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Chapter 18 Private equity

Corporate Financial Strategy 4th edition Dr Ruth Bender. Chapter 18 Private equity. Private equity: contents. Learning objectives The universe of equity investment Structure of a typical private equity fund The infrastructure of private equity players

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Chapter 18 Private equity

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  1. Corporate Financial Strategy4th edition Dr Ruth Bender Chapter 18Private equity

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

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

  4. The universe of equity investment Listed equity Private equity Venture capital Business angels Not to scale

  5. 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.

  6. competitors The infrastructure of private equity players fund providers vendors PE companies management teams angels advisers banks acquirers regulators

  7. Common types of private equity transaction

  8. The private equity deal process Negotiate the deal Find investments Make the investment Manage the investment Exit Due diligence

  9. 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

  10. Impetus for a buyout OWNER’S REASONS MANAGEMENT’SREASONS Desire for autonomy in running the business Fear of redundancy Dislike of potential trade buyers • Disposal of non-core operations • Release of funds for the rest of the group • Passing on a family owned business

  11. 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

  12. Deal structure What funding is needed? What can the business afford? Evaluate debt capacity using cover ratios, and cash flow forecasts Covenant limitations What do the parties want? • Consideration to be paid to vendor • Fees • Additional injection to develop business • Each investing party wants financial return and some element of control rights • Other stakeholders are also relevant

  13. Parties to the transaction Syndicate Syndicate Vendor PE company Mgt Banks Pension fund Newco Employees Customers Target business Suppliers

  14. Structuring the deal • How much finance is needed? • How much can be debt? • How much can management invest? • Balance the PE investment between ordinary shares and preference shares or subordinated debt

  15. An example (1) Purchase price of business 80 Additional funds required 5 Total finance needed 85 Financed by debt 42 Finance needed as ‘equity’ 43 Provided by: Management (1%) 0.5 Private equity (99%)42.5 43.0 The business will be sold for 150 in Year 3. At that time, 20 of the debt will have been repaid

  16. 150 22 128 38 90 9 81 162% >41% An example (2) Invest Yr 0 Money out / in 85 Less Debt [10 repaid] 42 Available for ‘equity’ 43 Less ‘subordinated loan’ * 38 For ordinary shareholders 5 Management – 10% 0.5 Institutions – 90% 4.5 *Could be preference shares instead Sell Yr 3

  17. Tweaking the deal terms

  18. How PE companies will evaluate their investment 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.

  19. 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

  20. Contrasting a buyout with an acquisition

  21. Ethical issues in private equity

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