Financially Yours – The Finance Guide
Table of Content
Section A: Accounting and ratios
1.
2.
3.
4.
5.
Financial Statements
Liquidity Ratios
Turnover Ratios
Profitability Ratios
Solvency Ratios
2
3
4
5
6
Section B: Mergers and Acquisitions, Corporate/Business Valuation
1.
2.
3.
4.
5.
6.
7.
8.
Types of M&A, Synergies, Services in M&A sector
Valuation Approaches
Intrinsic Valuations (Discounted Cash Flow)
Approaches to value equity: Firm Value and Equity Value Approach
Steps In DCF
How to Estimate Cash flows (CF), Discounting Rate (r), Beta, Growth (g), Terminal Value
Relative Valuations (Comparable and Multiples Approach)
Commonly used Multiples and Relevance for Industry
8
11
11
13
13
15
20
21
Section C: Private Equity and Venture Capital
Part A: Financing, Investments and Performance in Private Equity
1.
2.
3.
4.
5.
6.
7.
Introduction to Private Equity
Who Invests in Private Equity
The Mechanics of Investing
Management Fees and Profit Incentives
Private Equity Cash Flows
Assessing the Performance of Private Equity Investments
Summary
23
26
26
27
27
28
29
Part B: Portfolio Targeting and Shortlisting
1. De-construct Top Line
2. Estimating Volume Growth for The Company
3. Estimating Price Growth for The Company
4. Getting to The Bottomline
5. Estimating Changes in Margins for a Company
6. Estimating the Unit Economics of a Company
7. Other Important Factors to Consider
30
30
31
31
32
32
32
Part C: Preparation Strategy Based on Past Interviews
33
Section D: Fintech, Derivatives, Credit Risk
1. Fintech Industry – Growth factors
2. Derivatives
3. Risk
35
39
42
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Financially Yours – The Finance Guide
Section A: Accounting and ratios
Three types of Financial Statements
1. Balance Sheet – A statement of the financial position of an enterprise as at a given date.
It has three major componentsa) Assets – Tangible objects or Intangible rights owned or controlled by an entity as a result of
past transactions or events, which carry probable future benefits.
b) Liabilities – Obligations of the entity to provide service or transfer assets in future as a result
of past transactions or events.
c) Owner’s Equity or Capital – Refers to the interests of the owners in the assets of the
enterprise. It is the residual interest in the assets of an entity that remains after deducting its
liabilities.
Accounting Equation: Total Assets = Total Liabilities + Owner’s Equity
Owner’s
Equity
Total
Assets
Total
Liabilities
2. Income Statement – A statement of the financial performance of an enterprise over a given
period. It has major three componentsa) Revenues – Inflows of cash, receivables or other considerations from delivering or producing
goods, rendering services, or other activities that constitute the entity’s ongoing major or central
operations
b) Expenses – Outflows of cash or other considerations from delivering or producing goods or
services that constitute the entity’s ongoing major or central operations. Their benefits do not
extend beyond the accounting period.
c) Gains and losses - increases (decreases) in equity or net assets from peripheral or incidental
transactions.
3. Cash Flow Statement – A statement reporting the entity’s cash inflow and outflow during a
given period. The cash flows are classified under three major heads-
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a) Operating Cash Flows – Includes flow of cash from day-to-day operations of the entity.
b) Investing Cash Flows – Includes flow of cash from the acquisition or sale of property, plant, and
equipment, of a subsidiary or segment, and purchase or sale of investments in other firms.
c) Financing Cash Flows – Includes flow of cash from issuance or retirement of debt and
equity securities and dividends paid to stockholders.
Accounting Process- Record to report (R2R) is a finance and accounting management process that
involves collecting, processing and presenting accurate financial data. R2R provides strategic,
financial and operational feedback on the performance of the organization to inform management
and other stakeholders.
Current assets: include cash and other assets that will be converted into cash or used up within one
year or an operating cycle, whichever is greater.
Non-Current Assets: Assets that do not meet the definition of current assets
Current liabilities: obligations that will be satisfied within one year or an operating cycle, whichever
is greater.
Non-Current Liabilities: Liabilities that do not meet the definition of current liabilities.
Financial Ratios
Financial ratios are created with the use of numerical values taken from financial statements to gain
meaningful information about a company. The numbers found on a company’s financial statements
– balance sheet, income statement, and cash flow statement – are used to perform quantitative
analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return,
valuation, and more.
Uses:
1. Track Company Performance – Determining individual financial ratios per period and tracking
the change in their values over time is done to spot trends that may be developing in a company.
This is an analysis of performance over time.
2. Compare Company Performance - Comparing financial ratios with that of major competitors is
done to identify whether a company is performing better or worse than the industry average.
This is a cross-sectional analysis across different companies.
3. Benchmarking- Companies may set internal targets for what they want their ratio analysis
calculations to be equal to.
Liquidity Ratios
Liquidity ratios are used to indicate a company’s short-term debt-paying ability. Usually, short-term
creditors such as suppliers and bankers are interested in assessing the liquidity of a company. The
most used liquidity ratios are the current ratio and quick ratio.
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1. Current Ratio: It measures a company's ability to pay off its current liabilities (payable within one
year) with its current assets such as cash, accounts receivable and inventories. The higher the
ratio, the better the company's liquidity position.
Current Ratio =
Current Assets
Current Liabilities
2. Quick Ratio: Also known as the Acid Test Ratio, it measures a company's ability to meet its shortterm obligations with its most liquid assets and therefore excludes inventories and prepaid
expenses from its current assets.
Quick Ratio =
Quick Assets
Current Liabilities
where Quick Assets = Current Assets – Inventories – Prepaid Expenses
3. Cash Ratio: The cash ratio measures a company’s ability to pay off short-term liabilities with cash
and cash equivalents
Cash Ratio =
Cash and Cash Equivalents
Current Liabilities
Turnover Ratios
The concept is useful for determining the efficiency with which a business utilizes its assets. In most
cases, a high asset turnover ratio is considered good, since it implies that receivables are collected
quickly, fixed assets are heavily utilized, and little excess inventory is kept on hand.
1. Accounts receivable turnover ratio: The accounts receivables turnover ratio measures the
number of times a company collects its average accounts receivable balance. It is a quantification
of a company's effectiveness in collecting outstanding balances from clients and managing its line
of the credit process. It can be impacted by the corporate credit policy, payment terms, the
accuracy of billings, the activity level of the collections staff, etc.
Accounts Receivable
Turnover Ratio
=
Net Credit Sale
Average Accounts Receivable
2. Inventory turnover ratio: The inventory turnover ratio measures how many times a company’s
inventory is sold and replaced over a given period. It can be impacted by the type of production
process flow system used, the presence of obsolete inventory, management's policy for filling
orders, etc.
Inventory
=
Turnover Ratio
Cost of Goods Sold
Average Inventory
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3. Asset Turnover Ratio: The asset turnover ratio measures the value of a company's sales or
revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of
the efficiency with which a company is using its assets to generate revenue.
Asset
=
Turnover Ratio
Net Sales
Average Total Assets
Profitability Ratios
Profitability ratios measure the income or operating success of an enterprise for a given period of
time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. It also
affects the company’s liquidity position and the company’s ability to grow. Commonly used
profitability ratios are net income margin, return on assets and return on equity.
1. Return on Assets: Return on assets is an overall measure of profitability. It is calculated by dividing
net income by average assets for the period. It shows how effective a company is in deploying
assets to generate sales and eventually profits.
Return on Assets
=
Net Income (PAT)
Average Total Assets
* 100
2. Return on Equity: It is a ratio that measures profitability from the viewpoint of the common
stockholder measuring their ability to earn a return on their equity investments.
Return on Equity =
Net Income – Preference dividend
Average Equity
* 100
When preferred stock is present, preferred dividend requirements are deducted from net income to
determine income available to common stockholders, and in that case, may be referred to as Return
on common stockholders’ equity.
Another way to look at Return on Equity is Du Pont Analysis. Du Pont chart shows the relationships
between return on investment, assets turnover, and the profit margin. If the profit margin is low or
trending down, the manager can examine the individual expense items to identify and then correct
the problem.
ROE = Net Profit Margin X Total Assets Turnover X Equity Multiplier
ROE = Net Income
Sales
X
Sales
Assets
X
Assets
Equity
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According to DuPont Analysis ROE is affected by
a) Operating efficiency, which is measured by the profit margin
b) Asset use efficiency, which is affected by total asset turnover
c) Financial Leverage, which is measured by equity multiplier (assets/equity)
ROE is prone to three problems:
a) The Timing Problem: Many business opportunities require the sacrifice of present earnings in
anticipation of future earnings. This is true when a company introduces a new product
involving high start-up costs. If we calculate the company´s ROE after the introduction of the
new product, the ROE is low.
b) The Risk Problem: it says nothing about what risks a company has taken to generate its ROE.
c) The Value Problem: ROE measures the return on a shareholder´s investment, but the
investment figure used is the book value of shareholder´s equity, not the market value. a high
ROE may not be synonymous with a high return on investment to shareholders.
3. Earnings per share (EPS) of common stock is a measure of net income earned on each share of
common stock. It is calculated by dividing net income by the number of weighted average common
shares outstanding during the year.
EPS
=
Net Income
Average outstanding number of shares
Solvency Ratio
It is used to measure an enterprise’s ability to meet its debt obligations and is used often by
prospective business lenders. The solvency ratio indicates whether a company’s cash flow is sufficient
to meet its short-and long-term liabilities.
1. Debt to Total Assets Ratio: It measures the percentage of a company’s assets that are
financed by creditors, indicating the degree of leverage.
Debt to Total Assets Ratio =
Total Debt (short term + long term)
Total Assets
2. Debt - Equity Ratio: It is used to compare creditor financing to owner financing. It
demonstrates what proportion of equity and debt the firm is using to finance its assets.
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Debt Equity Ratio
=
Total Debt
Shareholder’s Equity
3. Interest Coverage Ratio: It provides an indication of the company’s ability to meet interest
payments as they come due. It is a widely used metric by rating agencies while determining
the credit rating of a debt instrument of a company.
Interest Coverage Ratio
=
Earnings Before Interest and Tax
Shareholder’s Equity
4. Debt Service Coverage Ratio: The debt-service coverage ratio (DSCR) is a measurement of a
firm's available operating income to pay current debt obligations. The DSCR shows investors
whether a company has enough income to pay its debts.
Debt Service Coverage Ratio
=
Net Operating Income
Interest + Principal Obligations
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Section B: Mergers and Acquisitions, Corporate/Business Valuation
Mergers and Acquisition
Consolidation:
Consolidated financial statements are the combined financial statements of a parent company and
its subsidiaries. Consolidated financial statements present an aggregated look at the financial
position of a parent company and its subsidiaries, and they provide a picture of the overall health of
an entire group of companies as opposed to one company's standalone position.
Minority Interest:
A minority interest is ownership or interest of less than 50% of an enterprise. The term can refer to
either stock ownership or a partnership interest in a company. The minority interest of a company is
held by an investor or another organization other than the parent company.
A minority interest shows up just below the shareholder’s equity and above the noncurrent liabilities
on the balance sheet of companies with a majority interest in a company. This represents the
proportion of its subsidiaries owned by minority shareholders.
Example: MN Corporation owns 80% of XYZ Inc., which is a $100 million company. MN records a $20
million as minority interest to represent the 20% of XYZ Inc. it does not own. XYZ Inc. generates $10
million in net income. As a result, MN recognizes $2 million—or 10% of $10 million—of net income
attributable to minority interest on its income statement. Correspondingly, MN marks up the $20
million minority interest by $2 million on the balance sheet. The minority interest investors do not
record anything unless they receive dividends, which are booked as income.
Joint Venture (JV):
A joint venture is an arrangement where two or more independent companies come together to
form a legal undertaking generally for a stipulated period of time or for a specific purpose or project.
It may be a temporary or a permanent one. For example, Maruti Ltd. of India and Suzuki Ltd. of
Japan come together to set up Maruti Suzuki India Ltd.
A JV is different from a merger in a way that the operations of a JV are different from the core
operations of the co-ventures. This creates a distinction in the businesses of the companies. In the
case of a merger, all the businesses are merged together without any distinction.
Associate:
An associate is an entity over which the investor has significant influence.
Significant influence means the power to participate in the financial and operating policy decisions
of the investee but is not in control or joint control of those policies. Significant influence is usually
acquired by purchasing more than 20% of voting power but less than 50%.
Merger:
A merger is a combination of two companies to form a single independent company where both
companies cease to exist independently and the shareholders have their shares in the old company
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exchanged for an equal proportion of shares in the merged entity. Example- Vodafone merging with
Idea.
Acquisition:
Involves the purchase of an entity that continues to operate, but does so under the control of the
acquirer. Takeover can take place with or without the support of the management and board of the
target company. Example- Shell acquiring BG Group
Essentially both mergers and acquisitions are methods used to achieve strategic objectives. In
practice, the terms merger, acquisition and takeover are often used interchangeably.
Synergy
The motive behind an M&A deal is to achieve some synergies. A synergy is any effect that increases
the value of a merged firm above the combined value of the two separate firms. In basic terms,
synergies mean that 1+1 > 2
Various types of Synergies
Description
Importance in
Deal Decision
Synergy
Breakdown
Ability to
control
achievement
Time to
achieve
Costs to
Achieve
Revenue Synergies
Cost Synergies
Capital Synergies
Recurring synergies from
incremental increases in
revenues compared with
standalone companies
Usually regarded as an add-on
to cost synergies
Recurring synergies from
realized cost savings across
corporate functions
Primarily Capex and working capital
reductions. Tax benefits are in
addition to balance sheet synergies.
The central argument in many
transactions
Cross-selling
Pricing
Additional distribution
Innovation
General & Admin costs
Procurement and COGS
Sales & Marketing costs
R&D costs
Other operating costs
Typically, only a minor role, high
importance in specific sectors, such
as financial institutions.
Inventory reductions
Financing terms
Better capital allocation
Elimination of duplicate Capex
Tax optimization
Low
High Low
High
Low
High
Fast
Slow
Fast
Slow
Fast
Slow
Low for the rollout of
products on existing platforms
Dis-synergies possible
One full run rate of synergies,
on average
Includes contract termination
costs
Renegotiation of financing terms can
incur costs
Tax optimization might require cost
for external advice.
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What services does a company offer to clients in a M&A
What is an IPO?
Initial Public Offer (IPO) - An initial public offer of shares or IPO is the first sale of a corporate’s
common shares to investors at large. The main purpose of an IPO is to raise equity capital for further
growth of the business. Eligibility criteria for raising capital from public investors are defined by SEBI
in its regulations and include minimum requirements for net tangible assets, profitability and net
worth.
Why do companies raise capital?
General corporate process- working capital, operating expenses, Capex
Research & Development- develop a new product or service
Organic Business Growth- growing the business organically
Future Acquisitions- generate capital to acquire another business
Debt Repayments- recapitalization to pay off existing debt
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IPO Process
Corporate/Business Valuation
Valuation : Approaches
Different valuations models are used to value the financial and non-financial assets of a company. It
is necessary to know the various models of valuations and what drives the value in each case. All
models can be classified under 2 broad approaches:
Intrinsic Valuation
In this valuation, the
present value of
expected future
cashflows from the
assets is evaluated to
reach the valuation.
Discounted cash flow
model and dividend
discount model are
examples for Intrinsic
Relative
Valuation
Valuation.
Relative Valuation
Valuation
Approaches
Intrinsic
Valuation
Relative
Valuation
Value of an asset or
the company is
determined by
looking at the price
of comparable assets
relative to common
variable(s) like
earnings, cashflows,
book value, sales,
number of products
etc.
Markets are always inefficient, they either overvalue or undervalue securities. However, in the long
run, prices are set to correct themselves. By calculating the fair value, investors evaluate if securities
are over-valued or under-valued and make buy and sell decisions.
Intrinsic Valuations (Discounted Cash Flow)
Intrinsic Valuation is also called Discounted Cash Flow model (DCF). It is the present value of all the
future cash flows an asset can generate.
The idea behind the approach is that a person would value the asset only based on its future cashgenerating ability.
3 major elements are estimated for DCF:
1. Life of the asset (n)
We need the life of an asset to know how long the asset can give us cash flows
2. Cashflow of the asset (CF)
To ascertain this, we generally calculate the growth (g) of the cash flows of the years
3. Discount Rate applicable (r)
This is to ascertain the present value of the assets
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Different DCF Models
Financially Yours – The Finance Guide
On the basis of
Cashflows
growth, DCF can
be divided into
various models.
Zero Growth Model
(CF is constant)
Constant Growth Model
(g is constant)
Differential Growth Model
(Nothing is constant)
Zero Growth:
Here, it is assumed that the cashflows received are constant over the years. For example Every year a
company pays out INR 10 as a dividend for n years.
Value =
D
r
Constant Growth Model
Here, it is assumed that the cashflows received are growing at a constant over the years. For example,
Company starts by paying out INR 10 as a dividend and increases it by 10% every year for n years.
Value =
D1__
r-g
Differential Growth Model
This is the model which is closest to reality. Here, it is assumed that the cash flows change every year
for some years before assuming a constant growth rate till perpetuity.
Value =
CF1__
(1 – r)1
+
CF2__
(1 – r)2
+
CF23__
(1 – r)3
+….
CFn__
(1 – r)n
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Financially Yours – The Finance Guide
Approaches to value equity
Firm Value Approach
(PV is value of the entire
firm and reflects the value
of all claims on the firm)
Equity Value Approach
(PV is value of equity claim
on the Firm)
Cash flows (CF) that are
considered are cashflows
from assets, prior to any
debt payments but after
firm has reinvested to
create growth assets
Cash flows (CF) that are
considered are cashflows
from assets, after debt
payments and after firm
has made reinvestments
needed for future growths
Discount Rate (r) reflects
the cost of raising both
debt and equity financing
in propotion if their use i.e.
WACC
Discount Rate (r) only
reflects the cost of raising
equity financing
Steps in DCF
Estimate the rate or rates to use in the valuation. Discount rate
can either be Cost of Equity or Cost of Capital
Estimte the current earnings and cash flows on assets. Cash flow
can either be CF to Equity of CF to Firm
Estimate the future earnings and cash flows on the firm being
valued, generally by estimating an expected growth rate in
earnings
Estimate when the firm will reach "stable growth" and what
characteristics (risk and cash flow) it will have when it does
Choose the right DCF model for the asset and value it
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Financially Yours – The Finance Guide
How to Estimate Cash flows (CF)
Cashflows
Firm Valuation
Approach
Equity Valuation
Approach
(FCFF)
(FCFE)
Free Cash Flow to Firm (FCFF)
This is a broader definition of cash flow wherein we look at not just the equity investor in the asset,
but at the total cash flows generated by the asset for both the equity investor and the lender. This
cash flow is before the debt payments but after operating expenses and taxes, is called the cash flow
to the firm (FCFF) This can be calculated by any of the flowing methods:
FCFF = CFO - Capital Expenditure + Interest (1-Tax)
FCFF = Net Income + D&A + Interest (1-Tax) - Capital Expenditure Investment in non-cash WCF
FCFF = EBIT (1-Tax) + D&A - Capital Expenditure - Investment in
non-cash WC
FCFF = EBITDA (1-Tax) + (D&A*Tax) - Capital Expenditure Investment in non-cash WC
Where, Net Capital Expenditure = Capex – D&A
Free Cash Flow to Equity (FCFE)
These are the cash flows generated by the asset after all expenses and taxes and after payments due
on the debt. This cash flow, which is after debt payments, operating expenses, and taxes, is called the
cash flow to equity investors (FCFE)
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Financially Yours – The Finance Guide
FCFE = EBIT - Interest - Tax + D&A - Capital Expenditure Investment in non-cash WCF + Net Borrowings
FCFF = Net Income + D&A - Capital Expenditure - Investment in
non-cash WCF + Net Borrowings
How to Estimate Discounting Rate (r)
The cost of capital or discounting rate (r) is the minimum return expected by whoever is providing the
capital for a business.
We use Cost of Equity (ke) for discounting FCFE under the Equity valuation approach & Cost of Capital
(WACC) for discounting FCFF under the Firm valuation approach.
Key Terminologies
Cost of Debt (kd)
Cost of Equity (ke)
WACC
Beta
Risk Free Rate (rf)
•Return expected by debt providers
•Return expected by equity shareholders
•Calculation of firm's cost of capital in which kd and ke are
propotionately weighted
•Measure of the systematic risk of an asset compared to market
risk
•Rate of return of an investment with zero (or negligible) risk,
eg: govt. bonds
WACC or Cost of Capital
WACC = ke *
D__
E__ + kd (1-t) *
(E+D)
(E+D)
Weight
of Equity
Weight
of Debt
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Financially Yours – The Finance Guide
Cost of Equity
The Capital Asset Pricing Model (CAPM) is the most commonly used model to estimate the cost of
equity. As per CAPM,
Ke= rf + (rm – rf) * Beta
Where, rm = Estimated market return (%)
rm – rf = Market risk premium
Beta = Beta of the stock
rf = Risk-free Rate
Cost of Debt
The cost of debt is the rate at which you can borrow, it will reflect the firm’s default risk and the level
of interest rates in the market.
The two most widely used approaches to estimating the cost of debt are:
1. Yield to Maturity (YTM) on a straight bond outstanding from the firm: This has limited use as very
few firms have long-term straight bonds that are liquid and widely traded
2. Estimating a default spread based upon the rating: The limitation of this approach is that different
bonds of a firm have a different ratings. Generally, the median rating is used as the cost of debt.
Estimating Beta
There are 2 approaches to calculating Beta:
1. Top-Down Approach
Beta is the covariance between the return on an asset and the return on the market portfolio divided
by the variance of the market. This is the top-down approach to calculating beta.
2. Bottom-Up Approach
Instead of calculating beta from regression directly (top-down approach), sometimes bottom-up beta
is used.
The bottom-up beta is a better estimate than the top-down beta because
1. The standard error of the beta estimate will be much lower
2. The betas can reflect the current (and even expected future) mix of businesses that the firm is in
rather than the historical mix
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Financially Yours – The Finance Guide
The bottom-up beta can be estimated by doing the following:
Find out the businesses that a firm operates in
Find the unlevered betas of other firms in the industry. Find regression betas of publicly traded firms in each of these businesses.
Compute the simple average across regression betas to arrive at an average beta for these publicly traded firms.
Unlever this average beta using the average debt to equity ratio across the publicly traded firms in the sample
Take a weighted (by sales or operating income) average of these unlevered betas of different business
Lever up using the firm’s debt/equity ratio
Beta is determined by 3 factors:
1. Industry in which the firm operates
The more sensitive a business is to market conditions, the higher its beta
2. Degree of operating leverage
High fixed cost relative to total cost-high is operating leverage. High operating leverage results in
higher beta
3. Degree of financial leverage
High financial leverage leads to high beta
Beta is of 2 types
Beta
Levered
Beta
Unlevered
Beta
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Financially Yours – The Finance Guide
Unlevered Beta
•
•
The beta of an unleveraged firm (unlevered beta) is determined by the type of business and
operating leverage. This is also called Asset beta.
Since different companies have different financial leverage (i.e., different D/E), if we want to
estimate the beta of an asset (irrespective of how it is financed), it is known as Unlevered beta.
Levered Beta
•
•
The beta of a leveraged firm (levered beta) is determined by the riskiness of the business & its
financial leverage. It is expected that firms that face high business risk should be reluctant to
take on financial leverage
From the below relationship below, it is obvious that the higher the Debt proportion – the higher
will be the Beta of a company
How to estimate growth (g)
There are 3 methods to estimate growth in earnings:
1. History:
The historical growth in earnings per share is usually a good starting point for growth estimation
2. Competitors:
Analysts estimate growth in earnings per share for many firms. It is useful to know what their
estimates are.
3. Fundamentals:
Finally, all growth in earnings can be traced to two fundamentals - how much the firm is
investing in new projects, and what returns these projects are making for the firm.
Fundamentals Approach
1. When looking at growth in operating income [NOPAT i.e., EBIT(1-t)], the definitions are
•
•
•
Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t)
Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity-Cash)
The expected Growth rate in Operating Income = Reinvestment Rate * ROC
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Financially Yours – The Finance Guide
2. When looking at growth in earnings per share, these inputs can be cast as follows:
•
•
Reinvestment Rate = Retained Earnings/ Current Earnings = Retention Ratio (b)
Return on Investment = ROE = Net Income/Book Value of Equity
Expected growth in earnings (g) = b * ROE
Where, b = retention ratio
ROE = Return on equity
Terminal Value
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash
flows forever. Since we cannot estimate cash flows forever, we estimate cash flows for a “growth
period” and then estimate a terminal value, to capture the value at the end of the period
Estimating Terminal Value
When a firm’s cash flows grow at a constant rate forever, the present value of those cash flows can
be written as:
_FCFFn+1_
WACC-g
Terminal Value =
(In firm valuation)
or
_FCFEn+1_
WACC-g
(In equity valuation)
Points to remember while calculating terminal g
•
•
•
The stable growth rate cannot exceed the growth rate of the economy
in practice, cash flows for an explicit period are estimated for not more than 10 years
The reinvestment rate and growth rate in a stable period should be in sync with each other
Summary of Formulas
Firm Value Approach
Equity Value Approach
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Financially Yours – The Finance Guide
where,
TV: Terminal Value
WACC: Weighted average cost of capital
where,
PT: Terminal Value
ke: Cost of equity
Relative Valuations (Comparable and Multiples Approach)
What is Relative Valuation?
The “value” of any asset can be estimated by looking at how the market prices “similar” or
‘comparable” assets. The idea behind relative valuation is the price of an asset is whatever the
market is willing to pay for it and that the intrinsic value of an asset is impossible (or close to
impossible) to estimate.
To understand relative valuation in layman's terms, let us take an example. You want to estimate the
value of your office.
The area of your office is 5000 sq. ft. Let’s say you don’t have any other information but you come to
know that a similar office in your immediate neighbourhood was sold for Rs. 4.5 Crore a few days
back. The only difference between your office and the other one is of area.
The area of another house is 4500 sq. ft vs 5000 sq. ft of your house. Using this, we can say that
value of your house is approximately Rs. 5 Crore.
This is a case of relative valuation where:
•
•
•
Your office – the asset you want to value
Neighbour’s house – Comparable
Price per sq. ft (Rs. 10000 per sq. ft) – Multiple
What do you need to calculate the Relative Value of an asset?
1. An identical asset, or a group of comparable or similar assets
2. A standardized measure of value (in equity, this is obtained by dividing the price by a common
variable, such as earnings or book value)
How to calculate Multiple:
Multiples are just a standardized measure of price. The numerator is what you are paying for the
asset (e.g., Market value of equity / firm value/enterprise value) while the denominator is what you
are getting in return (eg. Revenue / Earnings / Cash flow / Book value)
Multiple =
__Value___
Value Driver
Can be re-written as:
Value = Value Driver * Multiple
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Some commonly used multiples are:
•
•
•
•
•
•
•
EV / book value
Enterprise value / EBITDA
EV/ Sales
EV/EBIT
Price Earnings Ratio: Market price per share / Earnings per share
PEG Ratio: PE ratio/ Expected Growth Rate in EPS
Price to book ratio: Price / Book Value of assets
Enterprise value multiples are not affected by the capital structure and hence better to use
Relevant Multiples
S.No.
1
Multiple
EV / Revenue
2
3
4
5
EV / EBITDA
EV/(EBITDA-Capex)
EV/ EBIT
EV / Free cash flows
6
P/E
7
Price / Book Value
8
9
EV / Rooms
EV/Subscribers
Why is it used
Used for unprofitable or fast-growing companies or as a
reference
Widely used
Used for capital-intensive industries
Widely used
Increasingly used – focuses on cash generation, only good for
mature firms
Widely used, but impacted by capital structure and accounting
issues
Used for balance sheet-driven companies (e.g., banks,
insurance, real estate)
Used for Hotels
Used for telecom, publisher, cab (user) companies
Practical Use of certain Variables
P/E
• Building and
Construction
• Engineering
• Defence
• Healthcare
• Oil and Gas
• Luxury Goods
• Technology
• Utilities
EV/EBITDA
P/BV
• Building and
• Banks
Construction
• Metals and Mining • Paper
• Chemicals
• Engineering
• Defence
• Food Produces
• Healthcare
• Leisure
• Telecom
• Transport
P/S
• Automobiles
• Defence (E/S)
• Engineering
• Luxury Goods
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Types of Comparable
Trade Comparables
You select public traded
companies in same
industry as comparables
Transaction Comparables
Transactions that have occurred in
the recent past are considered as
multiples. When acquiring control
(>50% equity stake), trading comps
may not be the best indicator of
value as a few new elements like
control enter the picture.
Intrinsic Valuation V/S Relative Valuation
Intrinsic Valuation
Market mistake intrinsic value takes a long time
to correct and hence is considered more
suitable for investors with a longer horizon
Harder to do as it requires many explicit
assumptions. Also, can be manipulated to give
the value one wants
Less exposed to market perception and moods
More difficult to explain to a layperson
Relative Valuation
Market mistakes in relative valuation are
corrected more quickly as they clearly stand out
In relative valuation also, you make
assumptions. Only thing is that here, the
assumptions are implicit
Hugely driven by market sentiment
Easier to explain to a layperson
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Section C: Private Equity and Venture Capital
PART A: Financing, Investments and Performance in Private Equity
1. Introduction to Private Equity
A private equity investment can occur at virtually every stage of a company’s life cycle. Four
common subclasses of private equity are:
Types of
Private Equity
Venture
Capital
Leveraged
Buyout
Mezzanine
Debt
Distressed
Debt
Venture capital (“VC”) is an important source of financing for start-up companies or those in the
early process of developing products and services that do not yet have access to public funding by
means of stock offerings or debt issues. Most VC investments are in rapidly growing companies, with
a heavy concentration on the technology or life sciences sectors.
There are several stages of VC investing, which often mark financial and/or operational milestones
for the VC-backed company. As these companies grow and proceed from one round of financing to
the next, their valuations often increase. These rounds are often referred to as series A, B, C and so
on.
Generally, early-stage VC investors seek to acquire relatively large ownership interests in their
portfolio companies to maximize the proceeds they receive at exit value. The risk associated with
venture capital is heightened by the fact that the companies may have little or no track record. VCbacked companies may have unproven management teams and products and may generate very
little in terms of revenues or earnings.
Leveraged Buyout
A leveraged buyout, also referred to as a “buyout” or “LBO,” is a strategy that typically involves the
acquisition of a relatively mature business, from either a public or private company. As the name
implies, leveraged buyouts are financed with debt, commonly in the form of bank debt or high-yield
bonds. Typically, these securities, especially the high-yield bond portion, are either rated below
investment grade or unrated.
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Strategies among LBO firms can differ considerably. Some focus on consolidating large, fragmented
industries. This is also known as a “buy-and-build” strategy. By contrast, other firms focus on
turnaround or operational improvement situations. There are also “growth-oriented” LBO firms that
will purchase unwanted business units, such as a division of a larger corporation that is deemed
nonessential to the core business or parent company.
Mezzanine Debt
Mezzanine debt occurs when a hybrid debt issue is subordinated to another debt issue from the
same issuer. Mezzanine debt has embedded equity instruments attached, often known as warrants,
which increase the value of the subordinated debt and allow greater flexibility when dealing with
bondholders. In practice, mezzanine debt behaves more like a stock than debt because the
embedded options make the conversion of the debt into stock very attractive.
Mezzanine debt bridges the gap between debt and equity financing and is one of the highest-risk
forms of debt. It is senior to pure equity but subordinate to pure debt. However, this means that it
also offers some of the highest returns when compared to other debt types. Mezzanine financing is
typically employed to help finance leveraged buyouts when lower-cost financing alternatives, such
as high-yield debt, are not available.
Distressed Debt
Distressed debt private equity firms typically buy corporate bonds of companies that have either
filed for bankruptcy or appear likely to do so in the near future. There are two distinct strategies
within distressed debt investing.
The first strategy is often referred to as “debt to control,” where an investor seeks to gain control of
a company through a bankruptcy or reorganization process. Using this strategy, the investor first
becomes a major creditor of the target company by purchasing a company’s bonds or senior bank
debt at steeply discounted prices. The distressed debt investor’s status as a creditor gives the
investor the leverage needed to make or influence important decisions during the reorganization of
a company—a process that may ultimately enable a company to emerge from bankruptcy
protection.
As part of this process, distressed debt firms will exchange the debt obligations of a company in
return for newly issued equity in the reorganized company, often at very attractive valuations. This
type of distressed debt investing is often used as a relatively “cheap” means of taking control of
companies that have good assets, but have too much debt on their balance sheets. An example in
India would include Piramal India Resurgence Fund (India RF)
The second primary distressed debt investment strategy is a trading strategy (commonly employed
by hedge funds) in which an investor purchases distressed debt and seeks to profit as the underlying
company recovers and its debt appreciates. This strategy hinges on the investor’s ability to identify
companies that are currently in financial distress, but look likely to recover in the near future.
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How Investors Profit from Distressed Debt Investing (shown in chart)
Identify Good
Companies with Bad
Balance Sheets
Accumulate Debt at
Discounts to Par
Debt Defaults
Control company by
converting debt to equity
at low entry valuation
Exit through IPO or sale
Debt Recovers
Earn high current cash
return and gain on
principal until sale or
maturity of debt
Structural Advantages of Private Equity Vs Public Equity (Enunciated in the table below)
Consideration
Private Equity
Public Equity
Due diligence
» Access to proprietary information
» Access to public filings
Portfolio company capital
structure
» Optimized for particular company and
situation
» Subject to public market norms
Control of investment
» Typically, full control or significant
influence; hands-on and heavy board
involvement
» Proxy voting
Investor value-added
capabilities
» Access to resources such as capital
» Typically, passive investing,
markets expertise, industry contacts,
although larger institutional
senior management recruiting and growth shareholders can exert
capital
influence
Time horizon
» Commitment to long-term value creation, » Short-term pressure to meet
no public market pressure
quarterly earnings can
compromise long-term goals
Exit options
» IPO, M&A, dividend recapitalization,
secondary (fund-to-fund) transactions
» Sell at market
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2. Who Invests in Private Equity
In the 1980s, commitments to private equity funds were made primarily by institutions. Today public
and private pension funds, foundations, and endowments tend to allocate anywhere from 6-13% of
their portfolios to private equity, depending on their risk-return objectives and their need for
liquidity.
CONTRIBUTION PERCENTAGE OF GLOBAL PRIVATE EQUITY CAPITAL COMMITMENTS BY
INVESTOR TYPES
Others Include - Corporate Investors, Superannuation Schemes, Government Agencies, Investment
Companies, Family Offices
3. The Mechanics of Investing
The mechanics of private equity investing are illustrated in the figure below. Most private equity
investors access the asset class through capital commitments to private equity limited partnerships.
These limited partnerships then make direct investments in companies or funds (e.g., funds of funds).
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General Partner/Limited Partner Relationship
The manager of a partnership is called the “general partner,” while the individuals and institutional
investors who provide the majority of the capital are called the “limited partners.” Typically, the
general partner will also contribute at least 1% of the total commitments raised to the partnership,
and principals of the firm may also invest additional personal capital in the fund.
The general partner is responsible for reviewing investment opportunities and has authority over
investment decisions. Limited partners have no discretion over investment decisions and do not take
part in day-to-day management activities.
Capital Calls
In a private equity partnership, capital is drawn down from the limited partners in a series of events
known as “capital calls.” Private equity managers generally only call capital when they are ready to
make an investment. Calling capital without making an investment, acts as a “cash drag” on
performance.
Since fund managers are compensated on performance, they are motivated to closely match capital
calls with their investment pace. The period of time in which the partnership is allowed to make new
investments is called the “investment period. Most funds have five- to six-year investment periods
that begin once operations commence. Limited partners are contractually obligated to honour their
capital calls as dictated by the terms of the limited partnership agreement
4. Management Fees and Profit Incentives
In most private equity partnerships, a general partner receives a management fee and a percentage
of the profits or “carried interest.” Typical management fees run between 1.5% and 2.5% of total
capital commitments per year during the commitment period.
The management fee is charged on “invested capital”. In addition to a management fee, a general
partner will also earn a carried interest, which is a profit incentive for the general partner (typically
20% of gross profits, although some firms take as much as 30%). The carried interest is intended to
provide the manager with the bulk of its compensation and helps align its interests with those of the
limited partners.
Many funds also have a “preferred return” feature, which is the minimum IRR that the manager
must generate for investors before sharing in profits. The preferred return ensures that the private
equity manager will share in the profits of the fund only to the extent that the investments perform
at a minimum “acceptable” level, commonly 7-8% for LBO funds. If a manager does not exceed the
fund’s specified preferred return, it is not entitled to take its carried interest.
5. Private Equity Cash Flows
In the early years of the life of a fund, the cash flows are predominantly negative for investors as
cash is called by a partnership. In the latter years of a fund, cash begins to flow back to investors in
the form of distributions from realized investments, assuming that portfolio companies are sold and
profits are realized. The typical holding period for a portfolio company investment in a private equity
fund is three to five years before it is realized. Prevailing economic and capital market conditions will
also influence the holding period.
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Hypothetical Cash Flow of A Private Equity Partnership
Note: This chart is provided for illustrative purposes only and is not reflective of any actual fund or
investment. The chart assumes a 1.9x return multiple over ten years, which represents an IRR of
15.2%.
6. Assessing the Performance of Private Equity Investments
Two metrics are typically used to assess the performance of private equity investments: the internal
rate of return (“IRR”) and the cash-on-cash return multiple.
Internal Rate of Return
Strictly defined, the IRR is the discount rate that sets the net present value of a series of cash flows
equal to zero. Using an IRR allows investors to measure the performance of a series of periodic
uneven positive and negative cash flows. This feature is especially relevant in the context of private
equity investing because capital is drawn down and invested over time (negative cash flows) with
distributions paid out over time (positive cash flows). This contrasts with many traditional
investments that consist of one lump-sum investment and one cash-out, which tends to make
performance calculations
Despite its advantages, the IRR does have several drawbacks. It places too much weight on
investments that return capital after short investment periods, even if the absolute dollar returns lag
behind those of their peers
Another drawback is the lack of an industry standard in computing IRRs. Different private equity
firms may use slightly different methodologies in computing their investments’ IRRs. Even a small
change in the methodology can have a dramatic impact on the results.
Return Multiple
As an alternative to the IRR, the return multiple corrects one of the main IRR drawbacks: placing too
much weight on early distributions. Return multiples are simply a calculation of the monies invested
versus the monies returned, which is not sensitive to the timing of distributions
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However, the return multiple also has a drawback: it fails to take into account a basic premise of
investing—the time value of money, or the fact that a dollar today is worth more than a dollar
tomorrow due to inflation and the opportunity cost of tying up capital in investments.
Interpreting Private Equity Performance
We think it is prudent for investors to use both the IRR and return multiple together in evaluating
performance. A high IRR generated by “quick hits” is not typically a sustainable investment strategy
that produces long-term wealth. Similarly, a high return multiple is not attractive if it takes an undue
amount of time to generate. Striking a balance between the two metrics may be a sensible way to
think about performance measurement.
Years
1
2
3
4
5
Annual
IRR
Return
Multiple
Cash Flows
Investment
A
($25)
($75)
$145
$0
$5
36%
1.5x
Investment
B
($50)
($50)
$75
$25
$100
31%
2.0x
Based on the above table, an investor who evaluated the two sample investments strictly on the basis
of their IRRs would prefer Investment A to Investment B. However, on closer examination, Investment
B generates 100% more “cash profit” than Investment A (i.e., a return multiple of 2.0 times versus a
return multiple of 1.5 times), even though Investment B's IRR is five percentage points lower.
In our view, neither investment is technically “better” than the other: selecting between the two
choices may depend on an investor’s personal circumstances and access to other opportunities. For
example, an investor who had continuous access to fast-returning investments might prefer
Investment A so that the proceeds could be reinvested quickly into other high-returning
opportunities. But, if not, Investment B might be more attractive, its lower IRR notwithstanding.
7. Summary
Private equity investing can play an important role in a well-diversified portfolio. It seeks to achieve
excess risk-adjusted returns through value-added investing that exploits market dislocations and
unique business opportunities. Private equity investments have significantly outperformed the
broader public equity markets over 10- and 20-year trailing periods and have the potential to
provide investors with the opportunities to diversify their portfolios outside of traditional markets.
However, because of the nature of private equity investments extreme care and diligence should be
taken when making such investments. Information is less widely disseminated; risks can be difficult
to evaluate and investments may be illiquid for many years. These characteristics highlight the
importance of accessing this asset class through experienced and diligent private equity teams.
Investing in this asset class is intended for investors who are willing to bear the high economic risks
of the investment in pursuit of superior returns. Of course, past performance is no guarantee of
future results and real results may vary
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PART B: Portfolio Targeting and Shortlisting
1. De-Construct Top Line
Referring to the breakup given in the company’s investor presentation could be a good indicator of
the relevant criteria for the company & the industry.
2. Estimating Volume Growth for The Company
A useful check is to verify the growth projection with the historical growth rates of the company to
see whether they are reasonable. In case the short-term growth projection involves a recovery from
COVID-19, have supporting data facts to show the pace of recovery.
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3. Estimating Price Growth for The Company
A list of illustrative (non-exhaustive) factors to be considered for estimating a change in prices:
•
•
•
•
•
•
Market share/ market positioning: Different peers may occupy different positions in the market
and pricing growth will depend on yield growth in the segment rather than the overall market
Product functionalities vs competitors: Product functionalities may vary across peers and the
yield improvement may depend on growth in customer segment rather than the overall market
Capacity utilization: Higher utilization peers may command more pricing power than lower
utilization players
Inflation expectation: Inflation expectations can influence pricing indirectly by pushing costs
up/down
Margin-based pricing: For non-differentiated products and services, the product may be priced
on a cost + margin basis. For those categories, cost drivers will explain the margins
Other factors: competitive dynamics, IP protection on innovation, demand sensitivity in the
market, number of intermediaries in the marketing chain
4. Getting To the Bottomline
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5. Estimating Changes in Margins for a Company
6. Estimating The Unit Economics of a Company
A good way of summarising the business model of the company is to estimate the unit economics of
a company wherein one establishes profitability at the unit level. The unit could differ based on the
industry. For illustrative purposes, unit economics for the cement industry.
Key Pointers:
•
•
•
In addition to estimating the profitability per unit, do estimate the unit Return on Capital
employed based on estimates of capital investment required for setting up a capacity of 1
tonne/ bag of cement
Triangulate it with other metrics like NPV, IRR and payback period at a unit level, which would
help in furthering your business understanding
Analysing differences in unit economics between competitors could help in quantifying the
competitive advantage enjoyed by the company in relation to its competitors
7. Other Important Factors to Consider
•
•
•
•
Working capital – understand the working capital cycle of the industry (in terms of receivables,
inventory and payable days) – see how the company can improve the cycle. Understand how
much investment in working capital is required each year
Fixed assets – understand the committed and likely investment in fixed assets by the firm, and
also the nature of the expenditure – whether it is replacement capex or capex for expansion
Leverage – understand the extent of leverage by the firm in terms of – Debt to Equity, Debt to
EBITDA, Interest Coverage and DSCR – this can show if there are chances that the company can
come into immediate distress and if the company has the capacity to expand by leveraging more
Dupont Analysis – This tool is a way to break down the Return on Equity and helps in identifying
the return drivers of the company
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PART C: Preparation Strategy Based on Past Interviews
Overall, the candidate needs to demonstrate a strong grasp of both the operational and financial
side of the business, especially how the two relate to each other (e.g., How would an asset-light
strategy show up on a P&L).
Elements of both PE+IB preparation are recommended. Other specifics are detailed below:
Technical/Industry Knowledge
Detailed understanding of all drivers for industry and company. Granular understanding of what
moves revenues, costs and multiples for the chosen industry and how firms are positioned within
the industry
•
•
•
Strong grasp of FRA and Corporate Finance (Ashwath Damodaran videos on Intrinsic Value and
Relative Valuation)
A structured response to “How to Evaluate an investment opportunity”
What-if scenarios – similar to a consulting case (in shorter form)
About the Industry
•
•
•
•
•
•
Different stages and rounds
Difference between Angel funding, VC Funding and PE funding, LBO and Distressed Debt
Difference between PE, VC, Asset Reconstruction Companies, etc.
The capital structure of the PE funds and their investors
Assessing PE Performance
Private Equity and Public Equity Comparison
GENERAL AWARENESS
•
•
Major PE funds in India and their investing philosophy. Some Examples are British International
(CDC), The Rohatyn Group, Piramal Alternatives, Multiple Alternatives, GEF Capital, Baring Asia
Private Equity
Latest Deals and Funding rounds (optional but preferable) – Use deals in ET Prime and venture
intelligence resources in Library
https://www.ventureintelligence.com/dealsnew/index.php?value=1/
COMPANY-SPECIFIC QUESTIONS
•
•
•
Portfolio of the company and recent deals
One portfolio company you would invest in, one portfolio company you would not invest in
View on the Private Equity sector (in case of a sector-specific PE)
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HR QUESTIONS
•
•
•
•
•
Why PE?
Do you invest? (If not) How can we trust you to manage investors’ money if you are not
confident investing your own money?
Strong probing questions on the company/industry where you have worked in the past. Be on
top of the financials of key players in the industry
What are your key weaknesses/strengths?
The ability to do quick mental math is appreciated in PE interviews
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Section D: Fintech, Derivatives, Credit Risk
Fintech is a portmanteau of financial technology that describes an emerging financial services sector
in the 21st century. Originally, the term applied to technology applied to the back-end of established
consumer and trade financial institutions. Since the end of the first decade of the 21st century, the
term has expanded to include any technological innovation in the financial sector, including
innovations in financial literacy and education, retail banking, investment and even crypto-currencies
like bitcoin.
The term financial technology can apply to any innovation in how people transact business, from the
invention of digital money to double-entry bookkeeping. Since the internet revolution and the mobile
internet revolution, however, financial technology has grown explosively, and fintech, which originally
referred to computer technology applied to the back office of banks or trading firms, now describes a
broad variety of technological interventions into personal and commercial finance. According to EY's
Fintech Adoption Index, one-third of consumers utilize at least two or more fintech services and those
consumers are also increasingly aware of fintech as a part of their daily lives.
Reasons For Growth of the Fintech Sector
1. Unbanked Population
The country had an unbanked population of approximately 19 Crore people out of a population of 120
Crore people. This is the second largest number followed by China. This has presented opportunities
to take on the untapped market and provide people with banking solutions
2. Low Insurance Penetration
The country had a very low insurance penetration, especially in the non-life insurance segment. Major
fintechs were able to remove the hindrance of agents and provide people with low-cost insurance
with high convenience.
3. Suboptimal Portfolio
More than 88% of the wealth of the citizens of the country was earlier invested in safe financial
instruments such as Bank FDs. With the rise in awareness of people and platforms such as Zerodha
which have made the entire process much easier, there has been a sharp increase in retail investors.
4. Financial Inclusion and Government Initiatives
The government has launched various initiatives such as DBT, and PM Bima Yojana to promote
financial awareness among people and to introduce them to the banking industry. Initiatives such as
Jan Dhan Yojana have led to an increase in the depositors in the rural parts which have led to a way
for financial products specifically for these customers.
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Evolution
of Startups
Payments
Insurance
Lending
Wealth
Regulatory
Who are the Users
B2B (Business to Business)
Obtaining loans from banks for capital financing has been one of the primary tasks for most
businesses. But with the advent of fintech, businesses can easily get loans, financing, and other
financial services through mobile technology. Additionally, cloud-based platforms and even customerrelationship management services like Salesforce (CRM) - provides B2B services that allow companies
to interact with financial data to help improve their services.
B2C (Business to Consumer)
Cash apps like PayPal, Venmo and Apple Pay all allow clients or customers to transfer money via the
internet or mobile technology, and budgeting apps like Mint allow customers to manage their finances
and expenses. Much of the banking industry's first forays into fintech were focused on B2C
applications like lending and payment services Moreover, a noticeable shift toward mobile banking,
better availability of information, data, and more accurate analytics and decentralization of access are
some of the trends that are bound to create opportunities for all user groups to interact in heretofore
unprecedented ways.
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Monetisation Model
Fintech Landscape in India
In India, the rise of fintech companies has been primarily responsible for the formidable changes that
happened in the banking and financial sector since the global financial crisis of 2008. Fintech has,
among others, enabled cost optimisation, and improved customer interaction and ease of
transaction. Since 2010, fintech has played a crucial role in unbundling banking services from a
centralised system, setting payments, performing maturity transformation, sharing risk, and allocating
capital. Fintech players function as the fourth segment of the Indian financial system, alongside large
and mid-size banks, small finance banks, and regional, rural and cooperative banks.
In 2020, India continued to lead fintech investments in the Asia Pacific region, raising US$ 2 billion
across 121 deals. PhonePe alone raised US$ 788 million across three transactions. The following year,
the segment saw exponential growth in funding, receiving over US$ 8 billion across various stages of
investment. The National Association of Software and Service Companies (NASSCOM) 2020 report had
predicted that India would have 50 tech unicorns (of all kinds) by the end of 2021, but in fact, it
surpassed that number and produced 16 fintech unicorns by June 2021. Globally, there have been 187
fintech unicorns, of which 18 are in India. Most of them, including the exponentially growing mobile
wallets, are complementing existing financial service providers rather than replacing them.
The strength of India’s fintech industry is evident from the diversity of its fintech base. A few years
ago, the payment and alternative finance segment constituted over 90 percent of India’s investment
flows; by 2020, SaaS fintech saw investments of US$ 145 million, while insurance fintech got US$ 215
million. Most of the new players have not received seed funding but straightway began raising funds
through public rounds. They have re-bundled a variety of financial services under a single umbrella,
monetising the data and user base. Many are providing products and services at the same time. Pine
Labs, for example, which was primarily a POS/payment gateway firm has now added new value-added
services for merchants, rewards and loyalty points, consumer financing, neo-banking as well as
merchant lending. Similarly, Yono, which was primarily a digital banking platform, now also provides
pre-approved consumer loans, insurance, and e-commerce.
Fintech companies in India are focusing on lending to both retail customers and micro, small and
medium enterprises (MSMEs). The ecosystem includes a variety of new services including real-time
payments, faster disbursal of loans, investment advisory, insurance advisory and distribution, and
peer-to-peer lending that traditionally required human capital.
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Key Investment Highlights
1. Global fintech investment was US$210 billion across a record 5,684 deals in 2021 – up from
US$125 billion across 3,674 deals in 2020.
2. Payments remained the hottest area of fintech investment in 2021, with US$51.7 billion in
investment globally.
3. Record levels of investment were seen in blockchain and crypto (US$30.2 billion), cybersecurity
(US$4.85 billion) and wealth tech (US$1.62 billion) in 2021.
4. Other fintech areas also saw robust funding in 2021, including insurtech (US$14.4 billion), regtech
(US$9.9 billion).
5. Cross-border fintech M&A deal value more than tripled year-over-year – to $36.2 billion. Total
fintech-focused M&A deal value rose from US$76 billion in 2020 to US$83.1 billion in 2021.
6. PE funding to fintechs more than doubled from its previous high – with US$12.2 billion in
investment in 2021 compared to a peak of US$5.2 billion in 2018.
7. VC investment in fintech globally more than doubled year-over-year – from US$46 billion in 2020
to a record US$115 billion investment in 2021. Median VC deal sizes grew significantly for all deal
stages between 2020 and 2021, including Angel and Seed US$1.4 million to US$2.2 million), Early
Stage (US$4.6 million to US$7 million), and Late Stage (US$12.7 million to US$24.6 million).
8. Total fintech investment in the Americas reached US$105 billion in 2021, including a record
US$64.5 billion in VC funding. The US accounted for US$88 billion in total funding and US$52.7
billion in VC funding. EMEA saw US$77 billion in fintech investment in 2021, including a record
US$31.1 billion in VC funding. Fintech investment in the Asia-Pacific region almost doubled – from
US$14.7 billion in 2020 to US$27.5 billion in 2021.
9. Corporate VC investment in fintech was incredibly robust in 2021 at US$50 billion, with both the
Americas (US$29.7 billion) and EMEA (US$11.3 billion) seeing record levels of investment.
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Derivatives
A derivative is a security that derives its value from the value or return of another asset
or security.
A physical exchange exists for many options contracts and futures contracts. Exchangetraded derivatives are standardized and backed by a clearinghouse.
Forwards and swaps are custom instruments and are traded/created by dealers in a
market with no central location. A dealer market with no central location is referred to
as an over-the-counter market. They are largely unregulated markets and each contract
is with a counterparty, which may expose the owner of a derivative to default risk (when
the counterparty does not honour their commitment).
Derivatives
Exchange
Traded
Futures
Options
Over the
Counter
Forwards
Swaps
Forward Contracts
•
•
•
•
•
In a forward contract, one party agrees to buy and the counterparty to sell a physical or financial
asset at a specific price on a specific date in the future.
A party may enter into the contract to speculate on the future price of an asset, but more often
a party seeks to enter into a forward contract to hedge an existing exposure to the risk of asset
price or interest rate changes. A forward contract can be used to reduce or eliminate uncertainty
about the future price of an asset it plans to buy or sell at a later date.
Neither party to the contract makes a payment at the initiation of a forward contract. If the
expected future price of the asset increases over the life of the contract, the right to buy at the
forward price (i.e., the price specified in the forward contract) will have a positive value, and the
obligation to sell will have an equal negative value. If the expected future price of the asset falls
below the forward price, the result is the opposite and the right to sell (at an above-market
price) will have a positive value.
The party to the forward contract who agrees to buy the financial or physical asset has a long
forward position and is called the long.
The party to the forward contract who agrees to sell or deliver the asset has a short forward
position and is called the short.
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•
In a cash-settled forward contract, one party pays cash to the other when the contract expires
based on the difference between the forward price and the market price of the underlying asset
(i.e., the spot price) at the settlement date.
Futures Contracts
•
•
•
•
•
•
A futures contract is a forward contract that is standardized and exchange-traded.
A clearinghouse is a counterparty to all futures contracts. Forwards are contracts
with the originating counterparty and therefore have counterparty (credit) risk.
The government regulates futures markets.
A major difference between forwards and futures is futures contracts have standardized
contract terms. For each commodity or financial asset, listed futures contracts specify
the quality and quantity of assets required under the contract and the delivery procedure
(For deliverable contracts). The exchange sets the minimum price fluctuation (called the
tick size), daily price move limit, settlement date, and trading times for each
contract.
The long has agreed to buy the asset at the contract price at the settlement date, and the short
has agreed to sell at that price. The number of futures contracts of a specific kind (e.g., coffee
beans for June delivery) that are outstanding at any given time is known as the open interest.
Open interest increases when traders enter new long and short positions and
decreases when traders exit existing positions.
Each futures exchange has a clearinghouse. The clearinghouse guarantees traders in the
futures market will honour their obligations. The clearinghouse does this by splitting each
trade once it is made and acting as the opposite side of each position. The clearinghouse
acts as the buyer to every seller and the seller to every buyer. By doing this, the
clearinghouse allows either side of the trade to reverse positions at a future date without
having to contact the other side of the initial trade. This allows traders to enter the
market knowing that they will be able to reverse or reduce their position. The guarantee
of the clearinghouse removes counterparty risk (i.e., the risk that the counterparty to
trade will not fulfil their obligation at settlement) from futures contracts.
Each day, the margin balance in a futures account is adjusted for any gains and losses in the
value of the futures position based on the new settlement price, a process called the mark to
market or marking to market. The initial margin is the amount that must be deposited in a
futures account before a trade may be made. The initial margin per contract is relatively low and
equals about one day’s maximum price fluctuation on the total value of the assets covered by
the contract.
Maintenance margin is the minimum amount of margin that must be maintained in a
futures account. If the margin balance in the account falls below the maintenance margin
through the daily settlement of gains and losses (from changes in the futures price),
additional funds must be deposited to bring the margin balance back up to the initial
margin amount.
Differences between Forwards and Futures
FORWARDS
Private contracts
Customised
Less regulation, greater counterparty risk
FUTURES
Traded in active secondary markets
Standardised
More regulated, backed by a clearinghouse
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Swaps
•
Swaps are agreements to exchange a series of payments on periodic settlement dates over a
certain time period (e.g., quarterly payments over two years).
•
At each settlement date, the two payments are netted so that only one (net) payment is made.
The party with the greater liability makes a payment to the other party.
•
The length of the swap is termed the tenor of the swap and the contract ends on the
termination date.
Swaps are similar to forwards in several ways:
1.
2.
3.
4.
5.
6.
Swaps typically require no payment by either party at the initiation.
Swaps are custom instruments.
Swaps are not traded in any organized secondary market.
Swaps are largely unregulated.
Default risk is an important aspect of contracts.
Most participants in the swaps market are large institutions.
In the simplest type of swap, a plain vanilla interest rate swap, one party makes fixedrate interest payments on a notional principal amount specified in the swap in return for
floating-rate payments from the other party. In a plain vanilla interest rate swap, the party who
wants floating-rate interest payments agrees to pay fixed-rate interest and has the pay-fixed side of
the swap. The counterparty, who receives the fixed payments and agrees to pay variable-rate
interest, has the pay-floating side of the swap and is called the floating-rate payer. The payments
owed by one party to the other are based on a notional principal that is stated in the swap contract.
Options
• An option contract gives its owner the right, but not the obligation, to either buy or sell an
underlying asset at a given price (the exercise price or strike price).
• While an option buyer can choose whether to exercise an option, the seller is obligated to
perform if the buyer exercises the option.
• The owner of a call option has the right to purchase the underlying asset at a specific price for a
specified time period.
• The owner of a put option has the right to sell the underlying asset at a specific price for a
specified time period.
• The price of an option is also referred to as the option premium.
• American options may be exercised at any time up to and including the contract’s
• expiration date.
• European options can be exercised only on the contract’s expiration date.
• The seller of an option is also called the option writer. There are four possible options for
positions:
1. Long call: the buyer of a call option—has the right to buy an underlying asset.
2. Short call: the writer (seller) of a call option—has the obligation to sell the
underlying asset.
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3. Long put: the buyer of a put option—has the right to sell the underlying asset.
4. Short put: the writer (seller) of a put option—has the obligation to buy the
underlying asset.
Arbitrage
Arbitrage is an important concept in valuing (pricing) derivative securities. In its purest sense,
arbitrage is riskless. If a return greater than the risk-free rate can be earned by holding a portfolio of
assets that produces a certain (riskless) return, then an arbitrage opportunity exists.
Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until
they affect supply and demand enough to bring asset prices to efficient (No-arbitrage) levels.
There are two arbitrage arguments that are particularly useful in the study and use of derivatives.
The first is based on the law of one price. Two securities or portfolios that have identical cash flows
in the future, regardless of future events, should have the same price. If A and B have identical
future payoffs and A is priced lower than B, buy A and sell B. You have an immediate profit, and the
payoff on A will satisfy the (future) liability of being short on
The second type of arbitrage requires an investment. If a portfolio of securities or assets will have a
certain payoff in the future, there is no risk in investing in that portfolio. In order to prevent
profitable arbitrage, it must be the case that the return on the portfolio is the risk-free rate. If the
certain return on the portfolio is greater than the risk-free rate, the arbitrage would be to borrow at
Rf, invest in the portfolio, and keep the excess of the portfolio return above the risk-free rate that
must be paid on the loan. If the portfolio’s certain return is less than Rf, we could sell the portfolio,
invest the proceeds at Rf, and earn more than it will cost to buy back the portfolio at a future date.
Credit Risk
Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations. It is the risk to earnings or capital arising from a counterparty’s failure to
meet the terms of any contract with the lender. Traditionally, it refers to the risk that a lender may
not receive the owed principal and interest.
Credit risk can be measured by the 5Cs of the credit framework1. Character – What is the business, and reputation of the organisation as well as the owners. Is
the client trustworthy and honest? What are his savings/investment habits. Past offences.
2. Capacity – Will the business generate adequate cash flows to be able to repay debt and interest
payments. The lender looks at the profitability margins and cash flows of the borrower under
this criteria.
3. Capital – Check the existing capital structure i.e. the proportion of debt and equity of the
borrower. Also, check the existing financial situation of the borrower
4. Collateral – What is the amount and type of collateral that the borrower is providing. Are those
assets liquid or not? More the collateral lesser the risk.
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5. Conditions – External conditions that can negatively impact the borrower. PESTEL analysis and
Porter’s 5 forces can be done to assess the same. Check the industry and macroeconomic factors
such as GDP growth rate, inflation, interest rates, consumer spending etc.
Expected loss = Probability of default X Loss given default X Exposure
The probability of default depends on 2 factors –
1. Ability to pay 2. Willingness to pay
Exposure is the maximum potential loss a lender may incur if the borrower defaults. Basically, it
means the outstanding principal amount of the loan
The Probability of Default (PD) is the probability of an Obligor defaulting (Credit Event) on some
obligation.
Loss-given default (LGD) is the amount of money a financial institution loses when a borrower
defaults on a loan, after taking into consideration any recovery, represented as a percentage of total
exposure at the time of loss.
How do we measure credit risk?
Credit ratings are the most commonly used key parameter to measure and monitor exposure. Higher
the rating lesser the probability of default. The ratings are provided by various agencies such as
Moody’s, S&P, and Cibil.
There are qualitative and quantitative factors to assess the creditworthiness of the clientsQualitative methods –
1. Look at the Balance Sheet whether it is diversified or not. Does a major portion of assets of the
client include unfavourable assets such as cryptocurrency. Thus we look at the mix of assets and
the percentage of total assets in each segment. We have to also look at the authenticity of the
assets, the usefulness of the asset as a source of repayment or collateral.
2. Look at the cash flows – Cash Flows should be stable and adequately diversified. We should look
at recurring cash flows. There should not be any duplication of sources.
(Note- For high net-worth individuals, the main sources of cash inflows are dividends, interest
income and salaries. The major outflows are income tax payments, interest payments and living
expenses.)
3. Transparency – What are the sources of financial information? How much extra information is
the client providing willingly? Identify the sources of income and cash flows of the client. Check
whether the assets are located in a single country or in multiple countries. How much
percentage of the assets are verified?
4. Contingencies- Check for obligations that are not fully detailed or are omitted like public
settlements, impending divorce and pending lawsuits. Take a comprehensive look to determine
if the borrower has any obligations that are not fully detailed or may be omitted. This can be in
the form of contingent debt, pending lawsuits, personal guarantees impending divorces etc.
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Quantitative methods –
In quantitative analysis, various ratios are used to assess the creditworthiness of the borrower. The
major ratios applicable for lending to high net worth individuals are -
Interest coverage ratio = EBIT / Interest expenses
Difference between Debt service coverage ratio and interest coverage ratio –
The difference between DSCR and the interest coverage ratio is that the interest coverage ratio only
covers interest expenses. In reality, cash outflows include the principal amounts too which are
covered in DSCR. Coming to the numerator Interest Coverage ratio takes EBIT (which is not a pure
cash figure) whereas DSCR takes net recurring cash flow. Coming to the denominator, the Interest
coverage ratio takes into account only interest payments whereas DSCR covers interest plus
principal as well.
Verified assets – Borrowers claim an amount that they possess in assets. However, that amount is
subject to verification by an official from the lender. The higher the percentage of verified assets, the
better it is.
Encumbered assets –
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•
•
Encumbered security or asset is owned by one entity, but there is also a legal claim to that
asset by another entity.
These claims may be due to the owner of the asset owing money to a creditor who uses that
asset as collateral.
Encumbered assets are subject to restrictions on their use or sale.
Thus, assets can be grouped into 4 categories-
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Collateral Ideal collateral should be easy to value, liquid, less prone to periods of boom and busts and should
be controllable.
Given below is a list of assets for collateral in order of preference from lender points of view1.
2.
3.
4.
5.
6.
7.
8.
9.
Cash / CD’s
Diversified marketable securities
Concentrated stock position
Life insurance, Diversified hedge funds
Jets and yachts
Commercial real estate, fine arts
Private Equity
Unsecured loans
Pre – IPO
Covenants –
Contractual expectations are agreed upon by the lender and borrower. These tell the dos and don’ts
to the borrower.
If violated, the lender can ask for full repayment of debt or negotiate remedial actions. Example of
positive covenants (Do’s) –
•
•
•
•
The lender has to maintain a debt-equity ratio of xx.
The lender has to maintain a minimum net worth of xx
Example of negative covenants (Don’ts)Borrowers can’t raise additional debt or sell assets without the prior consent of lenders.
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