If in the course of a discussion, during which the rules of politeness have not been transgressed, but in consequence of which expressions have been used which induce one of the party to consider himself offended, the man who demands satisfaction cannot be considered the aggressor, or the person who gives it the offended; the case must be submitted to the trial of chance.
But if a man sends a message without a sufficient cause, he becomes the aggressor; and the seconds, before they allow a meeting to take place, must insist upon a sufficient reason being manifestly shown.
All these are insisted on because the selection of the weapons and the kind of duel rests with the offended party.
The swords are measured to ascertain that they are of equal length, and in no case must a sword with a sharp edge or a notch be allowed.
The combatants are requested to throw off their coats and to lay bare their breasts, to show that they do not wear any defence or cuirass that could ward off a thrust.
A refusal to submit to this proposal is to be considered a refusal to fight.
If, on comparing weapons, the swords are found to differ, the choice must be decided by chance, unless the disproportion is of a material nature.
At the word ALLEZ, "commence," they set to, the seconds holding a sword or a cane, with the point downwards, and standing close to each combatant, and prepared to stop the fight the moment the rules agreed upon are transgressed.
Unless previously stipulated, neither of the combatants is allowed to turn off the sword of his opponent with the left hand; should a combatant persist in thus using his left hand, the seconds of his adversary may insist that the hand shall be tied behind his back.
When one of the parties exclaims that he is wounded, or a wound is perceived by his second, the combat is stopped; but with the consent of the wounded man it may be renewed.
If the wounded man, although the combat is ordered to be stopped, continues to press upon his opponent, this act is equivalent to his express desire to continue the conflict; but he must be stopped and reprimanded. If, in the same circumstances, the combatant that is not wounded continues to press on his antagonist, although ordered to stop by the seconds, he must be immediately checked by them, and considered to have infringed the rules.
- Andrew Steinmetz, "The Romance of Duelling in all Times & Countries" (1868)
As with much written by Steinmetz about dueling and gambling, there are direct parallels to Steinmetz everywhere in Private Equity. We could easily be discussing the process of putting a company in play, and going to due diligence in the passages above.
In Private Equity the weapon of choice is usually the discounted cash flow analysis. (DCF).
The concept is simple. What would you have to pay me today to forgo $1,000,000 per year paid for 10 years? It should be obvious to most that the chance of seeing $1,000,000 next year is worth less than having $1,000,000 this year. This is the time value of money. How much less? That depends on how risky you think things are.
Clearly, we think that a loan by a bankrupt company is riskier than a loan from GE. We quantify how risky we think these obligations are with something called the "discount rate." It's the return we need to see on the capital at risk in order to be compensated for that risk.
That said, when we guess what a company will spill out to us in "free cash" each year and apply the discount rate back against it, we then decide how much those cash flows are worth paying for today. The higher the risk we perceive, the higher the discount rate, and the less we are willing to pay today.
It should be clear that sellers have several interests here:
First, to boost revenues. This will, holding all else equal, boost free cash and thus boost the value of the firm.
Second, to minimize costs. This will, holding all else equal, boost free cash and thus boost the value of the firm.
Third, to keep the "discount rate" low.
These, dear readers, are the protocols for the DCF duel.
The duel can begin anywhere. In discussions fostered by the LOI. Before the LOI. In the management meeting. After the management meeting. Anywhere. But it typically starts in the same way.
Last month I was engaged in a fencing match along these lines. I recount it to you now set to the background of the mortal duel fought in 1613 between Lord Sackville, 4th Earl of Dorset and Edward Bruce, 2nd Lord of Kinloss, over Venetia Stanley, the grand-daughter of Edward Stanley, 3rd Earl of Derby, and who was 13 at the time.
The part of Lord Edward Sackville is played by me.
The part of Lord Edward Sackville's Second is played by our attorney, Michael.
The part of Lord Edward Sackville's Third is played by our banker, Thomas.
The part of Lord Edward Bruce is played by the company's CFO, Ike.
The part of Lord Edward Bruce's Second is played by the sell-side investment banker representing the company we are considering purchasing.
The part of Lord Edward Bruce's Third is played by the company's general counsel.
The part of Venetia Stanley is played by the company. (It's a non-speaking part).
Scene, Manhattan, an elegant boardroom encompassing an obscenely expensive conference table, leather chairs and a wide range of expensive looking (but probably cheap) art on the walls. Present are Lord Edward Bruce, and the Friends of Lord Bruce, his Second and Third.
Enter Lord Edward Sackvlle with Second and Third, armed with swords and bucklers (pens and laptops).
Sackville's Second: "Gentlemen. I think everyone knows everyone else, so let's just get started, shall we?"
Handshakes all around. The newcomers sit.
Bruce's Third: "Alright. We have reviewed the provisions in your LOI and I have to say we don't feel we are very close on the purchase price."
Sackville: "What exactly do you base that on?"
Bruce: "I don't know who put together the valuation, but it needs to be reviewed. It's quite low."
Sackville (offended, icily): "I did the valuation."
A brief silence.
Bruce: "Management's projections are realistic and conservative."
Sackville: "Which are they. Realistic or conservative?"
Bruce (annoyed): "Look, anything less than 7 times [this means 7x EBITDA] isn't worth talking about."
Sackville: "Where are you getting that figure from? We aren’t going to pay 7 times just because that's management's favorite number."
Bruce's Second: "Ok, ok. Let's bring this back to reality. Do you have specific issues with management's projections."
Sackville: "Well, yes, we do. Shall we go over them?"
Bruce's Second: "I think that would be a good place to start. How did you do the valuation."
Sackville: "We did a discounted cash flow after making adjustments to management's projections, of course."
Bruce's Third: "I'm certain that if we go over those you will see our perspective on the company and why we are optimistic."
Sackville's Third (aside to Sackville): "First realistic, then conservative, now optimistic."
Sackville (drawing sword/laptop): "Ok, let's start with the projections management made for revenue growth."
Bruce (drawing sword/management spreadsheet): "Alright."
The two salute each other.
Sackville: "You show revenues of about $156 million in 2005."
Sackville (a gentle thrust): "Those are audited?"
Bruce (a weak parry): "Yes. Well, no. Not yet. We are expecting the auditor's to finish up soon."
A long pause.
Sackville (steps forward): "Ok. Now for 2006 you are forecasting $185 million."
Sackville (a quick lunge): "Growth of 18.5%?"
Bruce (another weak parry): "Yes."
Sackville (a second thrust): "In an industry with an average of 8.5% growth over the last 5 years?"
Bruce (stumbling back): "We have several new initiatives which we feel..."
Sackville (sensing weakness, presses the attack): "In the same industry? Or are you moving away from your core competency?"
Bruce (wavering): "We're not unfocused if that's what you mean."
Sackville: "So in the same industry. You're not going to start making plastic bookends, right?"
Bruce: "Same industry, but we feel..."
Sackville (a quick slash drawing blood from Bruce): "See, this is the problem I have with your projections. You are forecasting 18.5% growth in the year after a transaction when your company, by your own figures, has never seen more than 9% growth in the last 7 years. I might add that the number one player in the industry averaged 11% growth over the last 3 years and their record growth year was 12.4% How are you going to get..." (Looks at the figures) "18.5% in 2006, 22.0% in 2007, 16.0% in 2008, 13% in 2009, 12% in 2010... The list goes on. It looks to me like someone just picked a bunch of even percentages and figured revenue forward that way."
Bruce (wounded): "We are quite confident in the numbers."
Sackville: "Did you do a revenue build-up? Or did you just pick percentages?"
Bruce (wounded twice): "We didn't 'just pick' anything."
Sackville: "Did you do a revenue build up? Is there some way I can see where these huge growth figures are coming from? Which products are contributing what?"
Bruce (pushed to the ground): "I'll get back to you on that. I am sure we have something."
Sackville (backing off to let Bruce get back on his feet): "Alright, that would be helpful. Let's do this. For the moment let's just give you 11.5% growth. Better than industry average, yes?"
Bruce: "I don't think that's right."
Sackville: "Well, we certainly don't think 18% is the number. Even 12% is generous here, I think, but let's use that for the moment, at least until I get those buildup figures, ok?"
Bruce: "Alright, alright."
Sackville (cleaning the first blood from the sword/typing into excel): "12% across. Ok. Now, why is your cost of goods sold steadily decreasing every year? You're at 64% of revenue in 2005 but by 2008 you're down to 61%. How does that come about."
Bruce: "We've instituted improvements in our processes."
Sackville (renewing the attack): "Well, this would put you at the top of the industry for cost of goods sold too. The industry average is 63.6% and the only player I could find with lower is a Chinese firm that doesn't even sell to the U.S. They were 60.5% How are you going to be at 61% in 2 years?"
Bruce: "Part of that is through outsourcing arrangements."
Sackville: "You're already outsourcing 65% of your production costs, how much more savings can you get? Look, let's flat line that at 63%. Top quartile in the industry. We can live with that for the moment, can't we?"
Bruce (weak counter-attack): "Well I really don't think that's a good figure. We can do better than that."
Sackville: "Do you have pilots you've done? Have you gotten vendors to do studies? Where do these figures come from? It looks to me again just like someone picked a nice even number. It's not even 61.02% it's exactly 61%. Look, let's flat line it at 63%. We can come back to it."
Bruce (wounded again): "Alright."
Sackville (a brutal stab now): "Typically, I'd go into add-backs next, but let's just see where we are, ok? Just changing the revenue figures and the cost of goods sold figures to be in line with the industry, no at the HEAD of the industry, my DCF shows $196 million."
Bruce's Second (crying out): "That's WAY out of line."
Sackville: "Ok, well, where did this $350 million figure you have come from? I assume that was a discounted cash flow? Something of the sort?"
Bruce: "That's right."
Sackville: "Well, what did you use for your discount rate?"
Sackville (lunging again): "11%? I could get 12% out of the S&P 500 in 5 years. Are you trying to tell me this middle market company here is no riskier than a strong index fund?"
A long silence.
Sackville: "Ok, you did the discounted cash flow at 11%. Did you apply a liquidity discount? It's not like the buyer of this company has a ton of liquidity here folks. 20% even 30% of discount on the final DCF figure is not out of line in a case like this."
Bruce lays on the ground, bleeding from multiple wounds.
Sackville: "Alright, maybe we should take a break."
Exeunt all but Bruce and his Second and Third.
In this case we fought another 30 minutes, they seemed to even acquiesce to our points.
In the duel between Sackville and Bruce, Sackville killed Bruce, but then found that Venetia Stanley had decided to marry Sir Kenelm Digby instead.
You can win the duel over a DCF and still lose the company. This company sold for $365 million to someone else (thank god) dim enough to buy management's assumptions without fighting a duel.
They've gone through 3 layers of layoffs already, even though the company was already having problems meeting demand, and it's hard to imagine how they will survive given all the debt they took on.
As you may have noticed, this week is Andrew Steinmetz week. What can I say? I'm feeling romantic.
The graphic is from Jean-Léon Gérôme's "Duel After a Masked Ball" (1857).