Raising Equity Capital (Week 9)

Question 1

What are private equity funds?

Answer 1

Limited-duration, closed-end funds that invest primarily in equity stakes in companies.

Typically they

• Hold large stakes (often 100% of the equity) in private companies (i.e. companies that don’t have publicly-traded shares)
• are active in the management of their portfolio firms.

Question 2

How are PE funds organized?

Answer 2

As limited partners

Question 3

What are the two types of partners for PE funds?

Answer 3

1. Limited partners: investors, such as pension funds, endowments, investment funds, or high net worth individuals.
2. General partners: fund managers, who are responsible for the management of the partnership and for investments (“portfolio firms’).

Question 4

What are the two types of PE funds?

Answer 4

1. Venture capital funds specialise in financing new firms
2. Leveraged buyout funds specialise in buying mature firms

Question 5

What happens in a LBO?

Answer 5

In a LBO, a small group of investors (typically a PE fund) acquires all of a public company’s equity.

The acquisition is financed mostly with debt backed by the target’s assets.

After the acquisition, the target becomes a private firm with very high leverage (usually 60-90% debt-to-capital ratios).

Question 6

What happens post LBO?

Answer 6

The firm goes through a number of changes, such as restructuring, asset sales, changes in strategy and focus etc.

Debt is rapidly paid down

The PE investor typically exists within 5-10 years through trade sale (sale to a srategic buyer), sale to another fund (typically an LBO fund) or an IPO (calso called reverse LBO).

Question 7

What is an IPO?

Answer 7

Initial public offering. The process of selling a company’s shares to the public for the first time.

Question 8

What is an underwriter?

Answer 8

In a typical IPO, the firm hires an investment bank, who acts as an underwriter.

The underwriter performs a number of functions, including offering advice on the pricing of the issue, preparation of documents, advertising and selling the shares to selected investors and (sometimes) guaranteeing the proceeds of the issue.

Question 9

Why are IPOs underpriced?

Answer 9

Nobody knows for sure but:

1. Investor optimism and market timing: evidence that issues with high underpricing have the worst long-run performance.
2. Underwriter reputation and liability
3. Favors for clients of the underwriters
4. Once-in-a-lifetime very positive NPV project for owners.

Question 10

How do you value a project (or a firm)?

Answer 10

1. The Discounted Cash Flow (DCF) method.

• Estimate the expected cash flows
• Estimate the appropriate discount rate for each cash flow
• Caluclate the present value

2. Valuation by comparables
   * Look up the price of a comparable project/firm

Question 11

What are the two discounted cash flow methods?

(two main methods for valuing a firm or project with leverage)

Answer 11

1. APV: Adjusted present value method
2. WACC: Weighted average cost of capital method

Question 12

What is the APV DCF method?

Answer 12

Adjusted present value

• Cash flows: unlevered cash flow, interest tax shield
• Discount rate: unlevered (asset) cost of capital, tax shield cost of capital

Question 13

What is the WACC DCF method

Answer 13

Weighted average cost of capital

• Cash flows: unlevered free cash flow
• Discount rate: WACC (after-tax)

Question 14

What is free cash flow?

Answer 14

The expected after-tax cash flows of an all-equity firm.

Sometimes called the unlevered free cash flows.

Question 15

Equation for Free Cash Flow

Answer 15

Free Cash Flow = EBIT(1-tax rate) + Depreciation - CapEx - Change in NWV

Question 16

Equation for change in NWC

Answer 16

Change in NWC = Change in Inventory + Change in Accounts Receivable - Change in Accounts Payable