Private Equity 101
Private Equity (PE) is money that is invested in companies that aren't on a public stock exchange.
What is Private Equity?
Private Equity (PE) is money that is invested in companies that aren't on a public stock exchange. A PE firm will raise a pot of capital from external investors (pension funds, university endowments, wealthy individuals, etc.) and use that to buy into companies, often controlling interests. The majority of the companies in which they invest are private. Occasionally, they will buy a listed company and take it off the market entirely (a take-private).
The playbook is simple to describe and difficult to execute: buy a company, make it more valuable over a few years, and then sell it for a profit. The majority of the profit flows back to the investors in the fund, and the PE firm takes its cut.
If you've ever watched someone flip a house, you'll already know the basic principle. They put down a bit of their own cash, borrow the balance, do the renovation, and then sell. A buyout firm does exactly the same with a company (the 'renovation' might be a new CEO, better pricing or buying up the smaller competitors); just the timescale is a lot longer (more in the order of five years than five months).
- Private equity firms raise the money from institutional and high net worth investors and then use it to buy companies (usually private companies) with the intention of selling them on at a profit a few years down the track.
- PE firms create value in one of three ways: by growing earnings, by selling at a higher valuation multiple, and by paying down debt. The firm itself earns management fees and a share of the fund's profits (the carried interest).
- The private equity deal process goes through multiple stages. These stages include initial teasers, due diligence, and finalizing definitive agreements.
- PE investors value targets using comps, precedent transactions, and DCF. They're most reliant on an LBO analysis, which will tell you what return you get on a given purchase price.
- Private equity firms aim to improve acquired companies by increasing valuation and generating profit by exiting through sales or public offerings.
Private Equity Deal Process
Now that we have a general understanding of private equity, it is time to get into the steps involved in the transaction process.
Step 1: Bankers Send a Teaser
During this step, an investment bank briefly describes a potential seller without disclosing their name or in-depth information. The idea is to introduce an opportunity to the private equity firm briefly.
Step 2: Signing the NDA
If the firm is interested in the opportunity, it will sign an NDA restricting it from disclosing confidential information about the seller and the transaction details.
Step 3: A Bank Sends a Confidential Information Memorandum
Then, once the NDA is signed, the bank sends a confidential information memorandum (CIM) to the firm to give an overview of the target’s financials, business model, employee profile, value, and processes.
Step 4: Calls with the Management Team
When the acquirer gets all of the required information, some of it might still need to be clarified further. The seller's management answers the buyer's follow-up questions on a call.
Step 5: Financial Model and Valuation
Now, with all of the information at hand, the PE firm tries to estimate the company's value by using various valuation techniques. The DCF method involves projecting the company's financials and discounting them back to the present. Another is the comparable companies method, which consists of looking at the average or median valuation multiples of similar companies.
Step 6: Expression of Interest
Next, the buyer puts in a non-binding indication of interest (IOI) or expression of interest (EOI). This will contain a valuation range and will set out how the buyer would finance the transaction, what due diligence it still requires, and what approvals it needs.
Step 7: Data Room Open
The bank will be in control of access, but it's the buyer's job to verify the information is accurate. That's what due diligence is for.
Step 8: Meeting with the Management
The management team then presents the business to the shortlisted bidders and answers their questions. The PE firm uses that meeting to assess whether the management team is good enough to back, and early discussions around post-deal roles will often commence at this stage.
Step 9: Sending a Letter of Intent
Bidders who wish to move forward will submit a final bid or a letter of intent (LOI). The LOI will contain the price, the financing arrangement, and the key terms that the buyer expects to be in the Share Purchase Agreement (SPA), including the representations and warranties.
Step 10: Exclusivity Period and Final Due Diligence
The seller then selects the winning bidder. If there's any work left, that bidder may be granted a short exclusivity period during which the seller will not be negotiating with anyone else whilst the buyer is carrying out their due diligence.
Step 11: Definitive Agreements: SPA / APA
The deal is in a Share Purchase Agreement (SPA) where the buyer purchases the company's shares or an Asset Purchase Agreement (APA) where it purchases certain assets. The SPA/APA will set the price, the seller's representations and warranties, and the conditions to be met prior to closing.
Private Equity Investment Firm Varieties
There are two different PE firms that exist and invest in private companies today. The first one is an LBO investment firm, and the other one is a Venture Capital firm.
Private equity covers several strategies. The best known are leveraged buyouts and venture capital, but growth equity and a range of specialist strategies play a big role too.
LBO Investment Firm
An LBO investment firm, or leveraged buyout firm, searches for established businesses and invests in them using a considerably large portion of debt and a lower percentage of equity.
Then, the private equity firm operates the acquired target for several years and uses the generated cash flows to pay off the outstanding debt, increasing its equity stake. Additionally, the acquirer expects to sell the business at a higher price than it was initially acquired and realize a gain.
There are usually two LBO firms; one is a large institution that can invest in many businesses simultaneously, and the other is a small search fund, where an entrepreneur raises a fund to invest in one company and realize a future gain
Venture Capital Firm
Venture capital is a form of private equity, whereas the fund invests in early-stage startups that have a very high growth potential.
VC firms face a significant risk as the early startups have a very high failure rate, and finding the right one is tricky.
Growth Equity
Growth equity is in the middle of the spectrum between buyouts and venture capital. They take minority stakes in companies that are already growing rapidly and are often profitable, typically with little or no debt.
The capital is used to fund growth in new markets, new products or acquisitions. As they don't take control of the board, they protect themselves via various rights that are negotiated in the investment agreement (e.g., a board seat, a veto on key decisions).
Other Strategies
Distressed and special situations funds will buy struggling companies or their debt with a view to a turnaround or a restructuring.
Real estate and infrastructure funds apply the PE model to property and to assets such as airports, pipelines and data centers. Secondaries funds will buy into existing fund stakes from LPs who wish to exit early.
Private Equity Valuation Methods
PE firms typically value a company using four methods: comparable company analysis, precedent transactions, LBO analysis, and DCF analysis.
Comparable Company Transaction
An acquirer can determine a private company's value by comparing it to similar public companies. Usually, companies are searched for using the following criteria: size, age, geography, financials, and the market. They typically look for around 10 companies.
To calculate the value, analysts take the mean and median of the peers' valuation multiples (such as EV/EBITDA) and apply them to the target's own figures.
Precedent Transactions
It works in the same way, but the multiples are derived from the multiples actually paid in past transactions for similar companies rather than from current trading prices. As buyers are always paying a premium for control, precedent multiples are generally higher than trading multiples.
They're particularly useful in the PE space as they tell you what buyers have actually paid for similar businesses.
LBO Analysis
That's the method that PE firms rely on most. Rather than asking "what's this company worth?" you're asking "what's the most we can pay and still achieve our target return?" The deal team will model the purchase price, the debt package, five years of cash flow, and an exit value, and then work out the IRR and the MoM.
By running a number of different prices, they establish the ceiling that they can bid at. This is also the reason why bankers will include an LBO analysis when they're valuing a company for sale. It tells you pretty much where the financial buyers will stop.
DCF Analysis
The PE firms utilize DCF modeling if they have enough access to the company's financial statements and information. First, an analyst calculates the free cash flow metric, which is how much money is left to pay the investors after all of the firm's operating expenses have been paid.
Then, the idea is to forecast the firm's earnings using an estimated percentage growth. Once the numbers for the future are known, they are discounted back to the present using a rate of return required by the investors to arrive at a value for the firm.
Then, by dividing the value by the number of shares outstanding, an analyst can estimate the perceived value per share.
Private Equity 101 FAQs
Public equity is shares in companies that are listed on a stock exchange. You can buy and sell them in seconds via a brokerage account; the prices are constantly updating, and the companies are required to publish full financial statements. Private equity is ownership in companies that are not listed.
There's no exchange to trade on, so buying in involves negotiating directly with the owners, and getting out of the investment usually involves selling the whole company some years down the line. Private companies disclose a great deal less, and a private equity stake is only ever valued on a periodic basis rather than in real time. In return for that lack of liquidity, you generally get control, deep due diligence access, and the opportunity to change the way the business is run.
The vast majority of PE capital is provided by institutional investors: public and corporate pension funds, university endowments and foundations, insurance companies and sovereign wealth funds.
There is, of course, a significant amount of investment from wealthy individuals and family offices, and some of these will invest in funds of funds (which pool the capital of a number of investors and spread it across a number of PE funds). In the US, direct fund investment is generally restricted to accredited investors as the funds are illiquid and lightly regulated. All the rest get their exposure indirectly, e.g., by purchasing shares in a publicly traded PE firm.
The most typical route is a couple of years as an investment banking analyst, then a move into a PE associate role. A lot of the larger firms will be recruiting heavily out of banking, sometimes very early on in an analyst's career. An increasing number of firms will also be hiring straight out of undergrad.
The interviews will be technical on accounting and valuation, a paper LBO (a quick model done with pen and paper), and a timed modeling test or case study. Fluency in the concepts in this guide is the absolute prerequisite.
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