Reading 42 - Private Equity Valuation

Question 1

What are the 3 sources of value creation in private equity?

***Critical Concept******

Answer 1

1. The ability to re-engineer the portfolio company and operate it more efficiently
2. The ability to obtain debt financing on more advantageous terms
3. Superior alignment of interests between management and private equity ownership

Question 2

What are the control mechanisms used by private equity firms to align their interests with those of the managers of portfolio companies?

Answer 2

1. Compensation
2. Tag-along, Drag-along⇒anytime an acquirer acquires control of the company, they must extend the acquisition offer to all shareholders, including management
3. Board Representation
4. Noncompete clause
5. Priority in claims
6. Required approvals
7. Earn-outs⇒primarily in VC, tie the acqusition price paid by PE to the portfolio company’s future performance

Question 3

What are the 6 Private Equity valuation methodologies?

Answer 3

1. Discounted cash flow (DCF)
2. Relative value or market approach
3. Real Option Analysis
4. Replacement cost
5. Venture capital method
6. Leveraged buyout method

Question 4

What are the three main inputs in an LBO model?

Answer 4

1. The target company’s forecasted cash flows
2. The expected returns to the providers of the financing
3. The total amount of financing

Question 5

What are the determinants of the exit value of a Private Equity Investment?

Answer 5

= Investment Cost + Earnings Growth

+ Increase in price multiple + reduction in debt

= exit value

Question 6

What are the two fundamental concepts in venture capital investments and how are they calculated?

**Critical Concept**

Answer 6

1. pre-money (PRE) valuation PRE = POST - INV
2. post-money (POST) valuation PRE + INV = POST

or

= Terminal Value / (1+r)^t

Question 7

What are the ways a private equity firm can exit their investment?

Answer 7

1. IPO
2. Secondary Market sale
3. Management Buyout (MBO)
4. Liquidation

Question 8

What are the 8 economic terms of a Private Equity fund you need to understand?

**Critical Concept**

Answer 8

1. Management fees : fees are paid to the General Partner (GP) on an annual basis as a % of the committed capital and is commonly 2%.
2. Transaction fees : Are paid to the GP for fund investment banking services, such as arranging a merger
3. Carried interest / Performance fees : This is the GP’s share of the fund profits and is usually 20% profits (after management fees)
4. Ratchet : This specifies the allocation of equity between stockholders and management of the portfolio company.
5. Hurdle Rate : This is the IRR that the fund must meet before the GP can receive carried interest. Usually is between 7%-10%
6. Target Fud size : The stated total maximum size of the PE fund, specified as an absolute figure
7. Vintage : the yr the fund was started. Helps for comparison against other funds
8. Term of the fund: This is the life of the firm and is usually 10 years,

Question 9

What are the 9 Corporate Governance terms of a Private Equity fund?

**Critical Concept**

Answer 9

1. Key Man Clause : if a key named executive leaves the fund, the GP may be prohibited from making additional investments until another key executive is selected
2. Performance disclosure and confidentiality : Specifies the fund performance information that can be disclosed.
3. Clawback : If the fund is profitable early and subsequently underperforms, the GP is required to pay back a portion of the early profits to the LPs.
4. Distribution Waterfall : This specifies the method in which profits will flow to the LPs and when the GP receives carried interest.
   
   1. Deal by Deal Method - carried interest can be distributed after each individual deal
   2. Total Return Method - Carried interest is calculated on the entire portfolio
5. Tag-along, drag-along : Anytime an acquirer acquires control of the company, they must extend the offer to all shareholders, including firm management
6. No-fault divorce : allows a GP to be fired if a supermajority (>75%) of ythe LPs agree
7. Removal for cause : allows for the firing of the GP given sufficient cause
8. Investment Restrictions : specifies leverage limits, a minimum amount of diversification
9. Co-investment : allows the LPs to invest in other funds of the GP at low or no management fees

Question 10

Suppose a fund has committed capital of $100 Million and carried interest of 20%. An investment of $40million is made. Later in the yr, the fund exits the investment and earns a profit of $22million.

Determine whether the GP receives any carried interest under the deal by deal method…

Answer 10

Under the deal by deal method, carried interest can be distributed after each individual deal.

= 20% * 22,000,000 -> $4,400,000 is paid to the GP

Question 11

Suppose a fund has committed capital of $100 Million and carried interest of 20%. An investment of $40million is made. Later in the yr, the fund exits the investment and earns a profit of $22million.

Determine whether the GP receives any carried interest if interest is paid only after the portfolio value exceeds committed capital…

Answer 11

Committed capital is $100Million and total proceeds from the exit are only $62Million. So no carried interest is paid.

Question 12

Suppose a fund has committed capital of $100 Million and carried interest of 20%. An investment of $40million is made. Later in the yr, the fund exits the investment and earns a profit of $22million.

Determine whether the GP receives any carried interest if interest is paid only after the portfolio value exceeds invested capital by some minimum amount (typically 20%)…

Answer 12

Invested Capital + 20% = 40,000,000 * 1.20 = $48Million

Since total proceeds from the exit are $62Million, carried interest of $4.4million ($22M * 20%)

Question 13

Suppose a fund has committed capital of $100 Million and carried interest of 20%. An investment of $40million is made. Later in the yr, the fund exits the investment and earns a profit of $22million.

In the second yr, another investment of $25million is exited and results in a $4million loss. Assume the deal by deal method and a clawback with annual true-up apply.

Determine whether the GP must return any former profits to the LPs….

Answer 13

In the deal by deal method, the GP received carried interest of $4.4Million. With a subsequent loss of $4million, the GP owes the LPs 20% of the loss:

20% * 4,000,00 = 800,000

Question 14

What are the 6 ways GPs determine NAV?

Answer 14

1. At cost, adjusting for subsequent financial and devaluation
2. At the minimum of cost or market value
3. By revaluing a portfolio company anytime there is new financing
4. At cost, with no adjustment until exit
5. By using a discount factor for restricted securities
6. Less frequently, by applying illiquidity discounts to value based on those of comparable public companies

Question 15

What are some of the issues in calculating an NAV for a private equity fund?

Answer 15

1. If the NAV is only adjusted when there are rounds of financing, the NAVs can become stale
2. There is no definitive method because the mkt value of portfolio companies is usually not certain until exit
3. Undrawn capital commitments are not included in the NAV calculation but are essentially liabilities for te LP
4. Different strategies and maturities may use different valuation methodologies
5. The GP themselves usually values the fund.

Question 16

What are the two important differences between investing in public equity and in a private equity fund?

Answer 16

1. Funds are committed in the private investments and later drawn down as capital is invested in portfolio companies
2. The returns on a private equity investment typically follow a J-curve pattern through time. This means, negative returns at first and then turn positive when companies are sold

Question 17

What are some of the risks of investing in Private Equity?

Answer 17

1. Liquidity Risk - since not publicly traded, may be difficult to liquidate a position
2. Unquoted investment risk - do not have a publicly quoted price, may be riskier than publicly traded securities
3. Competitive Environment risk - competition for finding reasonably price private equity investments may be high
4. Agency risk - managers of portfolio companies may not act in the best interst of the PE firm or investors
5. Capital Risk - increases in business and financial risks may result in withdrawal of capital
6. Regulatory Risk - may be adversely affected by gov’t regulation
7. Tax Risk - Tax treatment of investment returns may change over time

Question 18

What are some of the costs of investing in Private Equity?

Answer 18

1. Transaction costs
2. Investment vehicle setup costs
3. Administrative costs
4. Audit costs
5. Management and performance costs
6. Dilution costs
7. Placement fees

Question 19

What is a trailer fee?

Answer 19

The compensation paid by the fund managers to the person selling the fund to investors

Question 20

What is the return metric recommended for private equity according to GIPS?

Answer 20

IRR

Question 21

What are some of the popular multiples used to evaluate Private Equity fund performance?

Answer 21

1. PIC (paid-in-capital) : is the capital utilized by the GP. Is specified in % terms as the paid in capital to date divided by the committed capital
2. DPI (distributed to paid-in-capital) : This measures the LPs realized return. Is cumulative distributions paid to the LPs divided by the cumulative invested capital
3. RVPI (residual value to paid-in-capital) : this measures the LPs unrealized return. Is the value of the LPs holdings in the fund divided by cumulative invested capital
4. TVPI (total value to paid-in capital) : Measures the LPs realized and unrealized return. Is the sum of DPI and RVPI.

Question 22

How do you calculate the fraction of VC ownership in an investment using the NPV method?

f = fraction of VC ownership

**Critical Concept**

Answer 22

f = INV / POST

INV = amount of the new investment by the VC firm

POST = (exit value) / (1+r)ⁿ

Question 23

How do you calculate the fraction of VC ownership in an investment using the IRR method?

Answer 23

f = FV (INV) / exit value

FV(INV) = the future value of the investment in round 1 at the expected exit date

Question 24

Company ABC believe they can sell their company for $40Million in 5 yrs. They need $5Million in capital now and the owners currently hold 1 million shares

The venture capital investors believe a discount rate of 40% is appropriate given its risk.

How would you calculate the pre-money valuation, post-money valuation, ownership fraction and price per share applying the NPV method if there is a single financing round….

Answer 24

Question 25

In regards to a Private Equity fund, what does the term Ratchet mean?

Answer 25

a mechanism to prevent dilution. An anti-dilution clause is a contract clause that protects an investor from a reduction in percentage ownership in a company due to the future issuance by the company of additional shares to other entities.

Question 26

In regards to private equity, what is a Distribution Waterfall?

Answer 26

This specifies the method in which profits will flow to the LPs and when the GP receives carried interest.

• Deal by Deal Method - carried interest can be distributed after each individual deal
• Total Return Method - Carried interest is calculated on the entire portfolio

Question 27

What does PIC (Paid-in-capital) measure?

*****Critical Concept********

Answer 27

is the capital utilized by the GP. Is specified in % terms as the paid in capital to date divided by the committed capital

Question 28

What does DPI (Distributed to Paid-in-Capital) measure & how is it calculated?

**Critical Concept**

Answer 28

This measures the LPs realized return. Is the cumulative distributions paid to the LPs divided by the cumulative invested capital

Question 29

What does RVPI (Residual Value to Paid-in-Capital) measure?

Answer 29

this measures the LPs unrealized return. Is the value of the LPs holdings in the fund divided by cumulative invested capital

Question 30

What does TVPI (Total Value to Paid-in-Capital) measure?

Answer 30

Measures the LPs realized and unrealized return. Is the sum of DPI and RVPI.

Question 31

The private equity firm Purcell & Hyams (P&H) is considering a $17 million investment in Eizak Biotech, of which $10 million is invested today and $7 million in four years. Eizak’s owners firmly believe that with P&H’s investment they could develop their “wonder” drug and sell the firm in six years for $120 million. Given the project’s risk, P&H believes a discount rate of 50% is appropriate for the first four years, and 30% for the last two years. The fractional ownership for P&H at the time of the initial investment would beclosest to:

Answer 31

The calculation requires four steps (all figures in millions except for fractional data):

Step 1: The terminal value must first be discounted to the time of the second-round financing to arrive at the post-money (POST2) valuation:

POST2 = ($120 million) / (1.30)2 = $71.01 million

Step 2: The pre-money valuation (PRE2) at the second round of financing is:

PRE2 = $71.01 million − $7 million = $64.01 million.

Step 3: The PRE2 valuation then has to be discounted back at the appropriate discount rate to the time of the first-round financing to arrive at the post-money (POST1) valuation:

POST1 = ($64.01 million) / (1.50)4 = $12.64 million

Step 4: The fractional ownership (f1) for first-round investors is:

f1 = INV1 / POST1 = $10 million / $12.64 million = 0.79.

Question 32

Describe how Management Fees are determined for Private Equity?

Answer 32

fees are paid to the General Partner (GP) on an annual basis as a % of the committed capital and is commonly 2%.

Question 33

Describe what Transaction Fees are in regards to Private Equity……

Answer 33

Are paid to the GP for fund investment banking services, such as arranging a merger

Question 34

Describe what Carried Interest is in regards to Private Equity and how it is calculated……

Answer 34

This is the GP’s share of the fund profits and is usually 20% profits (after management fees)

Question 35

Describe what a Ratchet is in regards to Private Equity….

Answer 35

This specifies the allocation of equity between stockholders and management of the portfolio company.

Question 36

What is the Hurdle Rate in regards to Private Equity???

Answer 36

This is the IRR that the fund must meet before the GP can receive carried interest. Usually is between 7%-10%

Question 37

What is the Key Man Clause?

Answer 37

if a key named executive leaves the fund, the GP may be prohibited from making additional investments until another key executive is selected

Question 38

What is a Clawback in regards to Private Equity?

Answer 38

If the fund is profitable early and subsequently underperforms, the GP is required to pay back a portion of the early profits to the LPs

Question 39

What is a Distribution Waterfall?

Answer 39

This specifies the method in which profits will flow to the LPs and when the GP receives carried interest.

Question 40

What a the two kinds of Distribution Waterfalls?

Answer 40

1. Deal by Deal Method - carried interest can be distributed after each individual deal
2. Total Return Method - Carried interest is calculated on the entire portfolio

Question 41

What is Tag-along, Drag-along in regards to Private Equity?

Answer 41

Anytime an acquirer acquires control of the company, they must extend the offer to all shareholders, including firm management

Question 42

What is Paid-in-Capital?

Answer 42

the amount of committed capital that has been transferred from the limited partner to the general partner.

Question 43

How do you calculate the number of shares the VC firm receives for its investment?

Answer 43

shares_VC = shares_Founders [f / (1 - f)]

Question 44

How can you calculate the price paid per shares by the VC firm?

Answer 44

= INV / Shares_VC

Question 45

Private Equity valuations are strongly affected by the discount rate. Firm management is often too optimistic about their prospects. Investors counteract this by adjusted the discount rate to reflect the fact the company may fail in any given yr.

What is the formula for Adjusting the Discount Rate?

Answer 45

Question 46

Assume a private equity investor has a discount rate of 30%. The investor believes,however, that the entrepeur’s projection of the company’s success is overly optimistic and that the chance of the company failing in a given yr is 25%.

Calculate a discount rate that factors in the company’s probability of failure….

Answer 46

r* = (1+0.30) / (1-0.25) -1 = 73.33%*