by John Rolfe
An associate didn’t stand a chance with a guy like Gator as his managing director. He may have been a great guy out of the office, he could have even been the Messiah, but when it came to banking the guy was an animal. Getting staffed on a pitch with Gator was a sure death sentence for the associate, and there was no appeals process. The electric chair was ready and waiting and the power was turned on.
Fishing for Value
A lie can be halfway round the world before the truth has got its boots on.
—James Callaghan
The investment banking associate devotes a significant portion of his or her existence to performing valuation work. Theoretically, every transaction involves a valuation. If the bankers are selling a company, then they need to do a valuation to figure out what a fair sales price is. If the bankers are doing an equity offering, then they need a valuation to tell them how much money the market will give them for the equity. If the bankers are doing a bond offering, the bond buyers will want to know what sort of value the assets backing the bonds have.
The valuation work begins at the very first stages of the pitch and continues throughout the entire process until the deal is actually consummated. The valuation will go up, down, sideways, and backward. The valuation will start out looking like Little Bo Peep and end up looking like Quasimodo.
Any associate who has graduated from business school knows all the different valuation techniques. There are market-based methods and theoretical methods. There are trading values and takeout values. There are going-concern values and liquidation values. Troob and I knew all this, but what we didn’t know was how the valuations in an investment bank usually got done. After we learned, we called it doggy-style valuation because it was done backward. In an investment bank, the managing director figures out what reasonable valuation number he is going to need to tell the client in order to win the business. It then becomes the associate’s job to work backward to figure out a way to display analysis that will validate the target value. In the process, associates try to convince themselves that what they’re doing is solid analysis and not simply pure pretzel logic or high-level finance magic tricks.
We had a lot of valuation techniques at our command. It would have been nice if we could have tried out a few techniques, and then used the one that gave us the target value we were hoping to reach. The problem was that usually our valuation techniques didn’t give us the numbers we needed. The numbers we had to give the companies during the pitch in order to win the business were usually bigger than we could reasonably justify. This was problematic, but it wasn’t insurmountable. As long as we were willing to push the limits of our optimism, we could come out where we needed to be. As long as we were willing to take a second mortgage on our integrity, everything would be Dy-No-Mite.
This is how we did it.
Comparable Multiples Analysis
The quickest method of valuing a company is through use of a comparable multiples analysis (“comp analysis”). In a comp analysis the associate identifies a group of companies, the comps, that are similar to the company being valued, then he looks at what prices the comps are trading for in the public market. For instance, the group of comps might be trading on average for ten times cash flow. If that’s the case, then the associate simply has to take the target company’s cash flow and multiply it times ten in order to derive a value for the company. It’s as easy as pie, and the principle behind the comp analysis is simple: if your neighbor’s 1975 Chevy Nova sold for three hundred dollars, your 1977 Chevy Nova should probably sell for about the same amount.
The problem with the comp analysis is that most of the time the banker wants to have a group of comps with the highest multiples possible and that, in turn, means that the bank may have to use companies as comps that are completely different from the company being valued. The associate’s job then becomes figuring out a way to make all the companies seem similar, even though they’re not. I once worked on an IPO for an engineering company that had a lot of clients in the broadcasting industry. Broadcasting companies were selling at huge premiums to engineering companies in the market, so we convinced the buyers that the company going public was actually a broadcasting company that just happened to employ a lot of engineers. It worked like magic. On the comp analysis, any company with even the slightest justification for inclusion is considered. It can be a redheaded stepson, or a second cousin through marriage three times removed, and it’ll still get invited to the family barbecue.
Bankers, in general, love comp analysis. A well-executed comp analysis contains lots of data, and that gets most bankers hotter than a plate of Louisiana crawdads. Our associate comrade Slick once worked on a deal for DLJ’s merchant bank. The merchant bank wanted to sell one of their portfolio companies and they needed a comp analysis to figure out what sort of price they could expect to get in the public markets. The portfolio company was a textile company. The managing director said that he needed a very thorough comparable analysis; he didn’t want to leave any stone unturned. Our man Slick had to put together a comparable analysis with one hundred companies on it. We called it the “100 Company Underwear Comp” because a lot of the companies made underwear. Four times a year each of the companies on the comp released their quarterly financial statement and Slick had to update all one hundred companies. It took him two entire days. That was when he realized he had hit it big as an investment banker. Nobody knew as much about the trading multiples of underwear companies as he did. He had found his niche.
Discounted Cash Flow Analysis
Another key weapon for the creative banker is the discounted cash flow (DCF) analysis. The DCF is the grand-daddy of all crocks of shit. It’s the technique that makes Linda Lovelace look like a Catholic schoolgirl and Richard Nixon look like Abe Lincoln. In a DCF analysis, the banker projects the company’s cash flow for a bunch of years into the future, then he figures out what all those future cash flows are worth today.
The DCF analysis is especially useful for valuing companies with no real business. A comp analysis, at least, requires that the company being valued have some revenues, cash flow, or earnings today in order to have any value. The DCF analysis does not. It finesses the problem by only attributing value on the basis of how the company is projected to do in the future.
The associate always takes the first pass at developing the DCF model. The associate has a quick rule of thumb—reality is irrelevant. The projections should always show revenues going up and expenses going down. That makes the DCF model spit out a big fat value for the business. Big fat values make CEO’s happy.
When the associate finishes taking wild stabs in the dark on the DCF model, the more senior bankers will get involved. The senior vice president will decide that the revenue growth should be 11 percent per year instead of 8 percent. The vice president will have the associate take the gross margin up a percentage point. There are standard investment banking reasons why any given margin should improve. They always involve phrases like “operating efficiencies,” “synergies,” and “economies of scale.” Everyone on the deal team will pull a few of these phrases out of the hope chest, and tweak the model a little bit so as to put his own special mark on it. It’s like animals marking their territory. At the end of the day, there’s only one immutable goal. The team has to reach the valuation target that the company will be happy with.
Over and over again associates tweak their DCF models. Over and over again they have models that show the company growing at a rate that, if continued, would allow the company being modeled to take over the entire planet within a generation. Over and over again the investors buy securities that are overpriced based on inflated and unrealistic expectations. For some reason, nobody ever learns. It’s part of the magic of the DCF.
The Research Analysts
There is one final line of defense after the bankers have marked their valuation territory. This is the research analyst, the person who will be expected to write research reports and provide coverage of
the company being valued. In theory, the research analyst is supposed to operate as a check on the overly optimistic bankers and is supposed to bring some incremental level of industry expertise to the entire valuation process. While some of them do, there are plenty of others who aren’t truly independent anymore. These analysts operate as extensions of the investment banking operation, helping to win deals and generate business.
Research analysts have a mixed set of incentives. On the one hand, they need to maintain some credibility because long after the bankers have headed for the hills following a deal’s sale, the analysts will continue to answer to the institutions whom they convinced to buy the deal in the first place. On the other hand, the bank is in the business of making money, and the investment banking fees associated with underwriting and advisory business are a prime contributor to the institution’s profitability. Anybody who isn’t a contributor to that profitability isn’t going to be kept around for long. There’s always the distinct possibility that the “cooperative” analyst will become accustomed to eating steak tartare at The Palm, while the less cooperative analyst will end up eating Salisbury steak at the Denny’s buffet.
During the underwriting process, bankers and analysts spend a lot of time working closely with each other. They work out the details of a company’s valuation, and debate what approaches should be used to position and market the company to the prospective buyers. In this close, intense atmosphere it’s not unheard of for a banker and an analyst to begin a deal as nothing more than professional acquaintances but end up as lovers or, better yet, serial copulators. DLJ certainly wasn’t immune to these semiprofessional trysts, and Troob and I heard scuttlebutt regarding bawdy romps, and subsequent spread-eagle delight, in darkened boardrooms after hours between members of the banking teams and their research analyst counterparts.
The thing is, these romps had the potential to be seriously controversial. By design, bankers and analysts are professional adversaries. Typically it is the banker’s responsibility to represent the client by pushing for the richest valuation, while it is the analyst’s responsibility to defend the bank’s integrity by putting out unbiased valuation reports and buy/sell recommendations. It wouldn’t be too much of a stretch to imagine that a devious banker might dangle the promise of some steamy sex in front of an undersexed, eager-to-please research analyst in exchange for just a few extra multiple points on a valuation.
No matter what sort of research analyst support a banker has on a deal, it’s always the market that drives pricing at the end of the day. The bankers can take management teams out on the road, and they can have their research analysts telling the accounts that a new issue should be priced at fifteen times earnings, but if the market is unwilling to sign off on the proposed valuation, the company won’t get the pricing and valuation points that they’ve been led to believe they can get. Since the bankers are known to regularly overestimate the market’s willingness to pay a given price for a new issue, the banker’s job uncomfortably becomes one of trying to figure out how to explain to the client at pricing time that the bank is going to be delivering less money than they originally promised. That reality exists whether or not the banker on the account is banging the research analyst.
Overall, investment bankers spend hours, days, and sometimes weeks of their lives trying to figure out a way to show a company what a tremendous amount of money the company is worth. Then, if they’re lucky enough to win the business, they spend more hours, days, and weeks slowly persuading the salespeople, the capital markets guys, and the markets that the company is truly worth the value that the bank attributed to it. It’s like catching a fish and then trying to hold on to it with your bare hands. Some investment bankers are just better fishermen than others.
The Merry-go-round
No passion in the world is equal to the passion to alter someone else’s draft.
—H. G. Wells
As Rolfe and I learned, the initial rounds of valuation work are just the first steps in the investment banking process. These inaugural throes are the opening volley in what will become a barrage of documentation necessary to, first, win the business and, second, process the deal. The associate has the task of making all the valuation numbers look good and the reasons behind the numbers look even better. The bullshit is set to accelerate. This is where the word processing department comes in.
Professional word processing is performed on any and every document an investment banking associate works on. When an associate does a pitch there is word processing, on internal memos there is word processing, on anything that leaves the investment bank to be seen by a client or prospective client there is word processing. Every sole, single, solitary document has to look good because this constitutes 90 percent of the associate’s value-added. If an investment banking associate is able to word process effectively and efficiently, then he or she will be successful for at least four years on Wall Street.
The word processing portion of an associate’s work is like the boxes of Raisinets at the movie theater. They’re a staple across the country, no one likes them and they should be rid from the planet, but they’re still there. Every associate detests word processing, but it’s a necessary evil in investment banking.
Unfortunately, that necessary evil occupies 40 to 50 percent of an associate’s time. This equates to anywhere between thirty to fifty hours per week of word processing per associate. The amount of time associates on Wall Street spend submitting documents to word processing, proofing the documents after they come back from word processing, reworking the drafts that were first submitted to correct some of the errors the word processing gnomes made, again submitting the documents to the word processing department, and then again proofing them is mind-boggling. After completing all this work, the vice president on the deal usually scraps 80 percent of the stuff the associate wrote, and the word processing cycle begins all over again.
At DLJ, the word processing department was staffed by a crew that seemed like they belonged on the brig of the good ship Lollipop. Rolfe boarded this ship many times and got to know the crew pretty well.
There were two basic groups of word processing people. The struggling actors and actresses and the Christopher Street fairies. All of them were temperamental and refused to take shit from any junior bankers. They were competent, but if they didn’t like us it seemed as though they would make lots of mistakes on purpose. They would fuck up fonts and underlines and paragraphs and make any long night even longer. It wasn’t easy to get on their good side. We had to be nice. We couldn’t pay them off. They got paid about twenty bucks an hour and didn’t give a flying fuck about money. They just wanted respect. It was a beautiful thing to watch a snot-nosed, stuck-up banker groveling to a guy who only wanted to go down to Christopher Street to pick up his boyfriend. Usually, the banker had a hard time relating to the word processing guy, but the word processing guy held the associates’ balls in his hip pocket. To cross the word processing department was one of the worst mistakes any of us could make.
The best way to convey the futility of the word processing merry-go-round is through an illustration. But keep in mind this won’t give full justice to the actual pain inflicted upon us by the word processing merry-go-round. We had to deal with this crap on a daily basis for just about everything we did.
An Example
On most pitches, when the initial valuation work is complete, the vice president tells the associate, “Take a crack at writing the executive summary.” The executive summary is used to state the business that the company being pitched is involved in, and to tell the company that the investment bank making the pitch should be chosen to lead manage the deal. The rest of the pitch book shows why the investment bank doing the pitching should get that business.
“Taking a crack” at something in investment banking is like jerking off on yourself in the corner. It’s bad enough that you’ve got to go and jerk off in the corner, but to add insult to injury you have to do it on yourself and
it’s a mess to clean up. The associate works on the executive summary and sends it through the word processing department. When it comes back, the vice president rewrites the executive summary and the associate sends it back through the word processing department, gets it back, and proofs it. Then the senior vice president rewrites the executive summary once again, the associate sends it back through the word processing department, gets it back, and proofs it. Eventually, the managing director rewrites the executive summary for the fourth time. You get the idea. The shit continues ad nauseam. Rolfe experienced this clusterfuck firsthand while he was writing an executive summary for a telecommunications company:
I wrote
I walked up to the word processing department so that I could submit the document and get the ball rolling. Fausto was sitting there looking haggard when I walked in. Fausto was the Grand Poo-Bah of word processing. He was responsible for allocating all the work in the word processing department. I don’t know why he looked so haggard. Maybe he’d had a long night at the Vault, a sex club, or maybe he was just tired. I wrote out a word processing ticket and clipped my handwritten document to it. I was neither nice nor mean to Fausto. But I think he thought that I was a little curt with him so he gave my job to Elena. Elena was a beauty, but she hardly spoke English and I believed that if she tilted her head too far to one side pebbles would fall out. Two hours later a document came back that looked like this:
