R.44 Private Equity

Question 1

1. explain sources of value creation in private equity;
2. explain how private equity firms align their interests with those of the managers of portfolio companies;

Private Equity Value Creation?

Answer 1

How Is Value Created in Private Equity?

1. Ability to re-engineer the private firm to get superior returns
   * talented in-house consulting capabilities. (possible w/ public too)
2. Ability to get favorable credit terms

• Private transactions use more debt. (tax shield significant)
• 8x EBITDA at high end
• Tax-shield from debt can be significant.
• Private uses more than public b/c private has better control over management and has rep for paying back debt reliably
• may transfer risk to credit markets (self-correct after downturn)
• Mgmt more focused b/c less discretionary cash available.

3. Better alignment of owners and managers

• management are primarily paid for results. A
• long-term focus is the norm in contrast to the short-term focus in public companies (quarterly earnings)
• keeps mgmt team focused w/ contractual clauses like controlling the board, non-compete clauses for founders, preferred dividends and liquidation preferences, and earn-outs that link the acquisition price to future financial performance.

Question 2

1. distinguish between the characteristics of buyout and venture capital investments;
2. describe valuation issues in buyout and venture capital transactions;

Contrasting Valuation in Buyout and Venture Capital Settings

Valuation Issues in Buyout Transactions

Valuation Issues in Venture Capital Transactions

Answer 2

Contrasting Valuation in Buyout and Venture Capital Settings

Buyout firms

• look for companies with predictable cash flows and steady EBIT growth.
• prefer companies with a strong, experienced management team.
• extensive use of leverage increases the potential return.
• Appealing companies: established products, restructuring potential, and low working capital req

Venture capital firms

• focus on a specific industry, looking for companies with high revenue growth.
• CF unpredictable.
• New Mgmt teams w/ strong track records
• Equity funding rather than debt (for majority)
• significant cash burn rate is needed for development.
• Returns = Few big booms and many busts

Valuation Issues in Buyout Transactions

• LBO transaction involves negotiations with providers of equity capital, senior debt, high yield bonds, and mezzanine finance.
• LBO model has three main inputs:

1. Cash flow forecast of target company
   * Management of the target company normally provides the free cash flow forecasts for a set horizon. The exit value must also be estimated, often based on multiples tied to peer companies.
2. Expected return from finance providers
3. Amount of financing available

Valuation Issues in Venture Capital Transactions

• Pre-money valuation (PRE) is the value prior to a round of investment (I).
• Post-money valuation (POST) is the company value after the investing round.

POST=PRE+I

The pre-money valuation is

• determined through intense negotiations between the founders and the venture capital firm.
• Uncommon to use DCF or comparable companies b/c of uncertain CFs and lack or comparables.
• Common to calculate value w/ replacement cost or real option approach.
• Cap often placed on pre-money valuation bc so subjective.

Question 3

1. explain alternative exit routes in private equity and their impact on value;

Exit Routes for PE: Returning Cash to Investors​

Answer 3

4 Primary Exit Routes:

1. Initial public offering (IPO)

• higher valuation multiples because of the enhanced liquidity and access to more capital.
• Expensive and time consuming.
• Large private companies w/ established history + solid growth prospects use most often.

2. Secondary market

• investor can sell to another investor or strategic investor.
• Tendancy for firms to sell buyout-to-buyout and venture-to-venture.
• very common approach (especially for buyouts)
• Advantages are possibly getting higher valuation multiple and using specialized firm skills to take the company to the next level.

3. Management buyout (MBO)

• significant amount of leverage.
• creates great alignment of interests, but high debt can limit flexibility.

4. Liquidation

• Controlling shareholders will liquidate company if it is no longer viable.
• Creates negative publicity for private equity firm.

Question 4

f. explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns;

Private Equity Structures

Terms

Economic

Corporate Governance

Answer 4

Structures

• Limited partnership is the most common b/c gives limited liability (only investment is at risk)
• General partner has managing control and is jointly liable for all debts.
• Corporate structures offer more legal protection, primarily for the general partner.

Terms

Economic Terms

• Management fees: % of committed capital paid to GP (typically 1.5% to 2.5%.)
• Transaction fees: paid to GP if GP does investment banking services (mergers)
• Carried interest is GP’s share of profits. (≈20% of profits after management fees)
• Ratchet determines allocation equity bw shareholders and management (mgmt gets greater allocation w/ better performance).
• Hurdle rate must be achieved by the fund before the GP gets any carried interest. It is typically between 7% and 10%.
• target fund size is absolute amount listed in fund prospectus. If fund raises amount significantly less than target, its negative signal for GP.
• The vintage year is the year the equity fund was launched. Funds are often compared with other funds of the same vintage year.
• The term of the fund is typically about 10 years.

Corporate Governance Terms

• Key man clause relates to key GP managers. If key person leaves, GP may be prohibited from making investments until that person is replaced.
• Private equity firms not required to publicly disclose financial results.
• Clawback provisions require GP to return some capital if early exits are profitable and later exits not as profitable. Makes profit split consistent w/ prospectus.
• Distribution waterfall specifies order of distributions bw LPs & GPs.
  
  • Deal-by-deal basis or total return.
  • If total return method, GP may not get carried interest until LPs get back all committed capital.
• Tag-along, drag along rights require future acquirers to make offer to all shareholders, including management, before acquiring control.
• No-fault divorce permits LPs to remove a GP w/ super majority (≈75%).
• Removal for “cause” allows GP termination or fund termination actions like gross negligence.
• Investment restrictions may require minimum level of diversification, limits on borrowing, etc.

Question 5

Risks and Costs of Investing in Private Equity

Importance of Due Diligence Investigations by Potential Investors

Answer 5

Risks and Costs of Investing in Private Equity

General Private Equity Risk Factors

• Illiquid investments
• Unquoted investments
• Competition for attractive investment opportunities
• Agency risk with management of investee companies
• Loss of capital due to high risk
• Government regulations
• Taxation risk
• Subjective investment valuations
• Lack of investment capital
• Lack of diversification
• Market risk

Costs for Private Equity Investments

• Transaction fees (due diligence, legal fees, …)
• Investment vehicle fund setup costs
• Administrative costs (custodian, transfer agent, accounting, …)
• Audit costs
• Management and performance fees (2% and 20% are common)
• Dilution (such as from management stock options)
• Placement fees

Importance of Due Diligence Investigations by Potential Investors

• PE funds tend to have persistent returns. Top performers continue to outperform.
  
  • Performance Range very large between top and bottom performers
  • Limited liquidity, so investors locked in for long-term.

Question 6

1. interpret and compare financial performance of private equity funds from the perspective of an investor;
2. calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund;

Evaluating Performance

Answer 6

Evaluating Fund Performance

• Each private equity fund is unique. Must account for this.
• IRR considered most appropriate performance measure for PE. But IRR approach is questionable bc implicitly assumes fund is liquid (most not).
• Gross IRR relates to CFs bw PE fund and its portfolio companies. This is good measure of mgmt team’s track record.
• Net IRR relates to CFs bw PE fund and LPs. Fees/profit-shares make it less than gross IRR.
• Multiples can also measure performance. Ratio of total investor returns to the total sum invested. This ignores the time value of money.
• Common multiples used by LPs are:
• PIC (paid in capital) to date
  
  • ^{PIC to date} / _{(committed capital)}
  • Committed cap => how much investor has committed to investing?
  • Only ratio that’s divided by committed. (all others are cumulative).
• RVPI (residual value to paid in)
  
  • ​Measures unrealized return on investment.(subjective b/c based on valuation)
  • ^{(LP shares value}) / _{(cumulative invested)}
• DPI (distributed to paid in)
  
  • Cash-on-cash return. Net of management fees and carried interest.
  • ^{(Cumulative distributions to LPs)} / _{(cumulative invested)}
• TVPI (total value to paid in)
  
  • Net of management fees and carried interest.
  • = DPI + RVPI
  • = ^{(Distributed + undistributed value)} / _{(cumulative invested capital)}

Question 7

Valuation of PE Funds

Answer 7

Valuation

GPs generally value assets/liabilities to calc NAV. Some LPs demand independent valuations. NAVs are more accurate after a round of financing b/c $$ changing hands.

Valuation methodologies:

1. Cost with adjustments
2. Lower of cost or market value
3. Revaluation when new financing (often required)
4. Cost with no adjustments until exit

Question 8

Basic Venture Capital Method

5 Steps (define calcs for each)

1. Post-Money Valuation
2. Pre-Money Valuation
3. Ownership fraction
4. Number of shares owned
5. Price of shares

Answer 8

Question 9

Broad Categories and sub-categories of Private Equity

Answer 9