Private Equity
PE Investment
PE includes Venture Capital investment and Buyout investment. In a buyout transaction, the buyer acquires a controlling equity position in a target company. Buyouts include takeovers, management buyouts (MBO), and leveraged buyouts (LBO).
One of characteristics that distinguish LBOs from VC investment is the amount of debt ud and the pattern of repayment. In an LBO, the initial level of debt is very high but then declines through time as debt is retired.蒸菜干
Sources of value creation in PE
- the ability to re-engineer the firm and operate it more efficiently
- the ability to obtain debt financing on more advantageous terms
In PE firms, debt is more heavily utilized and is quoted as a multiple of EBITDA as oppod to a multiple of equity, as for public firms.
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Many of the debt financing for PE firms comes from the syndicated loan market, but the debt is often repackaged and sold as collateralized loan obligations (CLOs). PE firms may also issue high-yield bonds which are repackaged as collateralized debt obligations (CDOs).
- superior alignment of interests between management and private equity ownership Related contract terms are contained in the term sheet:
●Compensation: managers of the portfolio companies receive compensation that is
cloly linked to the firm’s performance, and the compensation contract
contains claus that promote the achievement of the firm’s goals.
●Tag-along, drag-along claus: it gives management the right to buy an equity
stake if the PE firm lls its stake. This clau is usually contained in the
manager’s employment contracts.
Provisions to protect PE firm in term sheet, mainly by means of greater control, some of which are triggered by specific events
●Board reprentation: PE firm is ensured control through board reprentation if
the firm experiences a major event such as a takeover, restructuring,
IPO, bankruptcy or liquidation.
●Noncompete claus: core management must sign such claus that prevent
them from competing against the firm within a prespecified period of
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●Priority in claims: PE firm receives their distributions before other owners, often in
the form of preferred dividends and sometimes specified as a multiple of
their original investment. They also have priority on the firm’s asts if
the portfolio company is liquidated.
●Required approvals: Changes of strategic importance must be approved by PE
firm.
Earn-outs: the are ud predominantly in venture capital investments and tie the acquisition price paid by the private equity firm to the portfolio company’s
future performance over a specified time period.
桑椹子Leveraged Buyouts (LBO)
Three main inputs for LBO model:
- target firm’s forecasted cash flows
- expected returns to the providers of the financing
-
total amount of financing
Exit value = investment cost + earnings growth + increa in price multiple + reduction in debt
- Increa in price multiple comes from PE firms’ value.
- One purpo for the exit value is to determine the investment’s IRR nsitivity in the exit year.
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Valuation of LBO
Cash flow for an LBO for debt repayment (cash sleep) = NI + D + A – reinvested D – new capital expenditures – increa in NWC + decrea in NWC
The equity holders typically don’t receive any dividends and receive their return at termination of the LBO.
Valuation of equity investment in an LBO
- Target IRR method
家电促销Nature: the equity investment in an LBO is a residual claim on the asts of a risky, highly levered bu
siness. The LBO fund therefore eks a target IRR for their investment that compensates them for this risk:
塘沽外滩公园The target IRR must meet or exceed:
●The cost of the LBO’s debt financing
●The cost of equity capital for a similar, but unlevered firm
●The return that the fund managers market to client investors
PV of an equity investment = terminal equity value / (1+ target IRR)N
Enterpri Value (how much could be paid for the firm) = PV of Equity Investment + other
equity investment + debt investment – transactions Costs of LBO
- Equity cash flow method
Nature: one of the key facets of an LBO is that debt is initially very high then is paid down over time. Therefore, the expected return on equity would initially be very high, but then decline over time.
Beta equity = Beta ast / (E/(D+E)) → E(R Equity) CAPM
Valuation in VC investment
Pre-money valuation (PRE) + investment (INV) = Post-money valuation (POST)
The ownership proportion of the VC investor = INV/POST
- Backward method
1. VC method with single financing round
1) POST = FV / (1+r)N
2) PRE = POST – INV
3) f = INV / POST
4) f = S pe / (S pe + S e) → S pe = S e (f/(1-f))
5) P = INV / S pe
N: number of years until exit
f: fraction of shares held by the PE firm
S pe: number of shares to be held by PE firm
S e: number of shares to be held by the entrepreneurs
P: stock price per share
2. VC method for multiple financing rounds
1) Calculate the compound discount rate
r = ∏(1+r i) - 1
2) POST2 = FV / (1+ r2)
3) PRE2 = POST2– INV2
4) POST1 = PRE2 / (1+ r1)
5) PRE1 = POST1– INV1
6) f2 = INV2 / POST2
7) f1 = INV1/POST1
The first round investors will be later diluted when the cond round investors make an investment. They will be diluted by the amount (1 – f2)
8) S pe1 = S e (f1/(1-f1))
9) P1 = INV1 / S pe1
10) S pe2 = (S e + S pe1)(f2/(1-f2))
11) P2 = INV2 / S pe2
- Forward method
IRR approach
1) W = INV (1 + r)N
2) f = W / FV
3) S pe = S e (f/(1-f))
4) P = INV / S pe
5) POST = INV / f = P * (S pe + S e)
6) PRE = POST – INV = P * S e
Adjusting the discount rate & terminal value
Adjust the discount rate to reflect the risk that the company may fail in any given year:
R = (1+ r)/(1-q) -1
q : probability of failure in a year
Risks of PE Investment
1. risk specific to the investment strategy, industry risks, investment vehicle, and any
regional or country risk
2. general risk factors:
a) liquidity risk
b) unquoted investment risk
c) competitive environment risk
d) agency risk
e) capital risk
f) regulatory risk
g) tax risk
h) valuation risk
i) diversification risk
j) market risk
PE Fund
Costs of PE Investment
1. Transaction costs, including Due D fee, bank financing, legal fees from acquisition,
sale transaction in portfolio companies
2. Investment vehicle fund tup cost
3. Administrative cost
4. Audit costs
5. Management (1.5%-2.5%) and performance costs (usually 20% after management
fee, also called carried interest)
6. Dilution costs
植物园一日游7. Placement fee
Terms for PE Fund
1. Economic terms
●Management Fee
●Transaction Fee
●Carried Interest
●Ratchet: this specifies the allocation of equity between stockholders and
management of the portfolio firm and allows management to increa
their allocation, depending on firm performance
