Private Equity Valuation – Flashcards

It is commonly believed that PE firms have an ability to add greater value to their portfolio companies than do publicly governed firms. The sources of this increased value are thought to come from the following: 1. The ability to reengineer the portfolio company and operate it more efficiently. In order to reengineer the portfolio companies, many private equity firms have an in-house staff of experienced industry CEOs, CFOs, and other former senior executives. These executives can share their expertise in contact with portfolio company management. 2. 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 opposed to a multiple of equity, as for public firms. The use of greater amounts of financial leverage may increase firm value in the case of private equity firms. Because these firms have a reputation for efficient management and timely payment of debt interest, this helps to allay concerns over there heavily leverage positions and helps maintain their access to the debt markets. The use of data is thought to make private equity companies more efficient. According to this view, the requirement to make interest payments forces the portfolio companies to use free cash flow more efficiently because interest payments must be made on the debt. 3. Superior alignment of interest between management and private equity ownership.

In private equity firms, managers are able to focus more on long-term performance because, unlike public companies, private companies do not face the scrutiny of analysts, shareholders, and the broader market. Control Mechanisms Private equity firms use a variety of mechanisms to align the interests of the managers of portfolio companies with the private equity firm's interest. The following contract terms are contained in the term sheet that specifies the terms of the private equity firm's investment. >> Compensation. Managers of the portfolio companies receive compensation that is closely linked to the company's performance, and the compensation contract contains clauses that promote the achievement of the firm's goals. >> Tag-along, drag-along clauses. Anytime an acquirer acquires control of the company, they must extend the acquisition offer to all shareholders, including firm management. >> Board representation. The private equity firm is insured control through board representation if the portfolio company experiences a major event such as a takeover, restructuring, IPO, bankruptcy, or liquidation. >> Noncompete clauses. Company founders must agree to clauses that prevent them from competing against the firm within a pre-specified period of time. >> Priority in claims. Private equity firms receive their distribution 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 company's assets if the portfolio company is liquidated. >> Required approvals. Changes of strategic importance must be approved by the private equity firm. >> Earn-outs. These are used predominately in venture capital investments. Earn-outs tie the acquisition price paid by the private equity firm to the portfolio company's future performance over a specified time period.

Great chart on page 73 highlighting the differences between the two. Also too a picture of it. Many of the characteristics laid out on the chart on page 73 can be more easily remembered if you keep in mind that, relative to companies acquired through buyout, venture-capital portfolio companies are immature companies with risky prospects and cash flows. They require a great deal of funding but may have limited access to financing, especially debt. The returns on venture-capital come from a small number of highly successful investments.

Buyout Valuation Issues The view of a leveraged buyout (LBO) transaction, referred to as the LBO model, is not a form of valuation but rather a method of factoring in the company's capital structure and other parameters to determine the return a private equity firm should expect from the transaction. The objective is not to value the company but to determine the maximum price in negotiation that the private equity firm should pay for its stake. The LBO model has three main inputs: 1. The target company's forecasted cash flows. 2. The expected returns to the providers of the financing. 3. The total amount of financing. The cash flow forecasts are provided by the target's management but scrutinized by the private equity firm. The exit date (when the target company is sold) is evaluated at different dates to determine its influence on the projected returns. The value the company at that time is forecast using a relative value or market approach. In most LBOs, most of the debt is senior debt that will amortize over time. Exit Value Investment cost + earnings growth + increase in price multiple + reduction in debt = exit value One purpose for calculating the exit value is to determine the investment's internal rate of return sensitivity in the exit year. Valuation Issues In Venture Capital Investments The two fundamental concepts in venture capital investments are pre-money (PRE) valuation and post-money (POST) valuation. To estimate the pre-money valuation, the VC investor typically examines the company's intellectual property and capital, the potential for the company's products, and its intangible assets. A private equity firm makes an investment (INV) in an early-stage startup company. The post money valuation of the investee company is: PRE + INV = POST The ownership proportion of the venture capital (VC) investor is: VC = INV/POST The VC investors should keep in mind that his ownership could be diluted in the future due to future financing, conversion of convertible debt into equity, and the issuance of stock options to management. It is difficult to forecast the cash flows for a VC portfolio company. Therefore, discounted cash flow analysis is not usually used as the primary valuation method for VC companies. It is also difficult to use a relative value or market approach. This is because a VC company is often unique, and there may be no comparable companies to estimate a benchmark price multiple from. A replacement cost approach may also be difficult to apply. Alternative methodologies include real option analysis and the venture-capital method. There is a chart on page 79 you can reference the differences. Took a picture as well.

The purpose of valuation: to assess the ability of the portfolio company to generate cash flow and to represent a benchmark for negotiations. There are four exit routes that private equity firms typically use: IPO, secondary market sale, management buyout, and liquidation. Initial Public Offering In an IPO, a company's equity is offered for public sale. An IPO usually results in the highest exit value due to increased liquidity, greater access to capital, and the potential to hire better quality managers. However, an IPO is less flexible, more costly, and a more cumbersome process than the other alternatives. IPOs are most appropriate for companies with strong growth prospects and a significant operating history and size. Secondary Market Sale In a secondary market sale, the company is sold to another investor or to another company interested in the purchase for strategic reasons. Secondary market sales from one investor to another are quite frequent, especially in the case of buyouts. VC portfolio companies are sometimes exited via a buyout to another firm, but VC companies are usually too immature to support a large amount of debt. Secondary market sales result in the second highest company valuations after IPOs. Management Buyout (MBO) In an MBO, the company is sold to management, who utilize a large amount of leverage. Although management will have a strong interest in the subsequent success of the company, the resulting high leverage may limit management's flexibility. Liquidation Liquidation, the outright sale of the company's assets, is pursued when the company is deemed no longer viable and usually results in a low value. There is potential for negative publicity as a result of displaced employees and from the obvious implications of the company's failure to reach its objectives. The timing of the exit is also very important for company value, and the private equity firm should be flexible in this regard. When an exit is anticipated in the next year or two, the exit valuation multiple can be forecasted without too much error.

Private Equity Fund Terms Private equity investments are often only available to qualified investors, the definition of which depends on the jurisdiction. The terms in a fund prospectus are a result of negotiation between the general partner and the limited partners. If the fund is oversubscribed (i.e. has more prospective investors than needed), the general partner has greater negotiating power. The terms of the fund should be focused towards aligning the interests of the general partner and limited partners and specifying the compensation of the general partner. The most important terms can be categorized into economic and corporate governance terms. Economic Terms > Management fees. These are fees paid to the general partner on an annual basis as a percent of committed capital and are commonly 2%. Management fees could instead to be based on NAV or paid in capital. Committed capital is the amount of funds promised by investors to private equity funds. Paid-in capital is the amount of funds actually received from investors. > Transaction fees. These are paid by third parties to the general partner in their advisory capacity. These fees are usually split evenly with the limited partners and, when received, are deducted from management fees. > Carried interest/performance fees. This is the general partner's share of the fund profits and is usually 20% of profits (after management fees). > Ratchet. This specifies the allocation of equity between stockholders and management of the portfolio company and allows management to increase their allocation, depending on company performance. > Hurdle rate. This is the IRR that the fund must meet before the general partner can receive carried interest. It usually varies from 7% to 10%. > Target fund size. The stated total maximum size of the PE fund, specified as an absolute figure. It signals the general partner's ability to manage and raise capital for a fund. It is a negative signal if actual funds ultimately raised are significantly lower than targeted. > Vintage. This is the year the fund was started and facilitates performance comparisons with other funds. > Term of the fund. This is the life of the firm and is usually 10 years. Corporate Governance Terms The corporate governance terms in the prospectus provide the legal arrangements for the control of the fund and include the following: > Key man clause. If a key named executive leaves the fund or does not spend a sufficient amount of time at the fund, the general partner may be prohibited from making additional investments until another key executive is selected. > Performance disclosure and confidentiality. This specifies the fund performance information that can be disclosed. Note that the performance information for underlying portfolio companies is typically not disclosed. > Clawback. If a fund is profitable early and its life, the general partner receives compensation from the general partner's contractually defined share of profits. Under a clawback provision, if the fund subsequently underperforms, the general partner is required to pay back a portion of the early profits to the limited partners. The clawback provision is usually settled at termination of the fund but can also be settled annually. > Distribution waterfall. This provision specifies the method in which profits will flow to the limited partners and when the general partner receives carried interest. Two methods are commonly used. In a deal by deal method, carried interest can be distributed after each individual deal. The disadvantage of this method from the limited partners perspective is that one deal could earn $10 million and another could lose $10 million, with the general partner will receive carried interest on the first deal, even though the limited partners have not earned an overall positive return. In the total return method, carried interest is calculated on the entire portfolio. There are two variants of the total return method: carried interest can be paid only after the entire committed capital is returned to the limited partners; or carried interest can be paid when the value of the portfolio exceeds invested capital by some minimum amount (typically 20%). > Tag-along, drag along clauses. Anytime an acquirer acquires control of the company, they must extend the acquisition offered to all shareholders, including from management. > No fault divorce. This clause allows a general partner to be fired if a super majority (usually 75% or more) of the limited partners agreed to do so. > Removal for cause. This provision allows for the firing of the general partner or the termination of a fund given sufficient cause. > Investment restrictions. These specify leverage limits, a minimum amount of diversification, etc. > Co-investment. This provision allows the limited partners to invest in other funds of the general partner at low or no management fees. This provides the general partner another source of funds. The provision also prevents the general partner from using capital from different funds to invest in the same portfolio company.

Private Equity Structures The most common form of ownership structure for private equity funds is the limited partnership. In a limited partnership, the limited partners provide funding and do you not have an active role in the management of the investments. Their liability is limited to what they have invested. The general partner in a limited partnership is liable for all of the firm's debts said, thus, has unlimited liability. The general partner is the manager of the fund. Another form of private equity fund structure is the company limited by shares. It offers better legal protection to the partners, depending on the jurisdiction. Most fund structures are closed end, meaning that investors can only redeem the investment at specified time periods. Private equity firms must both raise funds and manage the investment of those funds. The private equity firm usually spends a year or two raising funds. Funds are then drawn down for investment, after which returns are realized. Most private equity funds last 10 to 12 years but can have their life extended another 2 to 3 years. Private Equity Valuation Because there is no ready secondary market for private equity investments, they are difficult to value. In a prospectus, however, the valuation is related to the fund's net asset value, which is the value of fund assets minus liabilities. The assets are valued by the general partner in one of six ways: 1. At cost, adjusting for subsequent financing 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 values based on those of comparable publicly traded companies. Issues in Calculating NAV First, if the NAV is only adjusted it when there are subsequent rounds of financing, then the NAV will be more stale when financings are infrequent. Second, there is no definitive method for calculating NAV for a private equity fund because the market value of portfolio companies is usually not certain until exit. Third, undrawn limited partner capital commitments are not included in the NAV calculation but are essentially liabilities for the limited partner. The value of the commitments depends on the cash flows generated from them, but these are quite uncertain. Fourth, investors should be aware that funds with different strategies and maturities may use different valuation methodologies. Finally, it is usually the general partner who values the fund. Private Equity Due Diligence Before investing, outside investors should conduct a thorough due diligence of a private equity fund due you to the following characteristics: First, private equity funds have returns that tend to persist. Hence, a fund's past performance is useful information. In other words, outperformers tend to keep outperforming and underperformers tend to keep underperforming or go out of business. Second, the return discrepancy between outperformers and underperformers is very large and can be as much as 20%. Third, private equity investments are usually illiquid, long-term investments. The duration of a private equity investment, however, is usually shorter than expected because when a portfolio company is exited, the funds are immediately returned to the fund investors.

General Risk Factors: > Liquidity risk > Unquoted investments risk > Competitive environment risk > Agency risk > Capital risk > Regulatory risk > Tax risk > Valuation risk > Diversification risk > Market risk Costs The costs of investing in private equity are significantly higher than that with publicly traded securities and include the following: > Transaction costs. > Investment vehicle fund set up costs. The legal and other cost of setting up the fund are usually amortized over the life of the fund. > Administrative costs. > Audit costs. > Management and performance costs. These are typically higher than that for other investments and are commonly 2% for the management fee and a 20% fee for performance. > Dilution costs. > Placement fees. Placement agents who raise funds for private equity firms may charge upfront fees as much as 2% or annual trailer fees as a percent of funds raised through limited partners. A trailer fee is the compensation paid by the fund manager to the person selling the fund to investors.

Internal Rate of Return The return metric recommended for private equity by the global investment performance standards (GIPS) is the IRR. The IRR is a cash weighted (money weighted) return measure. Although the private equity fund portfolio companies are actually illiquid, IRR assumes intermediate cash flows are reinvested at the IRR. Therefore, the IRR calculation should be interpreted cautiously. Gross IRR reflects the fund's ability to generate a return from portfolio companies and is the relevant measure for the cash flows between the fund and portfolio companies. IRR can differ substantially from Gross IRR because it is net of management fees, carried interest, and other compensation to the general partner. Net IRR is the relevant measure for the cash flows between the fund and limited partners and is therefore the relevant return metric for the limited partners. Multiples Multiples are a popular tool of limited partners due to their simplicity, ease of use, and ability to differentiate between realized and unrealized returns. Multiples, however, ignore the time value of money. Quantitative Measures > PIC (paid in capital). This is the capital utilized by the general partner. It can be specified in percentage terms as the paid in capital to date divided by the committed capital. Alternatively, it can be specified in absolute terms as the cumulative capital utilized or called down. > DPI (distributed to paid in capital. This measures the limited partner's realized return and is the cumulative distributions paid to the limited partners divided by the cumulative invested capital. It is net of management fees and carried interest. DPI is also referred to as the cash on cash return. > RVPI (residual value to paid in capital). This measures the limited partner's unrealized return and is the value of the limited partner's holdings in the fund divided by the cumulative invested capital. It is net of management fees and carried interest. > TVPI (total value to paid in capital). This measures the limited partner's realized and unrealized return and is the sum of DPI and RVPI. It is net of management fees and carried interest. See examples. Qualitative Measures The realized investments, with an evaluation of successes and failures. The unrealized investments, with an evaluation of exit horizons and potential problems. Cash flow projections at the fund and portfolio company level. Fund valuation, NAV, and financial statements. As an example, consider a firm that was started before the financial market collapse of 2007. If the RVPI is large relative to the DPI, this indicates that the firm has not successfully harvested many of its investments and that the fund may have an extended J-curve (it is taking longer than realized to earn a positive return on its investments). Benchmarks Private equity funds vary substantially from one to another; so before performance evaluation is performed, the investor should have a good understanding of the fund's structures, terms, valuation, and the results of due diligence. Because there are cyclical trends in IRR returns, the net IRR should be benchmarked against a peer group of comparable private equity funds of the same vintage and strategy. Note also that the private equity IRR is cash flow weighted whereas most other asset class index returns are time weighted. One solution to this problem has been to convert publicly traded equity benchmark returns to cash weighted returns using the cash flow patterns of private equity funds. This method however has some significant limitations.

See examples.

The discounted present value of the estimated exit value is called the post money value (after the investment is made). The value before the investment is made can be calculated as the post money value minus investment amount and is called the pre-money value. > POST = PV(exit value) > PRE = POST - INV Venture Capital Method Single Financing Round The fraction of the VC ownership (f) for the VC investment can be computed as: The first method (NPV method): > f = INV/POST INV = Amount of new investment for the venture capital investment POST = exit value/(1+r)^n The second method (IRR method): > f = FV(INV)/exit value FV(INV) = future value of the investment in round one at the expected exit date As long as the same compound rate is used to calculate the present value of the exit value and to calculate the future value of the VC investment, the fraction ownership required (f) is the same under either method. Once we have calculated f, we can calculate the number of shares issued to the VC (shares(VC)) based on the number of existing shares owned by the company founders prior to the investment (shares(founders)). > shares(VC) = shares(founders){f/1-f} The price per share at the time of the investment (price) is then simply the amount of the investment divided by the number of new shares issued. price = INV/shares(VC) Venture Capital Method Multiple Financing Round The 2 denotes the second round of financing. The steps follow: f2= INV2/POST2 INV2 = Amount of new investment for the venture capital investment POST2 = exit value/(1+r2)^n2 and PRE2 = POST2-INV2 POST1 is the discounted present value of the company as of the time of the first financing round, its post money value after the first round investment. POST1 = PRE2/(1+r1)^1 f1= INV1/POST1 shares(VC) = shares(founders){f/1-f} shares (VC2) = (shares(VC1) + shares(founders){f2/1-f2} price2 = INV2/shares(VC2) See examples.

Most investors apply a high discount rate that reflects both the probability of failure and lack of diversification available in these venture capital investments. Adjust the Discount Rate One approach to arriving at a more realistic valuation is to adjust the discount rate to reflect the risk that the company may fail in any given year. The following formula, r* is adjusted for the probability of failure, q: r* = 1+r/1-q where: r = discount rate unadjusted for probability of failure Adjusting the Terminal Value Using Scenario Analysis A second approach to generating a realistic valuation is to adjust the terminal value for the probability of failure or poor results. Typically to obtain the terminal value, the future earnings are estimated and multiplied by an industry multiple. The problem is that almost by definition, early-stage companies are innovative with few true comparables. Price multiples also fluctuate a great deal so that the current multiple may not be indicative of what can be obtained in the future. We should therefore use scenario analysis to calculate an expected terminal value, reflecting the probability of different terminal values under different assumptions.