Alt Investments #41 - Private Equity Valuation Flashcards
describe with a diagram a typical private equity transaction
LOS 41.a
explain sources of value creation in private equity
LOS 41.a
PE firms have the ability to add greater value to their portfolio companies than do publicly governed firms; sources are:
- _re-enginee_r portfolio company & operate it more smoothly
PE firms have experienced in-house CEOs, CFOs, etc. - able to obtain debt financing on more advantageous terms
greater use of debt vs equity –> higher financial leverage, lower taxes, forces port. co. to use free cash flow responsively - superior alignment of interests between management and PE ownership
mgnt can focus long term; ownership and control concentrated in the same hands; skin in the game
control mechanisms used by PE firms
LOS 41.b
Contract terms contained in the term sheet:
- compensation - clauses that promote reaching goals
- tag-along, drag-along - acquirer must extend acquisition offer to all shareholders, including firm management
- board representation - PE firm ensured board seats if port. co. experiences a liquidity/takeover event
- noncompete clauses - company founder not allowed to compete for a specific amount of time
- priority in claims - PE firms get paid first: distributions, and assets if company is liquidated
- required approvals - PE firm must approve strategy changes
- earn-outs - (used primarily with VC firms) earns-outs tie the acquisition price paid by VC firm to portfolio company’s guture performance for a period of time
distinguish between characteristics of “buyout” and “venture capital” firms
LOS 41.c
VC firms:
- companies are immature
- VC firms emphasize on growth
- VC firms usually have an industry focus
Buyout firms:
- companies are more mature and have stable earnings
- buyout firms emphasize on EBIT or EBITDA growth
compare key differences between VC and buyout investments
valuation issues in private equity (buyout vs venture capital)
LOS 41.d
Valuation Issue Buyout VC
use of DCF frequently used uncertain CF
relative value validates DCF no comps
use of debt high low (more equity)
key return drivers EPS growth, P/E pre-money valuation,
expansion, debt future dilution
reduction
typical costs and terminology of private equity investing
LOS 41.d
typical costs:
- management fee = 2%/yr of committed capital, NAV, or PIC
- carried interest or performance fee = 20%
- dilution costs: result of additional financing rounds and stock options
- placement fees: up to 2% up front, or annual trail paid to placement agents
other terms:
- ratchet - allocation of equity between stockholders and management of port. co.; allows mgmt to increase their allocation, dependent on company performance
- hurdle rate - IRR the fund must meet before the GP can received carried interest
- term of the fund - usually 10 years
general equation for exit value
LOS 41.d
exit value =
investment cost + EPS growth + P/E increase + debt redux
measuring IRR of PE funds (investor’s perspective)
LOS LOS 41.h
-
recommended: GIPS “since inception” IRR
- SI-IRR is a cash-weighted return
- assumes intermediate CFs reinvested at IRR but PE funds tend to be illiquid
-
gross or net of fees:
- gross - reflects fund’s ability to generate a return from portfolio companies; relevant measure for CFs between the fund and its portfolio companies
- net - CFs between the fund and LPs; relevant return measure for LPs
other measures of PE fund performance (investor’s perspective)
LOS 41.h
Multiples - popular, simple, easy to use; differentiates between realized and unrealized returns; specified by GIPS
- paid-in capital (PIC) - cum % of committed capital used “called down” by GP
- distributed to paid-in capital (DPI) - LP’s realized return; cum distributions to LPs divided by PIC (net of fees and carry int); also called “cash-on-cash” return
- residual value to paid-in capital (RVPI) - LP’s unrealized return; value of LP’s holdings in the fund divided by cum invested capital (net of fees and carry int)
- total value to paid-in capital - LP’s total retun; DPI + RVPI
using the venture capital method, calculate for single-round investment:
pre-money value
post-money value
ownership fraction
price/share
LOS 41.j
PRE = POST - INV
POST = PV(Vexit) = Vexit / (1 + r)n
fraction of VC ownership (f):
- NPV method: f = INV / POST
- IRR method: f = FV(INV) / Vexit = INV(1 + r)n / Vexit
sharesvc = sharesfounders * [f / (1-f)]
price = INV / sharesvc
using the venture capital method, calculate 1st and 2nd round for multiple-round investment:
pre-money value
post-money value
ownership fraction
price/share
LOS 41.j
NOTE: work backwards i.e. calc last round first
PRE2 = POST2 - INV2
POST2 = PV(Vexit) = Vexit / (1 + r2)n2
fraction of VC ownership (f):
- NPV method: f2 = INV2 / POST2
now connect 1st round to 2nd round using:
POST1 = PV(PRE2) = PRE2 / (1 + r1)n1
f1 = INV1 / POST1
sharesvc1 = sharesfounders * [f1 / (1 - f1)]
price1 = INV1 / sharesvc1
sharesvc2 = (sharesvc1 + sharesfounders) * [f2 / (1 - f2)]
price2 = INV2 / sharesvc2
determine dilution of 1st round shares after a 2nd round of equity financing
LOS 41.j
from f1 to f1 (1 - f2)
e.g. for f1 = 38% and f2 = 8.45%:
f1 (1 - f2) = .38(1 - .0845) = 34.79%,
so 1st round dilution 38% to 34.79%, which is a dilution factor of 8.45%
demonstrate alternative methods to account for risk in venture capital
LOS 41.k
adjust discount rate:
- simple: use appropriately high discount rate that considers probability of failure and lack of diversification
- adjust discount rate (unadjusted for prob of failure) to reflect chance of failure, “q”, each year:
r* = [(1 + r) / (1 - q)] - 1
- less straightforward: deflate each future CF to reflect cum prob of failure
adjust terminal value using scenario analysis:
Vterm = %1(Vterm1) + %2(Vterm1) + %3(Vterm1),
where sum (%1, %2, %3) = 100%,
and Vtermx = E(earnings) * industry multiple
