I mean, usually when you think about indicative private equity returns, in some ways, it's kind of simple. You're saying, all right, what am I paying for? How am I financing what I'm paying for? So I've got this 42.3 million enterprise value. What of that is financed with equity? What of that is financed with leverage that I'm bringing to a transaction? and then you roll forward the clock some period of time, usually let's say five, seven years on your kind of indicative returns analysis and say, all right, what do I think I can get EBITDA to in that period of time?

17:59Debs: Let me multiply that EBITDA by my assumed exit multiple. That gets me my exit enterprise valuation and then based on how much debt I've managed to pay off in the meantime, I then forecast my net debt, I subtract net debt from enterprise value and I get my assumed exit equity value. And then it's really a comparison of that exit equity value to entry equity value that provides the returns analysis. In some ways, it is that simple. There's obviously a lot of detail we get into when we put these models together, but at a high level, that's kind of it. And that's kind of what we got here. And given the sensitivities around the EBITDA normalization, what has Claude assumed in terms of the exit multiple versus the entry multiple?

18:41Because as you said, that's a key part of the returns.

18:42Debs: let's let's go let's go take a look and and see what we've got here okay so we've got our entry valuation we got entry enterprise value 42 42.3 uh 12 million of cash out to the seller and 30.3 million of debt of debt existing to to refinance we should have in here a where's our sources and uses we should have some assumptions here about how we're how we're actually financing this acquisition because ultimately how we finance it is going to have a material impact on what our equity returns are going to be. Okay, sources and uses. We've got cash consideration, refinance existing debt, bond defeasance make hole.

19:29Debs: I'd have to read through the IM. I'm sure there's something specific in here that's talking about. This looks like some kind of potentially some kind of call protection on the debt that's outstanding on the company's balance sheet already. Transaction fees, financing fees, OID presumably on the new debt that we're bringing with us. And interestingly, we've got an assumption here that we're going to fund $6 million of cash. We can think about this as our min cash requirement as an example. Okay, and then we're financing all that consideration with a$30 million term loan, an ABL revolver. It says drawn at close, but zero, so undrawn at close.

20:16Debs: A delay draw term loan, also undrawn at close. And the balance in sponsor equity. So it's that$22.2 million of initial sponsor equity that we're going to compare to whatever our exit assumptions are to work out our returns. so on that note returns analysis we're saying okay we're looking at it's a pretty quick exit assumption here exit in 2015 like most i mean if you think about most private equity hold periods are now really seven years plus seven years plus thinking about this from 2011 2015 is a really quick exit but it's it's enough to be indicative for a model or a model or piece of analysis like this.

20:57Debs: So we're saying we exit at 6.5 times. Now, again, we're comparing that to, you can think about that two ways. You can think about that as multiple expansion if we're believing the adjusted EBITDA that we bought into at the outset of this transaction, where it's 4.7 times that 9 million. Or you can think about it as we're building some multiple contraction in here if we're believing that the entry multiple is based off that actual cash EBITDA of 4.9 or whatever it was. So we've got exit EBITDA in 2015, 6.5x assumed multiple, less 28.9 million of net debt. So interestingly, we're not, it'll be interesting to take a look at the model because I want to say we're bringing, what,$30 million of debt with us.

21:46We're barely paying off any debt in this transaction. And I don't know if that's just because this business is just really, really not cash generative at all. We've got some assumptions for exit transaction costs. So we're comparing sponsor value at exit to entry. And that's our 2.3 times kind of 18 % base case IRR. Which, you know, I think is kind of indicative of where a lot of sponsors would look at their kind of base case, you know, baseline returns hurdles. You know, kind of double your money, you know, 15-ish percent IRR plus. No one's out fundraising at insane levels delivering returns like that, but it's kind of the base case.

22:33Okay, great. So we've got the returns analysis. One of the things you mentioned earlier is the risks of the transaction. Does it have a decent risks section and talk about mitigants of those risks? Let's see.

22:48Debs: Yep, here we go. key risks and mitigants. Rate thesis fails. So I guess we, I assume in our memo here, we're building in some kind of rate increase into the model. Reimbursement regulatory. Obviously, this is a hospital business. You're going to be working with insurers who are paying you. That is murky and complicated, especially in the US. So that's a real risk. There's an unfunded pension liability. CapEx. Yeah, this is a hospital business. You got to spend CapEx. single asset concentration, volume franchise erosion, exit risk, limited buyer universe for a single community hospital, and reputational political.

23:27Debs: You know, as a starting point for, you know, like I'm not a hospital expert, right? I think if the two of us had spent a couple minutes and, you know, pulled together thoughts, we'd probably come up with a really similar list. As a really kind of high level indicative first start, it's not crazy. It's not crazy. No, I think that seems sensible. I guess the only other thing that we haven't talked about for this transaction is kind of the strategic plan or the operational plan for improvements in this business. Now, you said it's not a huge business. We've got what EBITs are about, well, depending on whether it's adjusted or not, but somewhere between four and a half and nine million dollars.

24:06So what is the plan for this? Is this going to be on a standalone basis or as a part of a platform build?

24:14Debs: Well, yeah, I think you really hit the nail on the head. So the memo we've got here is looking at returns on a standalone basis. What actually happened, which is no surprise here, is that this hospital got bought up by a private equity-owned hospital platform. And if you think about the strategic rationale for doing something like that, again, I'm not a hospital expert, but you think, okay, I've got this subscale business. We probably aren't procuring our supplies at the best rates. You can do a lot on the cost side by bolting onto a bigger platform. And I looked at a lot of these kind of roll-up opportunities in my investing career, not necessarily in the hospital space, but a bunch of different sectors in and around the UK.

25:01You find the same thing here. You look at like, there's so many mid-market businesses that you think are these little

25:09Debs: regional players. It turns out they're all in by private equity because, you know, if you run these things together, you're buying whatever supplies you have for your business at cheaper rates. You've got a centralized head office. It's more efficient, you know, all that stuff. That means these businesses tend to be really interesting platform opportunities. So it doesn't surprise me at all that the deal that did happen here looked and felt like that. So what we don't have here, and one thing, let's take a look at the model. But before we look at the model, I want to go back and reprompt Claude to say, look at this from the perspective of being a bolt-on opportunity.

25:47And really, the only thing that we need to build in from that perspective is an increase in EBITDA. right so think about fundamentally what are we going to do here we're going to put we're going to put some cost synergies through this business we're going to boost EBITDA and we're going to boost our exit returns that's at a really high level that's fundamentally it so let me go back to Claude and say let's do it let's challenge Claude to how's Claude doing this session I'm going to say I'm going to say Claude's doing doing good so far well yeah you're a harsher critic

26:17Debs: you're a harsher critic than i am so bad fine good yeah i wanted to only do the analysis on a standard basis so we're going to push back on that ask it to rerun the analysis including a platform build so yeah okay i'm gonna go fine in that case all right i'm looking at this as a platform opportunity provide this analysis again including the impact of estimated synergies yeah i'm usually not that horrible of a typist but i do have my microphone wire like right on top of my keyboard here but i'm assuming claude is gonna is gonna figure that out. Let's go and look at the basic LVO model that it put together.

27:04Debs: Remember, by the way, the model it put together was off that simple prompt. Put together an IC memo with a model, basically, was pretty much the prompt I gave. So I've got Morton Hospitals. We've got our, I mean, nothing interesting here. We've got our historic financial data. We've got the normalized EBITDA bridge going from the four and a half to the nine million. We've got a summary of the debt outstanding okay so bonds bonds payable i guess this is where okay bond premium this is where we've got that that make hole that make hole on the bond some kind of some kind of call or prepayment protection uh pension liquidity i'm sorry for jumping around here unfunded pension deficit some more cash flow items planned capex okay so just historic historic financial data on this tab.

27:54Nothing too interesting. Sources and uses, just like the sources and uses we took a look at in the memo. So ABL revolver, and this is including the funded sources and uses, by the way, right? So a$10 million revolver, a$10 million delay draw term loan, and the$30 million term loan that is actually funded at close. Cash consideration to the seller, refinance existing debt. There's the bond make hole, transaction fees, entry valuation 4.7 times or 10.4 times, depending on which EBITDA we're taking. And then the sources and uses that we've got running through our memo. Here is actually the sources and uses that we've got in the memo, which is the funded debt at close 30 30 million dollar term loan and the 22 million dollars of sponsor equity um can i just pause there graham one thing on the term loan single term loan uh for this sort of transaction is that surprising because i i know certainly when i hear about um private equity deals there's often different layers different tranches of lending and the structure yeah i mean that is often the case.

29:11I think if you think about a, if we're looking at this on a standalone basis, we've got one, a subscale operator. It's obviously been in a challenging market environment. Like this is a, this is a tough debt deal. There's not a lot to get excited about. I think the thing that you would, the thing that you might not get excited about, but the reason you'd think about doing this deal from a credit perspective is the fact that you've got asset value. And at this stage in this deal, this company owned the hospital and owned the land and there's some real downside protection. Otherwise, I think it's hard to really back this from a debt perspective.

29:50And the thing you certainly wouldn't do here is consider any kind of subordinated debt investment. So if you think about how, the thing you're thinking about from a credit investor's perspective is how do I get out, right? I need to get my money back because my return is capped. so the way I get out here is by not providing a lot of leverage and certainly not by subordinating myself. So could I have seen if some lower mid-market sponsor bought this on a standalone basis, went out to the banking community and said, hey, what kind of leverage will you provide for me? I could see people getting, not excited, but providing something off the back of real asset backing.

30:32So it doesn't surprise me here that the proposed financing structure is pretty simple. also bear in mind this is this is the 30 million dollar financing so if you split this up then you you you kind of not going to say run the risk but let's say let's say someone's looking for a half a turn not that anyone would ever do that of second lean or mezzanine or something like that you're like oh i'm going to do like a five million dollar mez trunch and do a bunch of work uh to not put that much capital to work here it's just it's kind of a tricky a tricky thing to pull together so from that perspective i think i think this really simple first lien senior loan is probably the deal that would get done if it ever did and it didn't in this case right because it got bought by another platform yeah so interesting to hear all this nuance that you know i'm not you know i was from the private market so i love hearing about all this stuff i can talk for

31:28Debs: days about debt structuring so if you want to talk about that at some at some point in the future then always happy to get into that. Okay, then we've got our pro forma cap table at close and it's pretty simple, right? We've got the$6 million of cash that we're putting back on the balance sheet. We've got that$30 million term loan and we've got the sponsor equity and that's it. Equity is a percentage of total capitalization. Ultimately, this is not that high for a business like this. The other thing I know we've talked about before is just equity skin in the game. So the other thing you're thinking about if you're a lender here is you want the equity to be really motivated and committed to a business, particularly if it's something that's a little bit tricky like this.

32:17So in some ways, I don't know what the actual asset protection is from the hospital and the land. You can almost argue this looks aggressive, even though the headline multiples are really, really low. And it's interesting you mentioned that about the hospitals because presumably we're assuming they are all fully owned and not leased. I'm pretty sure that's the case on this business. And we'll talk about what actually happened later on once this business traded and then got looped into the wider platform. Right. But let's take a quick look at the model here and just see what we've got.

32:53Debs: Now, I'm expecting this to look very much like the financing model that Claude had pulled together when I was looking at this from a private credit perspective. okay we've got oh we've got a little a case selector here love love that upside base downside just real real simple just revenue growth and ebitda margin which by the way for something this indicative is not one thing i talk about in the classroom all the time is you can always add detail and complexity to something as you go to start off with what's your what's your base case assumption about what a business is going to do i don't know some kind of revenue growth rate hold margins flat, hold your cash flow assumptions flat, and use that as a starting point anyway.

33:34Debs: So I'm not mad about the fact that this is what we've got, at least at this stage of diligence. So operating case selector, we've got our real basic, let's see, operating case down there, funding policy and assumptions, base rate. I mean, God, cloud, we're talking about this is a 2010 deals, LIBOR back in those days, but we've got updated for SOFR today. So we've got our SOFR assumption just being held flat at this point. Let's see, term loan margin, 6.8%. I don't know how we're really coming up with that. We'd have to do a whole kind of exercise on where the debt market is at this point in time.

34:12Margins on the ABL, the ABL revolver, the delay draw term loan.

34:17Debs: We even got ticking fees on the unused portions of those facilities. Ticking fees or commitment fees just mean if you've got an undrawn component to a debt facility, you get paid your actual interest margin on the portion that's drawn if you're the credit provider and a fee on the undrawn portion. just to basically say the bank or the credit fund has had to reserve capital for that deal and hold it aside. So we've got actually like some relatively comprehensive fee mechanics built in here. Okay, here are CapEx assumptions, CapEx percentage of revenue. Let's see debt schedule. By the way, for anyone who's interested, a credit model and an LBO model for business like this are basically, they are exactly the same thing.

35:02Debs: We just look at it from a different perspective. But we're going through this whole exercise where really we're just modeling cash flows and we're figuring out of the cash flows we generate, what are we applying to making different debt repayments? How much cash do we ultimately build up when we exit so that when we subtract net debt from enterprise value, we work out what our appropriate equity value is here. So here we've got this whole cashflow waterfall, just figuring out how much cash do we generate? How much debt are we paying down? And let's see, where's our actual debt pay down? We've got our mandatory amortization here of$750 ,000 a year.

35:44Debs: We're not generating that much excess cash here. So we're not really changing our debt balance too materially, right? We go from$30 million on the balance sheet at close. And then we pay down all of$5 million in these five years. So not necessarily the most cash generative and interesting deal from a debt pay down perspective. Here's our actual cash flow builds. You're kind of going from EBITDA down to free cash flow. I mean, CapEx is just a huge factor of this business, right? 2011, we've got$6.5 million of EBITDA, and we've got$8.5 million of CapEx. Obviously, some of that is being funded by this delayed draw term loan.

36:34We've got these cash addbacks here from our drawdown of that DDTL. Now, we don't have enough time necessarily to get into the whole series of CapEx projections here. Has Claude done the best job in terms of funding that CapEx with debt? So that's a whole exercise in and of itself. But actually interesting here to see the way we're thinking about it, right? We've got a business that's not really cash generative. We're spending a lot on CapEx. That CapEx has got to get funded from somewhere. And we're funding that here with a drawdown on a DDTL or delay draw term loan. So for an indicative model, not bad.

37:15Yeah, I think it's really interesting. Actually, one question on the EBITDA thing, because we were talking a lot about the EBITDA multiple. And I know in the public markets, when we have very capex intensive businesses, we prefer to value it in a multiple of maybe EBITDA less capex. So you're not ignoring that important use of cash. Is that something you ever do in the private markets? Oh, 100%. 100%. Okay. Yeah.

37:37Debs: I mean, the thing you got to realize is, or the thing you got to remember is we're using EBITDA because it is a proxy for cash flow. But in some businesses, there's a pretty big delta between EBITDA and cash flow. If we looked at everything as a multiple of free cash flow, our lives would be a lot easier. But that's not the world that exists in the world we live in. We just have everything referred to as a multiple of EBITDA. So we have to make those adjustments sometimes for businesses that just have structurally really high levels of, say, capex. We also look at things like rent-adjusted leverage.

38:13So we look at EBITDA as an example to look at EBITDA before the impact of lease payments, but then capitalize those lease payments and include them as actual structural leverage.

38:25Debs: So there's all kinds of specific metrics we can get into. But for this kind of level of analysis, for a really early read on a deal, it's not crazy. And just last tab on the model is returns. so we have our really our main driver here it's not that much right we've got what EBITDA are we selling off of and that's built up in our model and we got to multiply that EBITDA by something so here we're saying we're multiplying by 6.5 you can make the argument that is either conservative or aggressive depending on whether you believe that adjusted EBITDA that we bought into and that 4.7 times entry multiple or if you think actually, you know, we really did buy it for 10 points something based on the actual cash EBITDA.

39:14But pretty simple, right?

39:15Debs: We've got our exit enterprise value EBITDA multiplied by the multiple. We subtract net debt and lo and behold, the thing we've got left is equity value. We compare that equity value to the check we wrote on the way in. And the thing that we wind up with is our base case equity returns. So 2.3x or 18%. One thing that's really interesting here is one of the things I talk about in the classroom all the time, if I'm teaching private equity instruction, and actually I usually give this as like a challenge at the end of a modeling session and say, okay, I want you guys to think about the attribution of value creation to a few different factors.

39:55And if you look at the equity returns, attribute that to EBITDA growth, multiple expansion, and debt pay down. And we've got, I didn't even prompt Claude for this, but this is such a common analysis. We've got some of that just built in here and ready to go, right? How much of this is coming from EBITDA growth?

40:16Debs: Multiple expansion, say deleveraging or releveraging. Interestingly, why are we saying releveraging here? Oh, you know, because we're paying down some of the the term facility but then we're also drawing down some in terms of the the ddtl and then we've got our leakage for fees um yeah so actually kind of cool that we've got this just as a as a basic output even without asking for it and graham just on that returns attribution point is there a specific um drive that you want of those returns or is it like dependent on the deal um what depends It depends on the deal. I mean, well, look, the private equity holy grail is doing all those at the same time.

41:01And this is why buy and builds and platform opportunities are really interesting private equity transactions. Because what tends to happen is you buy something, you buy an individual site like this, as an example, at 4.7 times EBITDA, if you believe that's the right multiple. You bolt it onto a platform that's worth, say, 10, 12, 15, whatever you think valuation is. So you get the immediate multiple arbitrage from buying low and bolting on that same EBITDA to a platform where that EBITDA is worth more. You grow your EBITDA and ideally you're buying a business that generates cash to pay down debt.

41:38So you're doing all those things at the same time. So you really, like the reason you get to some of the eye-watering P returns you sometimes see is because you've done all those things together. Okay. Okay. Now you mentioned the benefits of doing a bolt-on or a platform build. This is all done on a standalone basis. We gave Claw the challenge of updating the investment committee memo for a platform build. So how's it got on with that?

42:06Debs: Yeah, let's see what we got. Okay, download and open. Let's just take a look at the Word doc here. Let's see. Okay, we've gone from what was it? It It was like 2.3, 2.4 to 2.7. We've got up to a 27 % IRR. All right, our synergies,$7 million run rate at Morton. Ooh, that's a big synergy number. Right, we've got$10 million-ish of standalone EBITDA and then$7 million run rate synergies. Okay, that's a lot. Okay, supply chain, shared services, contract revid, phased evenly over four years, $3.5 million in cost to achieve. plus one and a half million per add-on. Oh, is this... Ah, I think Claude interpreted this as...

42:55This is the... Yeah, Morton Hospital is the platform, not the acquired entity. Fair enough. Fair enough. You have to go back and reprompt. I mean, by the way, this is kind of the analysis that you run through at a basic level. If you're, say, starting a buy and build opportunity to private equity firm, right? You look at an asset and then you say, make some assumption for how many businesses I think I can acquire. Maybe that's a couple of years, maybe it's one a year. You've got some kind of base case P &L and you say, all right, here's my entry assumption. Here's what I think I can deliver in terms of synergies.

43:36And I bolt that onto my platform. I exit in five years. Here are my exit returns. And ideally, I'm funding all those with leverage if I can do it. And Graeme, if you are starting off the process of building out a platform, would it be the case that you would start identifying all the other add-ons that you would be acquiring as part of this initial assessment? Or is that just kind of a vague, we think we can buy other companies and add them on? It depends. I say it depends because you might be buying something where you've already got your eye on something. You might be in... By the way, sometimes what happens is a company will get sold.

44:12The company's getting sold while it's maybe got, while it's under LOI, it's got a letter of intent to go out and purchase something else so that when you're the buyer for this company, you say, oh, I'm buying this and I'm in some kind of medium phase of diligence on this other opportunity. And I'm going to do some specific analysis on just that company. Or you say, you know what? I don't know what I'm going to buy yet, but I know there's stuff to go out and buy. I'm going to make some really finger-in-the-air assumptions and say, here's what I think I can do. It really depends on the individual situation.

44:46Okay, that's really interesting. I just assumed that always, as private equity firms, you would really want the certainty of knowing the full plan, operational plan, not just kind of a speculative, oh, we might be able to buy some other stuff.

44:59Debs: um well you know if you if you think about it like let's think about let's think about an opportunity like this where you say okay i know there are these crappy subscale hospital operators i'm i'm building up a a hospital platform i'm gonna use a business that looks like this as about my kind of my template that i'm gonna copy paste in essence as i make these other bolt-ons I don't necessarily have to know what the opportunities are but if anything about the way I generate return I generate return through acquiring cheap and selling high by financing all my acquisition with leverage if I can if I can do it I can model out the impact of what that that kind of template acquisition plan looks like without even knowing what they are yet of course as as you as you get to the point we're actually about to make them then you model them properly right but if you're thinking if you're trying to figure out what is the overall opportunity for this potential platform business before I make the investment?

46:01I'm probably looking at it on a pretty high level basis to begin with. Okay. So, Graham, gosh, we've learned so much. You promised us a little bit of deal workflow and a bit of AI, but we've actually ended up learning an awful lot about platform builds and how investment opportunities are appraised. But the real question I want to have answered is, what happened with this deal? Did it go ahead? Was it a success?

46:27Debs: Yeah. So it, well, it depends. Success depends on whose perspective you're looking at this from, right? And a few, a few people you can argue were, were some winners here. So this ultimately got bought by a private equity owned platform and bolted on onto a wider, a bigger, a bigger hospital business. It's a little bit hard to figure out exactly what the entry enterprise value was. there's a point saying$90 million was contractually spent or committed. I don't know if that includes, say, the unfunded pension liabilities. So it's a little bit murky to figure out exactly what this business sold for.

47:06But it did go to private equity, but critically went to a private equity-owned hospital platform as part of a buy and build. Which, again, I think if you think about a small subscale, not great asset, kind of makes sense from a financial engineering perspective. Then ultimately what happened is said private equity firm owned the business for a number of years. They did a big sale and lease back. So a sale and lease back generally relates to a business that's got a lot of property value. And what the owner says is, you know, I'm not in the business of owning property. I'm in the business of running hospitals.

47:42So what if I sold the actual property to another investor, some kind of real estate investment trust or whomever. And then I just sign a lease with that investor and lease these properties instead of own them. So the private equity owner had taken some money out through recaps, took some money out through this transaction.

48:04Debs: Because of course, if you own the business and own the property, you sell the property, you get paid the money for it. You take that as a dividend. Then what you're left with is an operating company that has a much bigger level of contractual obligations. Not only do you have your interest payments on whatever buyout financing you had, you also got your rent bill now. So what ultimately happened is, I don't know the ins and the outs of us, but in COVID, it turned out that the rent bill was just too big in terms of committed payments every month, every year. And the private equity owner wound up handing over the keys to the administrator and it went into chapter 11.

48:48Interesting as just kind of a learning point, the private equity sponsor, you think, oh, they lost here. They had a business that went into administration. No, they actually locked in a four times return on their equity because they'd taken money out before this business went into administration. And a big driver of that was this sale and lease back. So who lost in this transaction? You could probably argue some of the employees. I don't know what happened with the pension, with the pension liability. I assume that had to get funds or made whole as part of the whole bankruptcy process. But I'm sure there's some people actually sitting in this business who weren't necessarily the happiest with the outcome.

49:32But private equity owners seem to make out pretty well here. Yeah, that's really interesting. So basically, by getting their dividend out early, they weren't reliant on the exits valuation and exit proceeds. They'd already got their cash back already. That's really interesting and certainly something that Claude didn't model in its scenario. So yeah. Okay, well, I think that brings us to the end of a super interesting episode. As I said, we've had a little bit of a look at what AI can do in terms of producing investment committee memos, but also a real little explore there as a real transaction that happened albeit a few years ago.

50:08Thanks so much for listening to this week's episode. I hope you've enjoyed it. It's goodbye from myself and over to Graham.

50:14Debs: And thanks to everyone as always. If you've got any questions or comments on what we talked about in this episode, let us know. We'll cover it in a future one. And until then, we'll see everyone same time next week.