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Level 135

Private Equity Valuation


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portfolio company
companies that private equity firms invest in; sometimes referred to as investee companies
private equity investor
the outside investor who makes an investment in the fund offered by PE firm
the Ability to reengineer the company
source of value creation in private equity
- manager's compensation tied to the company's performance
how private equity firms align their interest with those of managers of portfolio companies
characteristics of venture capital portfolio
unpredicted cash flow and product demand
exit value
investment cost + earnings growth + increase in price multiple + reduction in debt = exit value
four main exit routes
initial public offering results in the highest exit value due to increased liquidity, greater access to capital, potential to hire better managers
most common private equity owning structure
limited partnership where limited partners provide funding and have limited liability; general partners manage the fund
Management Fees
Management fees include: postage costs, clerical time, commissions on the underlying assets, redemption fee - a fee to pay redemption expenses, ranging between 1 percent and 2 percent. Management fees are paid to fund mana…
transaction fee
paid to GP for fund investment banking services, such as arranging a merger; these fees are usually split evenly with the LPs and when paid, are deducted from management fees
carried interest/performance fees
GP's share of the fund profits and is usually 20% if profits (after management fees)
ratchet
specifies the allocation of equity between stockholders and management of the portfolio company and allows management to increase their allocation, depending on performance
hurdle rate
IRR that the fund must meet before GP can receive carried interest, usually from 7% to 10% an incentivizes the GPs
target fund size
stated total maximum size of PE fund, specified as an absolute figure, signals GP's ability to manage and raise capital for a fund; negative signal if actual funds ultimately raised are significantly lower than target
vintage
the year the fund was started and facilitates performance comparison with other funds
term of the fund
life of the fund, usually years
key man clause
if a key exec leaves the fund or does not specify sufficient amount of time at the fund, GP may be prohibited from making additional investments until another key exec 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 not disclosed
clawback
if the fund underperforms, GP is required to pay back a portion of the early profits to LPs (usually settled at the terminal of the fund but can be settled annually - true-up)
distribution waterfall (deal-by-deal)
specifies the method in which profits will flow to the LPs and when GP receives carried interest
distribution waterfall (total return method)
carried interest is calculated on the entire portfolio
co-investment
allows LPs to invest in other funds of the GP at low or no management fees; provides the GP another source of funds; prevent GP from using capital from different funds to invest in the same portfolio company
issues in valuing NAV
no Secondary market for investment
why due diligence
private equity funds have returns that tend to persist; the fund's past performance is useful information (out performers tend to keep outperforming and under performers tend to keep underperforming or go out of business)
general risk factors
liquidity risk; unquoted investment risk; competitive environment risk; agency risk; capital risk; regulatory risk; tax risk; valuation risk; diversification risk; market risk
Transaction Cost
Transaction Cost = Cost of trading
gross IRR
the IRR can be calculated gross or net of fees; gross IRR reflects the fund's ability to generate a return from portfolio companies and is the relevant measure for cash flows between the fund and portfolio companies
Net IRR
net of management fees, carried interest, and other compensation to GP; is the relevant measure for the cash flows between the fund and LPs and is therefore the relevant return metric for LPs
PIC (paid-in-capital)
capital utilized by GP; can be specified in percentage terms as the paid-in-capital to date divided by the committed capital (can be cumulative PIC called down)
DPI (distributed to paid-in-capital)
measure LP's realized return and is the cumulative distributions paid to the LPs divided by the cumulative invested capital (net of management fees and carried interest); it is also referred to as the cash-on-cash return
RVPI (residual value to paid-in-capital)
measures LP's unrealized return and is the value of LP's holdings in the fund divided by the cumulative invested capital, net of management fees and carried interest
TVPI (total value to paid-in capital)
measures LP's realized and unrealized return and is the sum of DPI and RVPI, net of management fees and carried interest
VC (venture capital) method
POST = PV (exit value)
adjust the discount rate
reflect the risk that the company may fail in any given year; valuation of venture capital is highly dependent on the assumption used
NAV before distribution
NAV after distributions in prior year + capital called down - management fees + operating results
NAV after distribution
NAV before distribution - carried interest - distribution