PRIVATE EQUITY

VALUATION

FinTree
 PE structure
=

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PE
investor Firm company
← Fund É
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partnership
ownership
interest

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LP 's
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partnership
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Fund Manager
GP

FinTree
 tag along is beneficial for
minority shareholder and drag
Explain sources of value creation in private equity. along is beneficial for majority

i
holder?

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Ability to Alignment
of interest
Obtain
reengineer
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portfolio management
company financing
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experience PE Firms
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portfolio
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be disciplined .

FinTree
 Explain how private equity firms align their interests with those of the
managers of portfolio companies.

The following contract terms are contained in the term sheet that -

specifies the terms of the private equity firm’s investment.

Compensation → '

←
$$← pay is a
1 Function of
portfolio achievement
company of goals .

Manager

Tag along
-

,
Anytime an acquirer acquires control of
the company, they must extend the
→ acquisition offer to all shareholders,
drag -

along including firm management.

FinTree
Board The private equity firm is ensured
→
control through board representation
Representation

Private equity firms receive their

distributions before other owners,
often in the form of preferred
priority of claims →
dividends .

They also have priority on the

company’s assets if the portfolio
company is liquidated.

clauses Company founders must agree to

Non-compete →
clauses that prevent them from
competing against the firm within a
prespecified period of time.

Approvals → Changes of strategic

Required importance (e.g., acquisitions,
divestitures, and changes in
the business plan) must be
approved by the private equity
firm.

FinTree
 These are used predominantly in venture
Earn outs →
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.

FinTree
Distinguish between the characteristics of buyout and venture capital investments.

Venture capital firms usually have a specific industry focus, such as

biotechnology, and emphasize revenue growth.

When private equity firms make buyout purchases, the emphasis is

on EBIT or EBITDA growth, and typically a portfolio of companies
with stable earnings growth is purchased.

FinTree
 Private Equity Valuation Methodologies

T.lt
DCF
Analysis

Rv{Market
Approach
Real option cost
)
Replacement
A. vc
.

B. LBO
Method
method

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/
,
1
1
Analysis

I
-
-
-
- '

← i
,
i
IBO Takooers
MBO

The view of an 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 the private equity firm should expect from the
transaction

FinTree
 Describe valuation issues in buyout and venture capital transactions.

Exit value =

Investment earnings increase

+
Reduction
* +
growth in price in Debt
Cost multiple

Example :

= .

LBO transaction @ 1200 mils .

Exit @ 19 times of investment

5yr

40% Equity / 60T . Debt

I
480

Éo
400 50

pref shares
.

equity management equity

FinTree participation
 will get 14-1 CAGR at exit .

pref shares
.

→
Equity PE firm will be 90% equity
value @ exit

will be 101
→ MEP .

→ till exit 500 OF debt will be repaid .

→ Calculate payoff to claimants 2

IRR and payoff to equity claimants .

multiple

FinTree
FinTree
FinTree
Pre 2 post Money Valuation
+
VC Method

Exompie :

FinTree
FinTree
FinTree
sir just to clarify, pre money is what the company is worth now
without any outside investors and post money is the valuation
that comes after taking into account the rise in value of business
after that investment. Correct?

FinTree
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FinTree
Valuation issues →
Buyout vs UC

FinTree
 Explain alternative exit routes in private equity and their impact on value.

- .
-
-
- .
-

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-

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- '

.
' I '

,
y
-

£ 4
-

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-

→
-
.

? -1
IPO Secondary
3
MBO
Liquidation

sale
highest exit value

+
The timing of an
IPO is key

Strategic Financial

FinTree
Explain private equity fund structures, terms, valuation, and due diligence in the context of an
analysis of private equity fund returns.

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.

The terms in a fund prospectus are a result of negotiation between the

GP and the LPs.

If the fund is oversubscribed (i.e., has more prospective investors than

needed), the GP has greater negotiating power.

Economic terms

Management fees: These are fees paid to the GP on an annual basis as a

percent of committed capital and are commonly 2%.

Management fees could instead be based on NAV or paid-in capital.

Transaction fees are fees paid to GPs in their advisory capacity when
they provide investment banking services for transactions (mergers and
acquisitions, IPOs) that benefit the fund. These fees may be subject to
sharing agreements with LPs, typically a 50/50 split. When such fee-
sharing agreements apply, they generally come as a deduction to the
management fees.
FinTree
Carried interest represents the general partner’s share of the profits
generated by a private equity fund. Carried interest is frequently in the
range of 20% of the fund’s profits (after management fees).

Ratchet is a mechanism that determines the allocation of equity between

shareholders and the management team of the PE-controlled company. A
ratchet enables the management team to increase its equity allocation
depending on the company’s actual performance and the return achieved
by the PE firm.

Hurdle rate is the internal rate of return that a private equity fund must
achieve before the GP receives any carried interest. The hurdle rate is
typically in the range of 7%–10%.

Target fund size is expressed as an absolute amount in the fund

prospectus or information memorandum (also called the private
placement memorandum, or PPM; offering memorandum, or OM; or
offering circular, or OC). Target fund size is critical investor information
because it signals the GP’s capacity to manage a portfolio of a
predefined size and also the GP’s ability to raise funds. A fund that closed
with a significantly lower size relative to the target size is perceived as a
negative signal.

Vintage year is the year the private equity fund is launched. Reference to
the vintage year allows performance comparison of funds operating at
the same stage and under the same market conditions.

FinTree
Examp CaoÑedinterest_

Committed capital =100 mil

carried int -20%
Hurdle Rate - 8%

The fund called 75% of its commitments from investors at the

beginning of Year 1, which was invested at the beginning of Year 1
in target company A for $40 million and target company B for $35
million.

Suppose that at the end of Year 2, a profit of $5 million has been

realized by the GP upon exit of the investment in company A, and
the value of the investment in company B has remained unchanged.
Suppose also that the GP is entitled to carried interest on a deal-by-
deal basis; that is, the IRR used to calculate carried interest is
calculated for each investment upon exit.

Calculate theoretical carried interest and actual carried interest to be

paid ?

FinTree
 Corporate Governance teams

Key man clause. Under the key man clause, a certain number of key
named executives are expected to play an active role in the
management of the fund. In case of the departure of such a key
executive or insufficient time spent in the management of the fund, the
clause provides that the GP may be prohibited from making any new
investments until a new key executive is appointed.

Disclosure and confidentiality. Private equity firms have no obligations

to publicly disclose their financial performance.

Distribution waterfall. This is a mechanism that delineates how

distributions are allocated to LPs and GPs

"
-
-
-
-
-
- -
- -
- -
-

← ,
American European
waterfall
waterfall
total Return
→ Deal by Deal →

which result in earlier

allow earlier distributions to LPs
distribution of because carried interest
carried interest to is calculated on the
the GP after each profits of the entire
individual deal FinTree portfolio
i.
 -

-
-
-

-
-
-
,
←
-
-

two
alternatives
the GP receives GP receives carried
carried interest interest on any
only after the fund distribution as long as
has returned the the value of the
entire committed investment portfolio
capital to LPs exceeds a certain
threshold above invested
orb
( "
capital, usually 20%

%d
b
-

one
?gÉ
Clawback provision. A clawback provision requires the GP to return a
portion or all of the carried interest to LPs if it turns out the GP has
received more than its share of profits. This provision ensures that
when an GP exits a highly profitable investment early in the fund’s life
and subsequent exits are less profitable, the GP pays back capital
contributions, fees, expenses, and carried interest profits to the LPs in
order to ensure that the profit split is in line with the fund’s prospectus.
The clawback is normally due on termination of the fund but may be
subject to an annual reconciliation (or true-up).

FinTree
Tag-along, drag along rights are contractual provisions in share-purchase
agreements

" -
-
-
-
- -
-
- -
-

← →
Tag-along rights Drag-along rights allow
majority shareholders who
ensure that minority have negotiated an exit to
shareholders have the right to require the minority
join in a sale entered into by a investors to participate in
majority shareholder at the the sale at the same terms,
same terms offered to the preventing minority
majority shareholder. investors from vetoing a
Essentially the buyer cannot sale.
acquire control without
extending its offer to all
shareholders, including the
management of the company

No-fault divorce. A GP may be removed both with and without cause

provided that a supermajority (generally above 75%) of LPs approve the
removal. In practice it is unusual for investors to succeed in removing
the GP.

FinTree
Removal for cause is a clause that allows for removal of the GP or an
earlier termination of the fund for “cause.”

Cause may include gross negligence on the part of the GP, a key person
event, the felony conviction of a key person, bankruptcy of the GP, or a
material breach of the fund prospectus.

It is difficult for LPs to remove the GP for cause because when there is an
allegation of wrongdoing, the GP will often agree to an out-of-court
settlement and pay a fine without having to admit guilt.

Moreover, it may be many years until a final court hearing takes place.

Investment restrictions generally impose a minimum level of

diversification on the fund’s investments, a geographic and/or sector
focus, or limits on borrowing.

Co-investment. LPs generally have a first right of co-investing along with

the GP. This can be advantageous for the LPs as fees and profit share
are likely to be lower (or zero) on co-invested capital.

The GP and affiliated parties are also typically restricted in their co-
investments to prevent conflicts of interest with their LPs.

Crossover co-investments are a classic example of a conflict of interest. A

crossover co-investment occurs when a subsequent fund launched by the
same GP invests in a portfolio company that has received funding from a
previous fund.

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FinTree
Example → Distribution waterfall

Suppose a private equity fund has committed capital of £300 million and
a carried interest of 20%. After a first investment of £30 million, the fund
exits the investment nine months later with a £15 million profit. Under
the deal-by-deal method, the GP would be entitled to 20% of the profit—
that is, £3 million.

In the first alternative for calculating carried interest under the total
return method, the LPs are entitled to the entire proceeds of the sale—
that is, £45 million and the GP is entitled to nothing (yet).

Under the second alternative, the exit value of £45 million exceeds the
invested value of £30 million by more than 20%. The GP would thus be
entitled to £3 million.

Continuing this example with a clawback provision with an annual true-

up, suppose that the deal-by-deal method applies and that a second
investment of £25 million is concluded with a loss of £5 million one year
later. At the annual true-up, the GP would have to pay back £1 million to
LPs. In practice, an escrow account is used to regulate these
fluctuations until termination of the fund.

FinTree
MAI

Ways to Determine NAV

The assets are valued by the GP 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 (e.g., those

that can only be sold to qualified investors). ( Reg 144 Securities
.

6. Less frequently, by applying illiquidity discounts to values based

on those of comparable publicly traded companies.

FinTree
Issues in Calculating NAV

There are several issues with calculating NAV for a private equity fund:

First, if the NAV is only adjusted 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 LP capital commitments are not included in the NAV

calculation but are essentially liabilities for the LP. The value of the
commitments depends on the cash flows generated from them, but these
are quite uncertain. When a GP has trouble raising funds, this implies that
the value of these commitments is low.

Fourth, the investor should be aware that funds with different strategies
and maturities may use different valuation methodologies. In the early
stages, a venture capital investment is typically valued at cost. In the later
stages, a method based on comparables may be used. Mature funds may
use market comparables for their investments that are near exit. Asset
price bubbles would inflate the value of these companies.

Finally, it is usually the GP who values the fund. LPs are increasingly
using third parties to value private equity funds.

FinTree
 Due Diligence of Private Equity Fund Investments Before investing,
outside investors should conduct a thorough due diligence of a private
equity fund due 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.

FinTree
 Explain risks and costs of investing in private equity.

The following material now takes the perspective of this outside

investor.

There are two important differences between investing in public equity

and in a private equity fund.

First, funds are committed in the private investments and later drawn
down as capital is invested in portfolio companies. In a public firm, the
committed capital is usually immediately deployed.

Second, the returns on a private equity investment typically follow a J-

Curve pattern through time. Initially, returns are negative but then turn
positive as portfolio companies are sold at exit.

General Risk Factors :

Liquidity risk: Because private equity investments are not publicly traded,
it may be difficult to liquidate a position.

Unquoted investments risk: Because private equity investments do not

have a publicly quoted price, they may be riskier than publicly traded
securities.

Competitive environment risk: The competition for finding reasonably-

priced private equity investments may be high.

FinTree
Agency risk: The managers of private equity portfolio companies may
not act in the best interests of the private equity firm and investors.

Capital risk: Increases in business and financial risks may result in a

withdrawal of capital. Additionally, portfolio companies may find that
subsequent rounds of financing are difficult to obtain.

Regulatory risk: The portfolio companies’ products and services may

be adversely affected by government regulation.

Tax risk: The tax treatment of investment returns may change over
time.

Valuation risk: The valuation of private equity investments reflects

subjective, not independent, judgment.

Diversification risk: Private equity investments may be poorly

diversified, so investors should diversify across investment
development stage, vintage, and strategy of private equity funds.

Market risk: Private equity is subject to long-term changes in interest

rates, exchange rates, and other market risks. Short-term changes
are usually not significant risk factors.

FinTree
 Cost Of Private Equity Investing

Transaction costs: These costs include those from due diligence, bank
financing, legal fees from acquisitions, and sales transactions in
portfolio companies.

Investment vehicle fund setup costs: The legal and other costs of setting
up the fund are usually amortized over the life of the fund.

Administrative costs: These are charged on a yearly basis and include

custodian, transfer agent, and accounting costs. Audit costs: These are
fixed and charged annually.

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: As discussed previously, additional rounds of financing

and stock options granted to portfolio company management will result
in dilution.

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.

FinTree
Interpret and compare financial performance of private equity funds from the perspective of an
investor.

④
III. → → DDD
'

Net GNSS
LRR portfolio
LP 's JRR
④ companies

GP

Multiples : FinTree
PIC (paid- This is the capital utilized by the GP. It can
be specified in percentage terms as the

in capital)
paid-in capital to date divided by the
committed capital.

DPI This measures the LP’s realized return

and is the cumulative distributions paid
(distributed to the LPs divided by the cumulative
invested capital. It is net of management
to paid-in fees and carried interest. DPI is also
referred to as the cash-on-cash return
capital)
RVPI This measures the LP’s unrealized

(residual return and is the value of the LP’s

holdings in the fund divided by the

value to
cumulative invested capital. It is net of
management fees and carried interest.

paid-in
capital)

TVPI This measures the LP’s realized and

(total value
unrealized return and is the sum of
DPI and RVPI. It is net of
management fees and carried
to paid-in interest.

capital) FinTree
 Qua1itativeMeasures_

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 fund 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).

The investor should carefully examine the GP’s valuations of the

remaining portfolio companies, potential writeoffs, and whether the
routes for future exit have dried up.

FinTree
 Benchma

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.

FinTree
E✗amp

FIDA FandB_
25% 2.5%
Gross IRR

18% -0.5%
Net LRR

performance I 3
quartile
0.2
143
DPL

152 1.05
RUPI

TUPI 2.95 1.25

Maturity OF 470s
Gyn .

Fund
FinTree
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.

The GP for private equity Fund X charges a management fee of 2% of

paid-in-capital and carried interest of 20%, using the first total return
method (i.e., carried interest is paid only when the value of the
investment portfolio exceeds committed capital).

The total committed capital for the fund was $150 million. The statistics
for years 2021- 2026 are shown in the following table (in millions).

Calculate the management fees, carried interest, NAV before

distributions, NAV after distributions, distributed to paid in (DPI), residual
value to paid in (RVPI), and total value to paid in (TVPI) of private equity
Fund X.

FinTree
FinTree
 Demonstrate alternative methods to account for risk in venture capital.

highly dependent on the assumptions, and sensitivity analysis should be

used to determine how changes in the input variables will affect
company valuation.

The discount rate used and the estimate of terminal value will strongly
influence the current valuation.

Adjusting 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. In the following formula, r* is adjusted for the probability of failure,
q:

Adjusting the Terminal Value Using Scenario Analysis

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