Corporate Financial Strategy

4th edition
Dr Ruth Bender
Chapter 18

Private equity

Corporate Financial Strategy

Private equity: contents

 Learning objectives  Deal structure

 The universe of equity investment  Parties to the transaction
 Structure of a typical private equity  Structuring the deal
fund  An example (1)
 The infrastructure of private equity  An example (2)
players  Tweaking the deal terms
 Common types of private equity  How PE companies will evaluate their
transaction investment
 The private equity deal process  Don’t just use IRR
 The ideal PE candidate  Contrasting a buyout with an
 Impetus for a buyout acquisition
 Selecting financiers  Ethical issues in private equity

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Learning objectives

1. Explain how private equity firms are structured, and how they make
their money.
2. Understand the different types of leveraged deal, and how value is
created for investors.
3. Create or use a financial model for structuring a private equity
transaction.

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The universe of equity investment

Listed equity

Private equity

Venture capital

Business
angels

Not to scale

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Structure of a typical private equity fund

Gilligan, J. and Wright, M. (2010) Private Equity Demystified, Corporate Finance Faculty of the ICAEW.
Used with permission.

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The infrastructure of private equity players

competitors

fund
acquirers providers

vendors PE
companies

management
teams angels

advisers banks

regulators

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Common types of private equity transaction

LBO leveraged buyout – can be any of the following

MBO management buyout – the existing management of the
company buy the company

MBI management buy-in – incoming management buy the

company

BIMBO combination buyout and buy-in

IBO institutional buyout – a PE company buys the company

and then puts in the management of its choice

P to P public to private (i.e. delisting)

Leveraged The PE company makes an investment in order to buy

build up (Buy a lot more companies in that sector and put them
& Build) together to make something big and profitable

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The private equity deal process

Negotiate
the deal

Find
Make the Manage the
investments Exit
investment investment

Due
diligence

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The ideal PE candidate

 Good business model, with competitive advantage

 Considerable growth potential
 Potential to reduce costs
 Good management team (existing or brought in)
 Cash-generative
 Can be bought cheaply

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 Impetus for a buyout

OWNER’S REASONS MANAGEMENT’S REASONS

 Disposal of non-core operations  Desire for autonomy in running
 Release of funds for the rest of the business
the group  Fear of redundancy
 Passing on a family owned  Dislike of potential trade buyers
business

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Selecting financiers

 Only approach banks and investors who might be interested in your

business
− Geographical area
− Industry type
− Size of investment
− Type of investment
 Do not approach all potential investors at one

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 Deal structure

What funding is What can the What do the

needed? business afford? parties want?
 Consideration to  Evaluate debt  Each investing
be paid to vendor capacity using party wants
 Fees cover ratios, and financial return
 Additional injection cash flow and some element
to develop forecasts of control rights
business  Covenant  Other
limitations stakeholders are
also relevant

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Parties to the transaction

Syndicate Syndicate

PE
Mgt Banks Vendor
company

Pension
fund
Newco

Employees

Customers

Target
business
Suppliers

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Structuring the deal

1. How much finance is needed?

2. How much can be debt?
3. How much can management invest?
4. Balance the PE investment between ordinary shares and preference
shares or subordinated debt

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An example (1)

Purchase price of business 80

Additional funds required 5
Total finance needed 85
The business
Financed by debt 42 will be sold for
150 in Year 3.
Finance needed as ‘equity’ 43
At that time, 20
of the debt will
Provided by: have been
repaid
Management (1%) 0.5
Private equity (99%) 42.5
43.0

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An example (2)

Invest Yr 0 Sell Yr 3
Money out / in 85
150
Less Debt [10 repaid] 42
22
Available for ‘equity’ 43
128
Less ‘subordinated loan’ * 38
38
For ordinary shareholders 5
90

Management – 10% 0.5

Institutions – 90% 4.5
9 162%
*Could be preference shares instead 81 >41%

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Tweaking the deal terms

Yield PE returns can be increased without affecting management % ownership

by increasing their yield during the investment period
Ratchets A positive ratchet can give management a higher % of the equity if
performance is good
A negative ratchet can reduce management’s % ownership if performance
is less than expectations
Leverage A leveraged recapitalization can ensure that the PE company recovers its
equity investment early while still retaining the investment

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How PE companies will evaluate their investment

Year 0 Years 1-y Year z

What Money Dividends Proceeds
happens spent to or interest of selling
buy Co received stake in Co
and (?)
finance the Or extra
deal finance?
Cash flows -–- + ++++

All evaluated to determine if the IRR is going to exceed their

required cost of capital
The greater the cash generation in years 1 – y, the more the
proceeds in z.

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Don’t just use IRR

IRR is a flawed measure,

especially if a leveraged
recapitalization is done

Although IRR is commonly

used, PE companies also
use cash-to-cash return as
a measure as well, in order
to allow for the size of the
return

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 Contrasting a buyout with an acquisition

  PE acquirer Corporate acquirer

Use of a Newco Newco must be created to hold the shares Target can be taken as a subsidiary
of the acquirer
Impact of debt Acquisition debt is held in the Newco and Debt relating to the acquisition is
does not gear up the PE fund not ring-fenced and affects the
acquirer’s capital structure
Conditional Ratchets can be used change shareholdings, Earn-outs can be used to give the
payments dependent on performance sellers further proceeds, dependent
on performance

Changes to target Part of the acquisition plan agreed with Generally plans for synergies to be
business operations management created

Management Linked completely to the eventual exit from Will depend on the corporate
incentives the investment objectives

Purpose and The acquisition is made with an ultimate Probably made for strategic
timescale of profitable disposal in mind reasons with no expectation of
acquisition selling on

Funding the A relatively high level of debt To meet the corporate financial
acquisition structure

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Ethical issues in private equity

Management should be acting for the owners,

Conflicts of interest but planning a buyout presents a conflict of
interest

Vulnerability of
Taking on too much debt makes the company
employees vulnerable, which is a problem for employees,
although not for diversified investors
– This applies to initial structure and,
particularly, to leveraged recapitalizations
Restructuring is often a euphemism for lay-
offs. Is it always useful?

Public-to-private deals can destroy confidence

Capital markets in the capital markets, e.g. for fear of insider
information

PE companies, their directors, and the

Tax avoidance portfolio companies tend to be ‘efficient’ at
managing their tax affairs

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