Finshaala

Learning about Private Equity – Part I

Recently I finished a book on Private Equity: "Private Equity as an Asset Class" [Author- Guy Fraser-Sampson; ISBN - 978-0-470-06645-4, Publisher- John Wiley & Sons]. The book is helpful to those who are still outsiders for PE business but are keen to learn it. Not only one gets a practical view of the concept, but also the reader-friendly writing makes it easier to grasp.

Some of the things I learnt, from this book and others and from discussions with people, shall be topic of my coming posts. Starting with this one, I am sharing what from an eagle's view PE business looks like. Any comments on the post are warmly welcomed.

Introduction: In its most typical form, private equity (PE) is provision of medium to long term funds to potentially high growth unquoted companies mainly in the form of equity.

Other kinds of PE investment can be:

Taking over a division of a large company which has been neglected and needs severe reconstruction.
Making a public company private [PIPE or Private Investment in Public Companies], in order to make changes in its management, business plan and capital structure. Such changes can be done even when the company is listed but it may be difficult to do so because of market's short-term view which weighs current earnings much more than long-term wealth creation.

Venture Capital (VC) / Angel Investing – These are investments done in start-ups or during seed-capital stage. The riskiness in these investments is more as there are no or negligible cash flows (during the early stages). So the investment done by VCs is more in the nature of debt as against PEs which have more equity component in their investments.

Features of PE investment:-

Funds are provided by PE firm for medium to long term (5-12);
Target of PE firms are companies which have either huge potential to grow fastest among the industry; or have an edge over the peers which if nurtured will lead to huge wealth creation;
PE firms usually revamp the top management of the investee company. This is very common in family run businesses. Experienced and talented manpower is provided to the company. Often PE firms place their own people, who are experienced in that sector, on company's board. All the strategic decisions of the company are taken after confirmation or recommendation by firm's executives.
Investments in the company are made in several rounds. Successive investments are made only if previous funds have shown expected results.

PE and Debt: -

Companies have two sources of funds – debt and equity. Debt has more rigidity in terms of interest and principal payments and equity has more cost. Now equity can be raised from public or PE firms. There are several reasons why companies go for PE instead of debt. First, no debt service burden. Secondly, PE firms bring with them lot of experience and expertise. These firms understand the industry structures very well and have exceptional domain knowledge. Thirdly, companies benefit from PE investments as latter bring lot of contacts and linkages which enable companies to spread their wings in domestic and in international markets. This enhanced networking can be used for inputs or for marketing. Another value-adding feature of PE investment is that PE firms are comfortable with negligible or no returns during initial periods of investment. This is because they have a long-term view for wealth creation and can sacrifice preliminary returns. This is not the case with debt-holders who command a timely return irrespective of stage and nature of operations. Last but not the least, PE firms come to rescue even if company is not able to turn-around even after the investment is made. But lenders are the first to file for liquidation in the event of company failing to honor its contracted payments.

Investor in PE firms:-

Institutional investors like pension funds, Mutual Funds, Hedge Funds, governments, etc.
Banks
High net-worth individuals (HNIs)
Parent organization (ICICI Bank holding stake in ICICI Venture Capital)
Other private equity firms

PE investment exit routes:

Sale to strategic investor- One of the most common ways PE firms realize their investment is by sale to another investor. For instance, a PE firm which had stake in a textile company sells it to a retail company which can take advantage by integrating its operations.
Initial Public Offer (IPO) - By timing the gestation period of investment with sale of stake to public through an IPO, many PE firms make considerable gain. This is because in IPO not only Investee Company's valuation is taken into consideration but also if the market is bullish the gains are huge.
Trade Sale- another mode by which firms exit from their investment is through sale to another investor. It can be another PE firm or any company in the same industry or in diversified industry.
Sale to management- There has been instances where the management of companies have bought stake from PE firms - MBO (Management Buy Outs, as these are commonly known).

Principles of PE investments:

The most distinct feature about PE investments is their strategies to restructure companies' management, turning them around and exiting their stake. No two PE investments will be exactly same in all respects. However there are some principles which can be associated with PE investments.

Some of these principles are listed below:-

Aim of management of a business is to maximize investors' wealth by consistently increasing after-tax cash inflows and reducing after-tax cash outflows. How to achieve this goal depends on industry in which company is operating. For a FMCG (Fast Moving Consumer Goods) company, a robust sales and distribution network is prime requirement. For a manufacturing firm, keeping margins intact by reducing input costs becomes the surviving factor. And companies in the telecommunication sector (marketing corporations like Airtel, Vodafone) are always busy building their brand value and providing value-added services to consumers.
Greater the degree of competition, lesser the chance of entity making supernormal returns. This is because if there exists any opportunity where huge returns can be made, then many players will jump into the arena to be a share the meal. With more players coming in, entity will not be able to charge wishful prices from consumers (as now latter have choices) nor the cost of resources will remain low (due to increased demand). It is mainly due to this reason that PE firms target companies which are in emerging industries. For example in a country like India where pollution has become a big problem for environmentalists, companies manufacturing pollution-control equipments are good investment opportunities for PE firms. By investing in research and development, a company can come up with innovative products and services which will open up one more profit avenue. Also tapping new markets will enable companies increase their top-lines.
When a division or business becomes more valuable for outsiders than internally, then it's wise to sell that division/business and deploy the funds in another investment avenue where owner believes can add value. This may happen because of poor strategic management of division or wasteful allocation of resources. This is the main area where PE firms show their magic.
An acquisition is successful only when the price paid for it is less than the incremental value which acquisition is expected to add. The incremental value should not be merely in terms of future cash flows but also include embedded value in assets acquired. This incremental value is commonly known as Synergy. In simple terms, it means that when an acquisition is made, the combined results of the two entities should be more than the individual results.
Synergies can be related manufacturing/provision of services (economies of scale), taxes (losses of one entity being used to reduce tax burden of a profit-making entity), market (clubbing of brands, customers, etc), sales and distribution (stores, franchises, agents, etc) or capital structure (lower cost of capital, increased capacity to raise funds, etc) and so on.
Acquisition, mergers and takeovers usually are common in fragmented market where there are many small players. For example, in India we saw lot of integration in banking sector in last ten years. Next was the airlines industry.
Out of two companies in same industry, one public and other being private, former will pay more than latter for Target Company. This is because of higher liquidity of shares of public company. As the acquisition/merger/takeover takes place, the value of purchasing company will increase with the incremental value added by the integration. Whereas this is not the case with private companies.

Difference between Private Equity firms and Hedge Funds:-

Many a times a comparison is between PE firms and hedge funds is made. Though both don't have any particular structure and both invest in companies but their investment objective and horizon are poles apart. Hedge funds, in most simple terms, are pools of money which invest in stocks, bonds, real-estate and almost everything, for short-term, to earn high gains while keeping the capital intact. These funds make use of short-selling and some of the most complicated derivative structures to reap profits. Hedge funds are not concerned with the financial results of Investment Company. Whereas PE firms are businessmen who want to make profits by taking performance of investment companies to new heights, allow their investment to grow and then exit.

Difference between Mutual Funds:

Mutual funds (MFs) are registered trusts which pool investors' money and invest in stock, bullion, real estate, etc.

Following are some distinctions between PE firms and MFs:

MFs are registered under SEBI in India, PEs not.
MFs have to report their daily performance to investors. There are two implications of this aspect. One, this actually prevents MFs from investing in potentially high growth companies which reap great gains. Secondly, the investment horizon of MFs can't be as long as PE firms. This is because low gains during initial period of investment, MFs will make no or negligible return which will make them unattractive in the market.
MFs issue units to investors, retail and institutional. PE firms have, as discussed above, only HNIs, FIs, Institutional investors, etc as their investors. As a result, MFs have small investments also (retail portion).
One of the most important feature of PE firms that is lacking in MFs is that latter are not bothered about the management of the company. They concentrate only on the returns from trading stocks. So to the investee company no value is added by MFs.

Naked Truth – Story about Stock Rigging

Many of us have always wondered why some stock/share rises beyond sensible limits, maybe over a period of time or sometimes in a day. This question has always been disturbing me and I was looking for some answers for it. Fortunately, I got hold over my old friend from Pune who gave me an insider's story.

Stock rigging, for beginners like me (even I was a beginner till I heard it), means artificially raising/lowering price of a stock for manipulative profits. Example might help readers understand what I am trying to say here. Say there is a stock United Airlines Ltd. (UAL) selling at Rs. 125 at a major bourse in India. What happens now is that some people, some really influential people we are talking about here, create an artificial demand (for raising price of UAL) or supply (for lowering). This leads to a rise/fall in price of UAL. However, retail investors, ones which are the most easily manipulated, are extremely off the ground here and have not even the slightest idea of what's happening behind the exchange. It might seem that the company is really a promising one, in case of rising price, or an ugly duck in otherwise case.

Now this is not that really simple as it seems. This exercise is in itself very complicated and has lot of people involved here. So let us go step by step.

Choosing the fish – A particular stock gets into the mind of a well established personality. Yes yes, this personality should be defined or at least exampled! He can be an influential Market Analyst or a Broker or a HNI (High Net Worth Individual) or an Institutional Investor or a Hedge Fund or any Corporate or someone else who has what is required to take a stock up and down in a matter of days with lots of substantial contacts. The reason why any stock becomes target could be some conspiracy going on against a rival company or by a company to take its own stock high up or just to misguide the market and make a profit.
Heating the pan – The next step is to get as many people in or out of your contact to recommend these people to buy or sell that stock (UAL in our case). Now here the all time hit and a must see Hollywood movie "WALL STREET" helps us to understand what exactly happens. Brokers make strong buy recommendations to buy/sell to their clients. Friends recommend. Families recommend. As a result, ticker shows UAL rising like anything.

Frying the fish – In this step we find many investment pros and gurus recommending the buy/sell on media. Be it TV, reports, websites, blogs and anything under the sun to raise the price further. All facts, true or otherwise, will be brought to the table. By this time we may have UAL selling for anything senseless, say Rs. 310.

Roasting the foolish – I should rather call it the death trap for investors like us. Because we are the ones who actually don't know what's happening out there. The news and reviews and reports make us belief we are going for a ten-bagger. So, what are we waiting for? Let us put in our money into UAL and become a millionaire in weeks. At this point, we have UAL sells say for about Rs. 450.

Ready to serve – So when all this buying is finally going to end? I mean we are not here to keep this stock where it is now. Here is where a killing is made by those perpetrators. Suddenly we find lot of bulk selling in UAL. Now this for a moment creates more buying pressure on retailers to average there stock and pile up more of this ten-bagger. Why? Because still we find news and reviews and reports saying this is a fortune-maker stock. So the stock rises again.

Gulping the poor thing – In this step, the Perpetrators are completely out. Left are the ones like us. Stock crashes like anything. There is a bear sentiment about UAL in the market. But when retailers do panic selling, we are in real danger. Stock can be expected to be at its original price or maybe much below from where it started.

The words of my friends made things a lot clear to me. But the one thing that kept disturbing me (please don't mind me using that phrase again as I have a habit of bothering myself every now and then), was how I can I be sure of that I am not part of any rigging drill going on. After some inside brainstorming, I came out with some solutions –

Checking the numbers – I still believe that a company with strong fundamentals will, not in normal circumstances, require going for rigging. But if by any chance, any rival or someone else wanted to put it down on the ticker, then it is all the more beneficial for me, as I am getting a good business at good price.
Looking at Institutional Investment – Here is something which might be of some use. Usually, and research also proves it, that Institutional buying leads to temporary hike in prices. But how do I know how long they are going to stay invested. So it might be an idea to stay out of stocks that have too much II got into it, more so when there is a recent heavy buying.

Doing my own homework – Again and again, this is one thing that I like to share with my family, friends, audiences in seminars and all other people who dare to ask me some tip to invest in the market. Since it is your money, why should someone else work hard to make sure it would multiply, till the time you have a portfolio manager handling it. What I need from the market, its news and reviews and reports, is facts which can be very cumbersome for me to collate. And honestly, it is not a rocket science to analyse financial facts, till the time we complicate it!

I hope this article brings lot of things happening in the market into our perspective. Maybe you can add on to it and help retail investors like us get a more practical view of the market.

Understanding Real Estate Market

Real Estate (RE) market has been one of the most talked about and widely covered by analysts. Also it is one of the sectors that has seen best booms and worst busts vis-a-vis other sectors. In fact, Asian crisis of 1997 and ongoing worldwide slowdown (the Sub-prime crisis) owe their losses to RE.

RE is part of a larger category of assets called Real Assets. Real assets are assets like real estate, gold, commodities, etc. which are tangible, unlike shares and bonds which are paper securities. Shares and bonds don't have any intrinsic value in themselves but these represent assets and hence hold values. RE is the oldest asset used by investors to park their surplus monies. In fact, it is believed that due to scarcity of land in historical periods, other securities like shares, bonds, etc. were developed. Even in today's times when investors are losing their risk appetite everyday and cost of capital is rising with each day passing, RE still happens to see major deals involving billions of rupees.

In India major players in this sector are:

Akruti City	DLF	Unitech
Indiabulls RE	Omaxe	HDIL
Peninsula Land	Sobha Developers	Parsavnath

Major Activities

As with any sector, RE also has a 'project life cycle' which can be broadly divided into following activities:

Land acquisition and conversion – This stage requires lots of approvals and permissions from various regulatory authorities. Apart from being the first, these activities are most risky ones. But following the fundamental principles of finance (for more risk, investors demand more return), this section of RE life cycle is most rewarding for investors.
Construction and development – Once the developer (one which undertakes the responsibility of placing a structure on a piece of land) has acquired the land and taken necessary approvals and permits, it starts the work of building structures. This can be done either through some third entity (construction contractors) or the developer can do this itself. Companies like DLF, Unitech, Sobha Developers are said to have strong execution skills.
Sales – This is the marketing section for developers. Here the industry gets exposed to retail investors who lured by discounts, easy loans, and so on. The credibility of Developer is what end-users/investors take very seriously for reasons like clean title. No one wants to put his/her money into some investment which tomorrow is claimed by many or is under litigation for some reason. A good developer is also believed to bring a quality product in the market.

With each section, some other attributes like type of investor, investment horizon, etc are related. Let us put these in form of a table :

Attribute ↓ Stage→	Land acquisition and conversion	Construction and development	Sales
Type of Investors	Private Equity, HNIs	SPVs, Retail	Corporates, Retail
Investment Horizon	Very small (months to 2 yrs)	Small – Medium (1 to 3 years)	Long*
Risk	High	Medium	Low
Return	High	Medium or Low	High, Medium, Low*

* Depend mainly on the market condition, whether boom or bust

Cash Flows of a RE company

Outflows
Cost of Land and related expenses	x x x
Construction and Development Costs	x x x
Interest	x x x
Admin and other costs	x x x

Inflows
Sales	x x x
Rentals/Leases	x x x

Valuation of RE assets

Some of the prominent methods of valuation are:

Build and Sell – Discounted Cash Flow (DCF) Method. In this method, we discount the prevailing actual sale prices at cost of capital.
Build and Lease – DCF method. Here we capitalise (divide) the prevailing rentals by the cost of capital.
Assets in construction stage – EBITDA (Earnings before interest, taxes, depreciation and amortisations) multiple. This method requires, first, estimating the sales price and then reducing from it the average direct expenses to arrive at EBITDA.

Why Boom!!!

Though it is not possible to list out the factors/reasons behind a boom in any industry, but with loads of research and analysis, experts say that the last rise in investments in RE was due to the following reasons:

High Liquidity in the market – Having a lot of investment in a particular sector, more so when it is not able to absorb so much lead to spiralling of prices. Any RE project can take 3-5 years from initiation to sale. It is not that with more demand, the supply will increase instantaneously. But why was there so much liquidity in the market? Reasons:
1. Huge foreign inflows
2. Low cost of capital
3. Active retail investment, through easy loans and increasing affordability (specially the salaried class)
High Valuations – backed by high liquidity and churning of capital within project stages led to high valuations. Churning of capital is supposed to take place when investment horizons fall and still market rewards you with handsome returns. What is said to have happened was that investors were realising their investments pretty soon and were re-investing in other projects as there was huge demand (at least in reports and forecasts, if not in real life!). Mathematically, if you have increased cash flows in few years against smaller cash flows in a stretched period, you will have a better NPV or IRR. This churning of capital happened mostly in the first stage of 'land acquisition and development'.
Regulatory Support – Recent years have seen government encouraging this sector with passing of SEZ Act, fast clearing of projects (mainly SEZs), tax benefits, etc. Though one can argue that banks were asked to value their investments in RE sector with more risk-weightage.

Why Bust?

The reasons behind the crisis could be many. Some of them are:

Diminished affordability – With Central Bank's aim of taming inflation, we saw lot of pressure on interest and other statutory rates in 2008. The result was falling economic activity as the cost of debt rose to high levels and investment decisions became all the more difficult. Businesses, whether big or medium or small had to bear the increased cost and wherever possible the increase was transferred to consumers. However, RE was one of those which suffered the most. At the producers' end, high cost of debt made it difficult for developers to execute the existing projects and to go for new ones. Since RE is another capital intensive industry in which any typical project has more than 50% debt, things became all the more difficult. Developer's found it difficult to complete the financial closure of projects on time.
On the consumers' side, rise in cost of loans and hence increased EMIs (Equated Monthly Instalments) reduced their appetite for making investment in the sector. In fact, many who had taken these loans for self-accommodation purposes also bore the brunt. Actually not only the rates were increased but also Loan-to-Value ratio (if value of property is Rs. 10 lacs and the loan that could be availed by mortgaging this property is Rs. 5 lacs, then L-t-V ratio is 50%) was reduced. Though now things are recovering with RBI bringing down the interest rates and issuing directives for encouraging banks to lend in this sector.
Faulty estimates – When oil was at $147 a barrel, analysts forecasted a price of $200. When Sensex was at 21k forecasts for 30k were not few. I think this is the way some analysts/experts use market scenario to make themselves famous. Nevertheless, year 2007 had many reports published that talked about acute shortage of land in India. I am not an expert to comment on the real demand/supply situation, but I am sure many of these reports exaggerated the real situation. The result, oversupply.
Exit by PE funds, foreign investors – PE funds, as said above, have been one of the main players in this rally. However with falling valuations and high cost of capital, it became difficult for them to invest. Moreover now they either had the choice to sell their investments at loss or wait for some more time. Whereas, foreign investors were busy withdrawing money from risky markets and refurbishing their domestic balance sheets. RE being one of the risky sectors, saw more redemptions. However, one can argue that the current mouth-watering valuations should bring more investments by strategic investors like PE funds, big developers.
Overall fear or recession – No economy I think has been able to save itself from deteriorating investor sentiments. All are worried about worldwide recessions, with exceptions being countries like India, China, Russia and other developing nations. But even economies like India saw losing investor appetite and more due-diligence. Investors' which are even more scared prefer to sit on cash or bank deposits rather investing in other assets. This further brought down the valuations.

What's next

With recent proactive actions from RBI and stable investor actions, one can expect that the market will not fall drastically, atleast from this level. But we may see some more declines as the 4^th quarter results are going to be worse than 3^rd quarter. As far as RE market is concerned we still may be able to see some downside because of cash-strapping of developers, decreasing profits of investors like Corporates, PE funds, HNIs, etc., increasing unemployment and some other reasons.

But if one was to forecast what one may see in coming times:

Lower real-market interest rates
and L-T-V ratio – By interest rates, I don't mean to say only statutory rates (as I believe that a lot has been done by our Central Bank). Interest rates here refer to the market interest rates which are currently different from bank rates. Actually it is stated by many that banks have not passed on the reduction in cost of money done by RBI to the consumers. And one of the main reasons behind it is that banks are sitting on cash. More so for RE sector due to its riskiness. Lenders are discounting valuations to large extent.LTV ratio is also said to be higher compared to year 2007 levels.
What we shall see in future times is lower real-market interest rates and lower LTV ratio.
More investments – With easier financing, one must see RE industry coming back on track with existing projects completing on time and new projects getting investors. But investors need to be more sceptical about the business model of the developers, contractors and other related businesses like facilities management, asset management, etc. This is because no one is sure of what will happen in future – whether Corporates (one of the major customer class for developers) will perform good or whether PE funds and foreign investors start pumping their investments in this sector.
More government support – As a sector RE is one of those which hires millions, has countless ancillary industries and brings much foreign investment. It is, I think, one of the agenda's of government to bring this sector on track. Already RBI has asked banks to go forward to in lending RE sector.

Let us all hope that we see more lucrative investments with robust markets in future times.

SUB-Prime Primer

We all, whether those who are part of financial markets or those who are not, have been hearing, reading and (now started) speaking about SUB-PRIME or U.S. financial crisis or credit crunch or financial market breakdown or … (the list goes on). No one has been fortunate enough to skip the aftermaths of inventions of complex financial products (CDO, CLO, CMO and alike) and have seen markets crumbling, whether developing or developed. In fact, this crisis has been hitting the hardest to the developed economies like world-power United States, U.K., etc. The question of how well regulators have been undertaking their responsibilities and how far can market-makers (big banks like erstwhile Merrill Lynch, erstwhile Bear Sterns, Goldman Sachs and counting) can go to innovate (without assessing the potential risks associated) has popped up.

For those, like me, who are still trying to understand the market, and need a primer on what is sub-prime, let us begin to explore the concept. First of all, as the classic definition goes, something which is not a PRIME is named as SUB-PRIME in the market (market in this article shall refer to financial markets). These refer to rates of interest or the credit-worthiness of the borrower. In clearer terms, a borrower who has a good credit history of honoring his/her obligations is said to be PRIME borrower and the one who has either defaulted or is expected to do so is called SUB-PRIME borrower. But how are these simple definitions responsible to collapse of such giants who have dozens of sophisticated investment analysts, economists and other experts? Also these institutions are not in retail lending / mortgaging, so how come these two are related?

Let’s first answer the second question. The story begins from a year 2000’s DOT COM bubble burst, when the markets crashed like pack of cards and there was an urgent need to revive the markets and boost confidence. For achieving the said goals, FED (Federal Reserve – US’ central bank) reduced interest rates to stimulate borrowing and kick-start business again. As expected, markets picked up and confidence was restored. There was a huge increase in amounts of loans granted by banks during this period.

In the real estate market, mortgagers (who get commission on the number of mortgages done) and bankers who wanted to increase their portfolio, went beyond and started serving those who did not deserved them (SUB PRIME borrowers). But since these borrowers gave more commission to the mortgager and more interest rates to these bankers, all were happy. Banks actually modified their lending criterion to book more profits without realizing the aftermaths of such loans which were slowly becoming a major chunk of their portfolio. Such borrowers kept their houses (which they bought with the money lent by banks) as collateral to banks for the funds borrowed, as a typical mortgage-backed transaction. And with easy and cheap money, it was not difficult to buy a home in US (the dream of – a house for each American – seemed to be becoming a reality). This led to surge in house prices, which further enabled SUB-PRIME borrowers to obtain more loan as their collateral value increased.

Securitisation is a form of off-balance sheet financing. (Now you must be wondering that why am I suddenly introducing you with another concept. This is because securitization is what brought our big I-Banks into picture.) Not all companies like to raise direct debt. Obviously there are reasons behind it. Firstly, more debt on my books will tarnish my ratios which are one of the primary tools used by market analysts to gauge a company’s worth and performance. Secondly, to comply with regulations (like in banking sector), I would be required to bring in more equity to balance capital structure. These and many other reasons, motivate firms to go for off-balance sheet debt. How they do this is by doing away with their illiquid assets like book debts, loans granted, etc?

Now this is the phase where I-banks play their pivotal role. Since huge amounts of loans given by (conventional/commercial) banks over-burden their balance sheets and restrict their ability to expand their portfolio. To overcome this, banks sell these loans to I-banks, through securitization, and get ready money for providing further loans. Now what these I-banks do with these loans/debts is that they sell these to investors (usually pension funds, endowment funds, high net-worth individuals). This is done by making packets (tranches) of such loans based on features like maturity, credit risk, etc. For e.g. making tranches of AA rated loans.

The story was going simple: Banks gave loans (since we are concerned with sub-prime crisis, so loans to sub-prime borrowers), then sold those loans to I-banks which further repackaged and sold these loans as credit products to investors. In this chain, a not-so-worthy man got a house, mortgager got his commission, bank got high interest rate and I-bank got commission to sell credit products. All are Happy!

The story was going fine until the something happened.

Fed and other Central banks (in countries like UK & Europe) realized that slowly and slowly asset prices went beyond their tolerance limit. To hold prices from surging further and to bring assets prices to their intrinsic (justifiable) value, Fed increased interest rates which actually increased the payments to be made by the ultimate sub-prime borrower. As a result, they started defaulting. This led to fall in the payments made by special purpose companies (those created to sell loans/debts). Since these companies were paying dividends to Institutional investors, defaults of borrowers affected them too. Gradually the defaults got the whole system infected and paralysed. Since now it was unaffordable to purchase property, the property prices started declining. Again one of the affects of this was that the margin of borrower (percentage of amount borrowed against property) declined.

So the outcome of this financial engineering was that all the systems in the financial markets started tumbling with banks (Commercial and Investment banks) facing billions of dollars of losses.

The moral of the story seems to be that innovation should be protected with adequate risk management, else it could be fatal.

What is a financial model?

One of the main tasks of an analyst is to prepare a robust and complete financial model for the investment for which he is doing analysis, which can be an existing business or a new project. In most simple terms, a financial model depicts the outgo (s) for investment and the revenues/cash flows from the investment. A financial model necessarily has to inculcate the business model of the investment - whether it is selling a product or a service.

typically a financial model should answer the following questions:

When and how much needs to be invested?
How the funds for investment will be raised (debt or equity or both)?
Life of project?
Major assumptions which will have a bearing on the numbers - like inflation rate, market interest rate, taxes, customers, etc.
What will be the recurring cash flows (due to various reasons including different accounting policies adopted by companies, artificial inflating of revenues, etc. cash flows are most preferred tool for an analyst for adjudging an investment)?
How much will be the cost of operations?
What will be the return to various stakeholders - debt providers, government (in form of taxes), shareholders?
What are the sensitive areas of which analyst has to take note?
What are risks which can affect the future cash flows?

The above list is not at all exhaustive. There can be countless variables which can be built in within the model.

Though, a financial model gives information only quantitative outcomes for an investment, it is the most pertinent task for an analyst in investment analysis. Once the model is complete, he should be able to know the NPV (the net of PV of Cash inflows and PV of investment (s) / IRR (annualized effective compounded return rate which can be earned on the invested capital) and other metrics for measurement of return from investment.

Scenario Analysis and Sensitivity Analysis are major tools for assessing the vunerability of investment. Former involves changing many variables (affecting the future cash flows) and then observing the outcome of these changes to the return on investment (or equity). In sensitivity analysis, analyst changes one variable at a time to know the result. For e.g. what will be the effect of a 1% rise in inflation rate or how much would the cash flows rise with 5% increase in number of customers. By these two excercises, one gets to know the trigger areas which could lead to fall of the project.

Some pointers I remember while preparing financial models:

Put (or try to put) all assumptions on a single sheet
Highlight the cells which have entered value (instead of calculations) - standard is to use blue color
Separate sheets for tax calculations, revenue detail, cost detail and outcomes (with scenario category - worst, most likely or best)
Focus on what the output should be and what the users of model like to see.
Try to complete the revenues, costs, cash flows, etc for a year and then extend to future years based on the assumptions.
Minimum number of sheets not only helps the analyst but the readers of the model too.
Make use of comments feature to highlight important information.