A bit of a new venture for me. I have wanted to become involved within the LBO industry for some time, getting established or even started has been a bit of a challenge in New Zealand. Well I have opened my own shop.

This business was one that I rejected as wholly inappropriate, not that I have any ethical or moral objections to whorehouses, simply that the business was not solid enough based on the financial data.

First off, in New Zealand, non-audited financial data is common place, thus if handed un-audited financial data, you really need to have the data audited, at least the last few years.

This business was also a “start-up” another big problem. You need a fairly established business. I would suggest a minimum of 5 years. In New Zealand I’d prefer at least 8 years. Having gone through the books, some problems were apparent immediately.

The Capital Structure had already undergone some fairly serious leverage with some substantial debt being added in the form of a new loan and to Capital Leases that were fluctuating in a rather odd manner.

This leverage had [possibly] contributed to an impressive expansion in EBIT and by conventional measures driving an impressive margin. However, when the true profitability was measured, the margin was very low.

One of the reasons for this was found within the Cost of Goods line entry. It would seem that the “girls” were taking a larger proportion of their earnings, thus driving margin compression. One possible reason for this margin compression may well have been the legalisation of prostitution in New Zealand. No longer requiring the “protection” of unsavoury characters, they pressured for higher pay.

Operating expenses have also fallen precipitously in relation to revenues. It may be that some of these costs have been capitalized to again produce a higher EBIT in anticipation of a sale.

Depreciation, a crucial cashflow when considering an LBO, was already being pressured. Accumulated Depreciation had declined while Plant, Property & Equipment had risen. The reason most likely for this was to cause a rise within EBIT for preparation for sale, or, to qualify for the loan [that was taken on in the last set of statements] and/or to increase Interest coverage, which was simply too low at 1.47X to take any more debt.

There was also a suggestion that upkeep via CapEx was insufficient to offset the reduced Depreciation, thus again looking to pump up the EBIT line entry.

Lastly, there are no discretionary cashflows that are [normally] hidden by which management can allocate to whatever purpose is deemed the best use for said cashflows. Thus no hidden value, and no additional cashflow to support an LBO.

All-in-all a definite pass.