As an analyst, as you say, previously, you'd have spent time extracting this, analyzing the earnings, analyzing the opportunity.

And Claude is going to do all of that, or has done all of that already, has it? Back in our day, it wasn't automated.

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

And by the way, I'm not suggesting that you should just do that now, but the results you get are pretty interesting.

Well, it only did the analysis on a standalone basis.

So we're going to push back on that and ask it to rerun the analysis, including the platform builds.

I didn't even prompt Claude for this, but this is such a common analysis.

We've got some of that just built in here and ready to go.

Welcome to this week's episode of What's the Deal? Graham, what are we going to be talking about this week? What is the big deal? So this week we use Claude Fable to put together an IC memo, and we're going to look at an old deal. We've got some information that's available in the public domain, which is not that easy to find for transactions like this.

But we're going to use this as the basis of, let's say you are a first-year associate sitting in a private equity firm.

This is relevant or indicative of a screening-type memo that you pull together in a job. So you get a call from, say, a sell-side advisor.

They say, "Hey, have I got this deal for you." And the first thing you've got to do is take that memo, digest it, pull out the key risks, the key investment highlights, and then pull together some kind of indicative financing model to see what your early view on returns is going to be.

And you use this as just an early test to figure out, does this deal have any interesting characteristics? Is it worthy of our time as a firm to invest some time and pursue due diligence, or do we just want to say no at this stage? And this is, I'd say, I pulled together a lot of these more from a credit investment perspective in my Ares days than an equity investment perspective.

They're basically the same kind of thing and talk about the same factors.

And you'd spend a reasonable amount of time pulling this kind of information together, because back in our day, it wasn't automated.

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

And by the way, I'm not suggesting that you should just do that now, but the results you get are pretty interesting.

So we want to run a test and see what kind of results we get and have a discussion about this now dated, but also kind of interesting deal.

So this sounds really interesting because actually there's lots we can learn from this, not just the AI angle, but also learn a little bit more about deal flow in private equity. You mentioned a few acronyms there, Graham, so let's just dig into those. I want to hear more about SIMs.

You said that we're going to dump a SIM into Claude and use that to extract investment committee memo. Can you tell me a little bit more about that? What are SIMs? Why are they used? Yeah. Actually, you know what's funny? There's a European-American distinction on this, too. Americans say SIM.

In the UK, we'd usually say IM. So SIM is confidential information memorandum.

IM is just info memorandum. You say IM in the UK. In the US, you say SIM.

Uh-huh.

It's a little bit funny to me because ultimately everything in this world should be confidential, but the SIM is the only thing that gets it in the actual title.

So I don't know. Should we be saying confidential term sheet, confidential indication of interest, and all this other stuff? But no, SIM is the doc that gets that title.

And a SIM or an IM, whatever your favorite term is, is basically a sales pitch for a business. Think about it like a really short form S-1.

If an S-1 is your public company prospectus, where a company is coming to market and you're learning about it for the first time, an IM or SIM is basically the same thing for a private company. Now, it's not a few hundred pages long like an S-1 tends to be. They're usually 30 to 60, 70 pages, depending on how complicated the business is. And the idea is it's a document put together by a sell-side advisor that's designed to give you enough information on a business to get you interested, hopefully enough to put a basic model together, but it's nowhere near enough to form a full investment hypothesis.

Okay.

It's really the start to the whole process if you indeed want to learn more.

It's also preceded by, there's a notion of a teaser as well.

So a lot of times you think about the way processes work in this kind of world.

The first thing you get is a teaser.

It's like a one- or two-page, just really high-level doc with some bullet points on a business basically saying, "Is this something you're interested in at all? If you are, sign the confi," the NDA, nondisclosure agreement, "and then we'll send you the SIM or the confidential information memo." So it's like the first real piece of info you get on a private business, and in particular, one that is being sold in usually some kind of auction process.

Okay. So as you said, it's a bit like an abbreviated S-1.

So presumably it has financials, an overview of the business, a bit about the management team, maybe a little bit about the market that it operates in.

But that goes to all the investors, doesn't it? Well, it goes out to really anyone who wants one, anyone who's willing to sign up to an NDA- Right ... to actually get the document. It's not like an S-1 where literally anyone- Yeah ... who's interested can go onto SEC EDGAR and just pull it.

This is private market confidential info, and you only get it if you're really invited to view it. That's also why finding precedents, even to put together episodes like this, is really, really tricky because a lot of this stuff just tends to stay private. I mean- Yeah ... I've read thousands of these, but I don't actually have any of them because they still sit on the respective repositories, on network drives, on whatever else, but they stay confidential.

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

Can you tell me a bit about that investment committee memo? Yeah. And this is going to look different at every investment house, but most places follow a similar kind of structure in that there are multiple phases of investment committee. So the first thing, I mean, thinking about back in my investing days, we'd have kind of three real stages.

A stage that looks a little bit like the one that we'll look at today, although the output of that would be even more condensed.

It'd just be a one-pager just with highlights, key risks, and just a bit of information on the business just to have a quick discussion around the team table and just say, "Hey, what do we think? Is this really worth our time?" Then we'd have the first proper IC stage where most likely by that point you would've had...

By the time you do that discussion analysis, you might not even have the IM yet.

That might have just been off the back of a teaser as an example.

Certainly by the time you go to your first-stage investment committee, you would've had the IM. Most likely there's some kind of diligence pack that's produced as well. You've got diligence, especially common in the UK and in Europe, you have vendor diligence where if you are selling a company, you also pay for financial diligence, for commercial diligence that gets basically stapled along the IM and sent to the prospective buyers. Of course, prospective buyers are not going to trust just the vendor diligence, so they're going to do their own work as well.

So by the time you go to first-stage investment committee, you've probably seen some combination of that work. And usually the way it works is you approach your investment committee, you will get a green light to proceed subject to, you'll have a bunch of questions that you have to come back and answer by the time you get to final investment committee. And that's really the whole purpose of diligence is to answer all the questions that you've got kind of open items on, just to figure out is this something you really want to do.

And then by the time you go to your final investment committee, that's when you get actual sanction and sign-off to go do the deal, or you don't, or you get a decision which basically says, "You know what? We like this deal as documented here. We don't like it enough.

If you, the deal team, go out and change these few things, then come back and we'll give you sanction and sign-off." So it looks different at every place, but I think- Okay ... everywhere follows about the same kind of process.

Okay.

You have multiple stages of formal investment committee, and of course, pretty much everywhere will have like a weekly WIP or work in progress meeting where you're talking about stuff that's going on at that period of time, and everyone's just going to be constantly updated on the moving pieces and all the deal the firm is looking at at that point in time.

Okay. Gosh, it's so interesting to hear all this, Graham, because as outsiders, we don't get to hear about all this process that goes on behind the scenes.

And you mentioned actually that all of this is confidential information.

Only people who have signed, or parties that signed an NDA, have access to this information. So it does make it really hard to learn about how deals work and some of the documentation. So how on earth have you managed to find a deal sim for us to use in this episode? And what exciting deal is it that we're going to be using? So, no surprise, I used the help of AI to pull together some- Yeah ... public precedents to see what we could find, because finding these is not necessarily that easy. The one we came up with this morning is for a, this is a 2010 IM for a hospital business. It was, at the time, a not-for-profit hospital business in Massachusetts called Morton, and being sold in a process that would result in it being a for-profit hospital.

And I'm not any expert with the Massachusetts regulator, but as I understand it, the Massachusetts regulatory body basically says if you're converting a not-for-profit hospital to a for-profit one, you have to put all the information from the sale process out in the public domain.

So this came from the Massachusetts district attorney or something like that.

I don't remember the exact source, but a proper publicly available source just because the regulator said, "Hey, this has to be public." Okay.

And ultimately, it looks to be kind of a small subscale private hospital provider. There's plenty of tricky aspects to the business.

There are unfunded pension liabilities. There's a big EBITDA bridge.

When I say EBITDA bridge, I'm usually talking about the actual LTM EBITDA business is generating to the EBITDA that the sell-side process is trying to get you to buy into to bid off of. It's kind of a, on the one hand, it sounds a little bit boring and dull, just private hospitals, but on the other, there are actually some interesting financial aspects of this transaction that we'll talk about as we take a look at the memo that Claude has pulled together this morning.

Absolutely. So this is a real deal that happened.

We're going to use the real sim to get Claude to extract the investment committee memo. And as you say, even the most boring deal can come to life when you actually have the numbers, you've run the analysis. So let's have a look.

Yeah.

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Okay. So if you can see my screen, we've got a- Yeah ... I want to say this is a, where's our page count? Seven-page Word doc.

This would be realistically indicative of, if I translate this back to the process that we used to use, this would be somewhere between that very first and very second phase. Again, this is going to look different depending on your actual firm. But most of these are going to follow a similar kind of cadence.

We've got an executive summary. We've got our entry valuation, investment thesis, value creation plan, couple operating cases, sources and uses, returns analysis, exit considerations, and then some notes on diligence.

And by the way, my prompt for this was really simple.

If I go back to, I did this in the Claude app.

I first did this memo from a private credit perspective, and then did the same thing from a private equity perspective.

Literally, the prompt was, "I'm looking at the following opportunity from a private credit perspective. Summarize the opportunity, the credit highlights and risks, identify any key diligence items, propose an indicative financing structure based on this analysis." And it pulled together all that stuff.

I said, "Hey, compile this in a quick memo." And then my prompt to get this document was literally, I'll scroll back down.

Literally, "Can you pull this memo together and model from a private equity investment perspective?" That was it.

Basically, do the same thing and replicate it for private equity.

Okay.

So let's have a quick chat about Morton.

So we've got this, by the way, here's the IM for Morton.

It's a 43-page PDF, and it doesn't look great because this came from whatever public body we pulled it from.

It's a little bit grainy. It's not the most interesting document in the world. But again, most of these IMs follow a similar kind of cadence. We've got a table of contents here, executive summary, investment considerations, market dynamics, overview on the company, financial overview.

It's going to have some kind of information on the company, its management team, its position within the market- Mm-hmm ... and then some information on financials.

So if I go to, let's just go to the financial overview and just get a quick look at what exactly this business looks like.

So we've got a really short form P&L for the business.

As you can see here, we've got actual EBITDA in 2011 of $4.5 million. And then if you go all the way down to the normalized EBITDA down at the bottom, we're at $9 million. And the adjustments we've got are, let's see, adding back professional fees related to the transaction, some management incentive add backs, a few expense adjustments.

By the way, a big part of the work that any analyst or associate in this world needs to go through is actually figuring out what EBITDA is.

Mm-hmm.

It's really funny. We all think about EBITDA as earnings before interest, tax, depreciation, and amortization, but it's used in so many aspects of finance, and it's used as the number you bid off of.

It's used as the number you leverage off of.

Actually figuring out exactly what it is EBITDA is or what you believe it to be is a huge part of the work. So a big thing that the analyst or associate on this deal will be doing is trying to figure out, okay, of these adjustments that are getting me from four and a half to nine, how many of these do I actually buy into, and what's the real EBITDA that I'm either leveraging off of or bidding off of? And that's something that takes, obviously, a lot of time and work.

That's something called a quality of earnings analysis- Mm ... if that's a term that people have heard before.

Absolutely, because if you're doubling EBITDA by making those normalizing adjustments, you're effectively halving the multiple that you're paying for it.

Yeah.

So if you're using precedent transactions and saying, "Well, actually, I'm prepared to pay five times EBITDA," knowing what that actual EBITDA is and whether you actually believe it, is the difference between whether or not it's overpaying or paying a fair price for this hospital.

100%.

Yeah.

Absolutely. Really important.

Absolutely. Okay. So as an analyst, as you say, previously, you'd have spent time extracting this, analyzing the earnings, analyzing the opportunity, and Claude is going to do all of that, or has done all of that already, has it? 100%. So let's just- Wow ... let's take a quick look at what the output of this memo is.

We don't have time to go through necessarily all seven pages in detail.

Yeah.

But we've got, let's see, entry valuation.

Let's see, illustrative enterprise value, $42.3 million.

We're saying 4.7 times normalized 2011 EBITDA.

Actually, okay, really important here, and we've got a really big bridge from actual to LTM. We're also reporting our actual multiple as well. Okay.

And so you kind of have your multiple, right? We're trying to pick up on that. Yeah.

4.7 times 2011 normalized or 10.4 times 2010 reported EBITDA. We've got some initial outputs on structured returns. We'll flip back in the model and take a look at how we're actually building those returns.

Usually when you think about indicative private equity returns, in some ways it's kind of simple. You're saying, all right, what am I paying for? How am I financing what I'm paying for? So I've got this $42.3 million enterprise value.

What of that is financed with equity? What of that is financed- Mm-hmm ... with leverage that I'm bringing to a transaction? And then you roll forward the clock some period of time, usually let's say five, seven years, on your kind of indicative returns analysis and say, all right, what do I think I can get EBITDA to in that period of time? Let me multiply that EBITDA by my assumed exit multiple.

That gets me my exit enterprise valuation, and then based on how much debt I've managed to pay off in the meantime, I then forecast my net debt.

I subtract net debt from enterprise value, and I get my assumed exit equity value.

And then it's really a comparison of that exit equity value to entry equity value that provides the returns analysis. In some ways it is that simple.

Okay. There's obviously a lot of detail we get into when we put these models together, but at a high level, that's kind of it, and that's kind of what we got here.

And given the sensitivities around the EBITDA normalization, what has Claude assumed in terms of the exit multiple versus the entry multiple? Because as you said, that's a key part of the returns.

Let's go take a look and see what we've got here.

Okay, so we've got our entry valuation.

We've got entry enterprise value 42.3, 12 million of cash out to the seller, and 30.3 million of debt existing to refinance.

We should have in here a-- Where's our sources and uses? We should have some assumptions here about how we're actually financing this acquisition because ultimately- Yeah ... how we finance it is going to have a material impact on what our equity returns are going to be. Okay. Sources and uses.

We've got cash consideration, refinance existing debt.

Bonds defeasance make whole. I'd have to read through the IM.

I'm sure there's something specific in here that's talking about...

This looks like potentially some kind of call protection on the debt- Yeah ... that's outstanding on the company's balance sheet already.

Transaction fees, financing fees, OID, presumably on the new debt that we're bringing with us. And oh, interestingly, we've got an assumption here that we're going to fund $6 million of cash.

We can think about this as our min cash requirement as an example.

Yeah.

Okay. And then we're financing all that consideration with a $30 million term loan, an ABL revolver. It says drawn it closed, but zero, so undrawn it closed. A late draw term loan, also undrawn it closed, and the balance in sponsor equity. So it's that 22.2 million of initial sponsor equity that we're going to compare to whatever our exit assumptions are to work out our returns.

Okay.

So on that note, returns analysis, we're saying, okay, we're looking at, it's a pretty quick exit assumption here. Exit in 2015.

If you think about most private equity hold periods are now really seven years plus.

Mm-hmm.

Thinking about this from 2011 to 2015 is a really quick exit, but it's enough to be indicative for a model or piece of analysis like this.

So we're saying we exit at 6.5 times.

Now again, we're comparing that to, you can think about that two ways.

You can think about that as multiple expansion if we're believing the adjusted EBITDA that we bought into at the outset of this transaction where it's 4.7 times that 9 million. Or you can think about it as we're building some multiple contraction in here if we're believing that the entry multiple was based off that actual cash EBITDA- Mm-hmm. Correct ... of 4.9 or whatever it was. So we've got exit EBITDA in 2015, 6.5x assumed multiple, less 28.9 million of net debt.

So interestingly, we're not... Oh, be interesting to take a look at the model because I want to say we're bringing, what, $30 million of debt with us.

We're barely paying off any debt in this transaction.

And I don't know if that's just because this business is just really, really not cash generative at all.

We've got some assumptions for exit transaction costs.

So we're comparing sponsor value at exit to entry, and that's our 2.3 times 18% base case IRR. Which I think is kind of indicative of where a lot of sponsors would look at their kind of baseline return hurdles.

Yeah.

Kind of double your money, 15-ish percent IRR plus.

No one's out fundraising at insane levels delivering returns like that, but it's kind of the base case.

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

Let's see. Yep, here we go. Key risks- Ah, great ... and mitigants.

Rate thesis fails. So I guess I assume in our memo here, we're building in some kind of rate increase into the model.

Reimbursement regulatory, obviously this is a hospital business.

Yeah. You're going to be working with insurers who are paying you.

That is murky and complicated, especially in the US, so that's a real risk.

There's an unfunded pension liability.

CapEx, yeah this is a hospital business, you've got to spend CapEx.

Single asset concentration, volume franchise erosion, exit risk, limited buyer universe for a single community hospital, and reputational political.

As a starting point for...

I'm not a hospital expert, right? I think if the two of us had spent a couple of minutes and pulled together thoughts, we'd probably come up with a really similar list. As a really kind of high level indicative for a start, it's not crazy.

Mm-hmm.

It's not crazy.

No, I think that seems sensible.

Yeah.

I guess the only other thing that we haven't talked about for this transaction is kind of the strategic plan or the operational plan for improvements in this business. Now, you said it's not a huge business, and we've got what? EBITDA of about, well, depending on whether it's adjusted or not, but somewhere between $4.5 and $9 million. So what is the plan for this? Is this going to be on a standalone basis or as a part of a platform build? Well, yeah, I think you really hit the nail on the head.

So the memo- Mm ... we've got here is looking at returns on a standalone basis.

What actually happened, which is no surprise here, is that this hospital got bought up by a private equity-owned hospital platform.

Ah, okay.

And if you think about the strategic rationale for doing something like that, again, I'm not a hospital expert, but you think, "Okay, I've got this subscale business. We probably aren't procuring our supplies at the best rates." You can do a lot on the cost side by bolting onto a bigger platform.

And I looked at a lot of these kind of roll-up opportunities in my investing career. Not necessarily in the hospital space, but- Mm-hmm ... a bunch of different sectors around the UK. You find the same thing here.

You look at like there's so many mid-market businesses that you think are these little regional players. It turns out they're all owned by private equity because if you run these things together, you're buying whatever supplies you have for your business at cheaper rates. You've got a centralized head office that's more efficient, all that stuff. That means these businesses tend to be really interesting platform opportunities.

So it doesn't surprise me at all that the deal that did happen here looked and felt like that. So what we don't have here, and one thing, let's take a look at the model. But before we look at the model, I want to go back and re-prompt Claude to say, "Look at this from the perspective of A, of being a bolt-on opportunity." And really the only thing that we need to build in from that perspective is an increase in EBITDA, right? Yeah. So thinking about fundamentally what are we going to do here, we're going to put some cost synergies through this business.

We're going to boost EBITDA, and we're going to boost our exit returns.

Absolutely.

At a really high level, that's fundamentally it.

So let me go back to Claude and say- So let's do it. Let's challenge Claude to update the memo. Oh, how's Claude doing this session? I'm going to say Claude's doing good so far.

Did we already do this? Well, yeah, but it only did the analysis- You're a harsher critic than I am. So bad, fine, good.

Yeah. It only did the analysis on a standalone basis, so we're going to push back on that and ask it to rerun the analysis including platform builds.

So yeah, I would say fine. Oh, okay. I'm going to go fine in that case. All right.

I'm looking at this as a platform opportunity.

Provide this analysis again, including the impact of estimated synergies.

Yeah.

I'm usually not that horrible of a typist, but I do have my microphone wire like right on top of my keyboard here.

It's what it means. But I'm assuming Claude is going to figure that out.

Let's go and look at the basic LBO model that it put together. And remember, by the way- Yeah ... the model it put together was off that simple prompt like put together an IC memo with the model basically- Yeah ... was pretty much the prompt I gave. So I've got Morton Hospitals.

We've got our, I mean, nothing interesting here.

We've got our historic financial data.

We've got the normalized EBITDA bridge going from the 4.5 to the 9 million.

We've got a summary of the debt outstanding. Okay, so bonds payable.

I guess this is where, okay, bond premium, this is where we've got that make whole in the bond, some kind of- Mm-hmm ... call it prepayment protection.

Pension liquidity. I'm sorry for jumping around here.

Unfunded pension deficit Some more cash flow items, planned CapEx.

Okay, so just historic financial data on this tab, nothing- Mm-hmm ... too interesting. Sources and uses, just like the sources and uses we took a look at in the memo. So ABL revolver, and this is including the funded sources and uses, by the way, right? So a $10 million revolver, a $10 million delayed draw term loan, and the $30 million term loan that is actually funded at close.

Cash consideration to seller, refinance existing debt.

There's the bond bank hole, transaction fees.

Okay, entry valuation 4.7 times or 10.4 times, depending on which EBITDA we're taking. And then the sources and uses that we've got running through our memo. Right? Here is actually the sources and uses we got in the memo, which is the funded debt at close, $30 million term loan, and the $22 million of sponsor equity.

Can I just pause there, Graham? One thing- Yeah ... on the term loan. A single term loan for this sort of transaction, is that surprising? Because I know certainly when I hear about private equity deals, there's often different layers, different tranches of lending in the structure.

Yeah, that is often the case. I think if you think about a-- If we're looking at this on a standalone basis, we've got, one, a subscale operator.

It's obviously been in a challenging market environment. This is a tough debt deal.

There's not a lot to get excited about.

I think the thing that you might not get excited about, but the reason you'd think about doing this deal from a credit perspective, is the fact that you've got asset value.

And at this stage- Yeah ... in this deal, this company owns the hospital and owned the land, and there's some real downside protection.

Yeah.

Otherwise, I think it's hard to really back this from a debt perspective.

And the thing you certainly wouldn't do here is consider any kind of subordinated debt investment. So- ...

the thing you're thinking about from a credit investor's perspective is: how do I get out? Right? I need to get my money back because my return is capped.

So the way I get out here is by not providing a lot of leverage, and certainly not by subordinating myself. So could I have seen if some lower mid-market sponsor bought this on a standalone basis, went out to the banking community and said, "Hey, what kind of leverage will you provide for me?" I could see people getting, not excited, but providing something off the back of real asset backing. So it doesn't surprise me here that the proposed financing structure is pretty simple.

Yeah.

Also, bear in mind, this is just a $30 million financing.

So if you split this up, then you kind of, I'm not going to say run the risk, but let's say someone's looking for a half a turn. Not that anyone would ever do that, of second lien or mezzanine or something like that. You're like, "Oh, I'm going to do like a $5 million mezz tranche and do a bunch of work to not put that much capital to work here." It's kind of a tricky thing to pull together.

Right. Yeah.

So from that perspective, I think this really simple first lien senior loan is probably the deal that would get done if it ever did.

And it didn't in this case, right, because it got bought by another platform.

Yeah. So interesting to hear all this nuance that I'm not-- I was in private markets, so I love hearing about all this stuff.

And then what we've got next- I can talk for days about debt structuring- There you go. ... so if we want to talk about that at some point in the future, then always happy to get into that.

Okay, we've got our pro forma cap table at close, and it's pretty simple, right? We've got the $6 million of cash we're putting back on the balance sheet.

We've got that $30 million term loan, and we've got the sponsor equity, and that's it.

Equity as a percentage of total capitalization.

Ultimately, this is not that high for a business like this.

The other thing I know we've talked about before- Mm-hmm ... is just equity skin in the game.

So the other thing you're thinking- Yeah ... about if you're a lender here is you want the equity to be really motivated and committed to a business, particularly if it's something that's a little bit tricky like this.

Yeah. So in some ways, I don't know what the actual asset protection is from the hospital and the land. You can almost argue this looks aggressive, even though the headline multiples are really, really low.

And it's interesting you mentioned that about the hospitals, because presumably we're assuming they are all fully owned, they're not leased.

I'm pretty sure that's the case on this business, and we'll talk about- Yeah ... what actually happened later on once this business traded and then got looped into the wider platform.

Right. Okay.

But let's take a quick look at the model here and just see what we've got.

Now, I'm expecting this to look very much like the financing model that Claude had pulled together when I was looking at this from a private credit perspective.

Okay, we've got a little case selector here. Love that. Upside-based downside.

Just real simple. Just revenue growth- Mm-hmm ... and EBITDA margin, which by the way, for something this indicative, is not-- One thing I talk about in the classroom all the time is you can always add detail and complexity to something as you go.

Okay.

To start off with, what's your base case assumption about what a business is going to do? Some kind of revenue growth rate, hold margins flat, hold your cash flow assumption flat, and use that as a starting point anyway.

So I'm not mad about the fact that this is what we've got, at least at this stage of diligence. So operating case selector, we've got our real basic, let's see, operating case down there. Funding policy and assumptions, base rate.

I mean, God, Claude, we're talking about this is a 2010 deal.

It was LIBOR back in those days, but we've got- Mm-hmm ... updated for SOFR today. So we've got our SOFR assumption just being held flat at this point. Let's see, term loan margin, 6.8%.

I don't know how we're really coming up with that.

We'd have to do a whole kind of exercise on where the debt market is at this point in time. Margins on the ABL revolver, the delayed draw term loan.

We even got ticking fees on the unused portions of those facilities.

Ticking fees or commitment fees just mean if you've got an undrawn component to a debt facility, you get paid your actual interest margin on the portion that's drawn if you're the credit provider, and a fee on the undrawn portion.

Just to basically say- Okay ... the bank or the credit fund has had to reserve capital for that deal and hold it aside. So we've got actually some relatively comprehensive fee mechanics built in here.

Okay, here are CapEx assumptions, CapEx percentage of revenue.

Let's see, debt schedule. By the way, for anyone who's interested, a credit model and an LBO model for a business like this are basically, they are exactly the same thing. We just look at it from a different perspective.

But we're doing this whole, we're going through this whole exercise where really we're just modeling cash flows and we're figuring out of the cash flows we generate, what are we applying to making different debt repayments, how much cash do we ultimately build up when we exit, so that when we subtract net debt from enterprise value, we work out what our appropriate equity value is here.

So here we've got this whole cash flow waterfall, just figuring out how much cash we generate, how much debt are we paying down.

And let's see, where's our actual debt pay down? We've got our mandatory amortization here of 750,000 a year.

We're not generating that much excess cash here, so we're not really changing our debt balance too materially, right? We go from $30 million on the balance sheet at close, and then we pay down all the $5 million in these five years.

So not necessarily the most cash generative, interesting deal from a debt pay down perspective.

Here's our actual cash flow builds.

You're kind of going from EBITDA- Mm-hmm ... down to free cash flow.

I mean, CapEx is just a huge factor of this business, right? Yeah. 2011, we've got six and a half million of EBITDA, and we've got 8.5 million of CapEx. Obviously, some of that is being funded by this delayed draw term loan, right? We've got these cash add backs here from our drawdown of that DDTL. Now, we don't have the time to necessarily get into the whole series of CapEx projections here. Has Claude done the best job in terms of funding that CapEx with debt? That's a whole exercise in and of itself, but actually interesting here to see the way we're thinking about it. We've got a business that's not really cash generative. We're spending a lot on CapEx.

That CapEx has got to get funded from somewhere, and we're funding that here with a drawdown on a DDTL or delayed draw term loan.

So for an indicative model, not bad.

Yeah, I think it's really interesting.

And actually, one question on the EBITDA thing, because we were talking a lot about the EBITDA multiple, and I know in the public markets, when we have very CapEx-intensive businesses, we prefer to value at a multiple of maybe EBITDA less CapEx, so you're not ignoring that important use of cash.

Is that something you ever do in the private markets or do you just basically- Oh, 100%.

Okay. That's interesting.

Yeah. I think the thing you've got to realize is or the thing you've got to remember is we're using EBITDA because it is a proxy for cash flow.

Yeah.

But in some businesses, there's a pretty big delta between EBITDA and cash flow.

Yeah.

If we looked at everything as a multiple of free cash flow, our lives would be a lot easier. But that's not the world that exists and the world we live in.

We just have everything referred to as a multiple of EBITDA.

So- Yeah ... we have to make those adjustments sometimes for businesses that just have structurally really high levels of, say, CapEx.

We also look at things like rent-adjusted leverage.

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

Yeah. So there's all kinds of specific metrics we can get into.

Okay.

But for this kind of level of analysis, for a really early read on a deal, it's not crazy. And just last tab on the model is returns.

Yeah.

So we have really our main driver here. It's not that much.

We've got what EBITDA are we selling off of, and that's built up in our model, and we've got to multiply that EBITDA by something.

So here we're saying we're multiplying by six and a half.

You can make the argument that is either conservative or aggressive, depending on whether you believe that adjusted EBITDA that we bought into and that 4.7 times entry multiple, or if you think actually, no, we really did buy it for 10 point something based on the actual cash EBITDA. But pretty simple, right? We've got our exit- Yeah ... exit enterprise value, EBITDA multiplied by the multiple.

We subtract net debt, and lo and behold, the thing we've got left is equity value.

We compare that equity value to the check we wrote on the way in, and the thing that we wind up with is our base case equity returns. So 2.3x or 18%.

One thing that's really interesting here is one of the things I talk about in the classroom all the time if I'm teaching private equity instruction, and actually, I usually give this as like a challenge at the end of a modeling session and say, "Okay. I want you guys to think about the attribution of value creation to a few different factors." Mm. And if you look at the equity returns, attribute that to EBITDA growth, multiple expansion, and debt paydown.

And we've got-- I didn't even prompt Claude for this, but this is such a common analysis. We've got some of that just built in here and ready to go.

How much of this is coming from EBITDA growth, multiple expansion, say, de-leveraging or re-leveraging? Interestingly, why are we saying re-leveraging here? Oh, because we're paying down some of the term facility, but then we're also drawing down some in terms of the DDTL. And then we've got our leakage for fees.

Yeah.

So actually kind of cool that we've got this just as a basic output even without asking for it.

And Graeme, just on that returns attribution point, is that a specific driver you want of those returns, or is it dependent on the deal? What are you looking for? Depends on the deal.

Yeah.

Well, look, the private equity holy grail is doing all those at the same time.

Yeah.

And this is why buy and builds and platform opportunities are really interesting private equity transactions. Because what tends to happen is you buy something, you buy an individual site like this, as an example, at 4.7 times EBITDA, if you believe that's the right multiple.

You bolt it onto a platform that's worth, say, 10, 12, 15, whatever you think valuation is. You get the immediate multiple arbitrage from buying low and bolting on that same EBITDA to a platform where that EBITDA is worth more.

You grow your EBITDA, and ideally, you're buying a business that generates cash to pay down debt. So you're doing all those things at the same time.

So really, the reason you get to some of the eye-watering P/E returns you sometimes see is because you've done all those things together.

Okay. Now, you mentioned the benefits of doing a sort of a bolt-on or a platform build. This is all done on a standalone basis.

We gave Claude the challenge of updating the investments committee memo for a platform build. So how's it gone with that? Yeah. Let's see what we've got. Okay, download and open.

Let's just take a look at the Word doc here. Let's see, two-point.

Okay, we've gone from, what was it? It was like 2.3, 2.4 to 2.7.

We've gone to a 27% IRR. All right. Our synergies, $7 million run rate at Morton.

Ooh, that's a big synergy number.

Relative to EBITDA, that's huge.

Right. We've got $7 million, sorry, $10 million-ish of standalone EBITDA and then $7 million run rate synergies. Okay, that's a lot.

Okay, supply chain, shared services, contract rebid phase evenly over four years, $3.5 million in cost to achieve, plus $1.5 million per add-on.

Oh, is this...

Ah, I think Claude interpreted this as this is the, yeah, Morton Hospital is the platform, not the acquired entity. Fair enough.

Ah, okay.

Fair enough. We have to go back and re-prompt.

Right. Okay.

By the way, this is kind of the analysis that you run through at a basic level if you're, say, starting a buy and build opportunity at a private equity firm.

You look at an asset, and then you say, make some assumption for how many businesses I think I can acquire. Maybe that's a couple a year, maybe it's one a year. You've got some kind of base case P&L, and you say, "All right.

Here's my entry assumption. Here's what I think I can deliver in terms of synergies, and I bolt that onto my platform. I exit in five years.

Here are my exit returns." Again, ideally, I'm funding all those with leverage if I can do it.

And Graeme, if you are starting off the process of building out a platform, would it be the case that you would start identifying all the other add-ons that you would be acquiring as part of this initial assessment? Or is that just kind of a vague, we think we can buy other companies and add them on? It depends. I say it depends because you might be buying something where you've already got your eye on something.

You might be in- Right.

By the way, sometimes what happens is a company will get sold.

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

Okay. That's really interesting.

I just assumed that always as private equity firms, we want the certainty of knowing the full plan, operational plan, not just kind of a speculative, "Oh, we might be able to buy some other stuff." But hey- Well, if you think about it, let's think about an opportunity like this where you say, "Okay, I know there are these crappy subscale hospital operators.

I'm building up a hospital platform.

I'm going to use a business that looks like this as about my kind of my template that I'm going to copy-paste, in a sense, as I make these other bolt-ons." I don't necessarily have to know what the opportunities are, but if I think about the way I generate return, I generate return through acquiring cheap and selling high by financing all my acquisition with leverage if I can do it.

I can model out the impact of what that kind of template acquisition plan looks like without even knowing what they are yet.

Right.

Of course, as you get to the point where you're actually about to make them, then you model them properly, right? Right.

But if you're trying to figure out what is the overall opportunity for this potential platform business before I make the investment, I'm probably looking at it on a pretty high-level basis to begin with.

Okay. So Graham, gosh, we've learned so much.

You promised us a little bit of deal workflow and a bit of AI, but we've actually ended up learning an awful lot about platform builds and how investment opportunities are appraised. But the real question I want to have answered is what happened with this deal? Did it go ahead? Was it a success? Yeah. Success depends on whose perspective you're looking at this from, right? Yeah.

And a few people you can argue were some winners here.

So this ultimately got bought by a private equity-owned platform and bolted onto a wider, bigger hospital business.

It's a little bit hard to figure out exactly what the entry enterprise value was.

There's a point saying $90 million was contractually spent or committed. I don't know if that includes, say, the unfunded pension liability.

So it's a little bit hard to figure out exactly what this business sold for.

But it did go to private equity, but critically went to a private equity-owned hospital platform as part of a buy and build, which again, I think if you think about a small subscale, not great asset, kind of makes sense from- Yeah ... a financial engineering perspective.

Then ultimately what happened is said private equity firm owned the business for a number of years. They did a big sale and leaseback.

So a sale and leaseback- Oh ... generally relates to a business that's got a lot of property value, and what the owner says is, "I'm not in the business of owning property.

I'm in the business of running hospitals.

So what if I sold the actual property to another investor, some kind of real estate investment trust or whomever, and then I sign a lease with that investor and lease these properties instead of own them?" So the private equity owner had taken some money out through recaps, took some money out through this transaction, because of course, if you own the business and own the property, you sell the property, you get paid the money for it, you take that as a dividend. Then what you're left with is an operating company that has a much bigger level of contractual obligations.

Not only do you have your interest payments on whatever buy-out financing you had, you've also got your rent bill now.

Yeah.

So what ultimately happened is, I don't know the ins and outs of this, but in COVID, it turned out that the rent bill was just too big in terms of committed payments every month, every year.

And the private equity owner wound up handing over the keys to the administrator, and it went into chapter 11. Interesting as just kind of a learning point. The private equity sponsor, you think, "Oh, they lost here. They had a business that went into administration." No, they actually locked in a four times return on their equity because they'd taken money out before this business went into administration, and a big driver- Oh ... of that was this sale and leaseback.

So who lost in this transaction? You can probably argue some of the employees.

I don't know what happened with the pension liability.

I assume that had to get funded or made whole- Yeah ... as part of the whole bankruptcy process.

But I'm sure there's some people actually sitting in this business who weren't necessarily the happiest with the outcome.

Right.

But private equity owners seem to make out pretty well here.

Yeah, that's really interesting.

So basically, by getting their dividend out early, they weren't reliant on the exit's valuation and exit proceeds. They'd already got their- Yeah ... cash back already. That's really interesting, and certainly something that Claude didn't model in its scenario. So yeah. Okay.

Yeah.

Well, I think that brings us to the end of a super interesting episode.

As I said, we've had a little bit of a look at what AI can do in terms of producing investment committee memos, but also a real little explore there of a real transaction that happened, albeit a few years ago.

Thanks so much for listening to this week's episode. I hope you've enjoyed it.

It's goodbye from myself and over to Graham.

And thanks everyone. As always, if you've got any questions or comments on what we talked about in this episode, let us know. We'll cover it in a future one.

And until then, we'll see everyone same time next week.