The Private Equity Industry

Published Date: 02 Nov 2017

Julien Lucas

TABSA Student 2013

Introduction

Nowadays, more and more people pay attention to the stock market. We have seen during the recent crisis that stock market fluctuations were considered by the news as the only economic barometer. Indeed when the sub-prime crisis started in 2008 all our attention was focused on the staggering fall of the Dow Jones Industrial Average (DJIA). However, during the past year a lot of economist pointed out the fact that the stock markets were more and more disconnected from the reality. The DJIA recently reached its past highest level when meanwhile the world economy is falling apart. Unemployment rates throughout the world are dramatically high, GDP stagnate and recession is still a major concern for most developed countries.

In this particular context, the purpose of this memoir will be to study how is the Private Equity (PE) Industry doing during this time and if it is not a more appropriate mirror of the real economy’s shape.

In order to respond to this problematic, I will focus on the valuation criteria that managers from PE firms use in their decision making process and how did these criteria evolved through the financial crisis. My first part will be dedicated to a broad explanation of what exactly capital investment through Private Equity is. In order to do so I will address the history of the Private Equity industry as well as a specific form of transaction that helped PE investment to expand over the last 20 years "The Leveraged Buyout" (LBO).

My second part will be dedicated to the decision making process that a fund manager go through when evaluating a potential investment. This part will be focused on, first, explaining the process of finding the fair value of any opportunity. And second on explaining what are the criteria that investment decision-makers use and how these criteria evolved over the last decade in order to adjust the whole process with new risk we never thought about before.

Finally, I will try to develop and explain two recent cases of acquisitions that happened and have been highly mediated during this year, the H.J Heinz company buyout by Warren Buffet and 3G capital and the Dell Inc buyout that is executed by Michael Dell himself and Silverlake Capital. Even though these two operations may seem similar the Dell’s one presents the particularity of having Mr. Dell in both the sell and buy side of the transaction.

Summary

I/ What is the private equity industry?

Capital investment and different stages

History of the private equity

The leveraged buy-out (LBO)

The Private equity industry nowadays

Overview

Trends

II/ Investment valuation criteria and how it evolves

What is the fair value

The principle of fair valuation

Different methods of valuation

Selection of the appropriate method

Additional considerations

Criteria used by fund manager to make decision?

The Net Present Value

The Internal Rate of Return

The payback period

The NPV: an inaccurate measurement?

How are these criteria adjusted with new risk

III/ Recent examples

The Dell’s leveraged buyout

The H.J Heinz Company buyout

I/ What is the Private Equity industry?

Capital Investment and different stages

The Private Equity also referred, as Capital investment is a financial activity that consists in an investor who funds a company that needs capital at a specific time. This operation can be done through two main ways. First the investor can buyout some already existing stocks to former stockholders who would like to cash out. Second the investor can bring in new fund to the company, by issuing new stocks; this is called an increase in equity. Therefore the term of Capital Investment covers all the investments in companies outside of the public stock market, which explains why we also call it Private Equity in opposition to the term public. According to the French Association of Capital Investors (FACI), the capital investment is "a fundamental support for the publicly unlisted company throughout its existence. It contributes directly to the creation of companies, promoting innovation and new technologies, growth, employment and the renewal of the economy.

The capital investment can be divided into 5 different phases.

- The "Seed Capital" is an investment done at a very early stage. Usually it consists in financing a company only upon its business plan even before the company is launched. The investor does not only fulfill capital needs for this project but he also brings in a network and its expertise in the area. This step of capital investment is considered as the most risky because the company does not show any proven past success. However it is also the most rewarding step because in exchange of capital, investors usually control a part of the company. Thus when the company goes from a business plan to a multi-national the seed investor is the most rewarded. These investors are usually wealthy individuals who want to be part of exciting and innovative projects (angel investors, family members, friends…).

- The "Venture capital (VC)" also known as "Early stage capital investment". This stage is usually the first stage when institutional investor comes in. It allows early stage companies to get access to capital in exchange of temporary and minority share of the company. It also replaces other sources of financing available for early stage companies such as bank loan.

Nowadays, the competition among companies that seek to be funded by VC becomes harder and harder. Actually over the last 5 years the demand for VC funding has significantly grown when meanwhile as the chart below shows the amount of dollar invested as well as the number of deals have decreased.

Source: http://www.nvca.org

This phase of capital investment is also very risky for investors since by definition the company is at an early stage. Many things can happen throughout the early stage of a company’s life but when successful these investments provide a high Internal Rate of Return (IRR) to investors.

- The "Expansion stage" follows the VC stage and fund companies that need capital to enhance their already existing growth. Usually, this enhancement is done through two main ways. The first one is called organic growth and can take place via factory expansion, target of a broader market, massive advertising campaign. The second one is external growth and usually takes place via acquisition of other entities such as suppliers or even competitors. As a matter of fact, both strategies are capital consuming and can hardly be achieved without external sources of capital.

- The next phase is called the Later Stage or Leveraged Buy-out (LBO) and holds a very specific place in the capital investment life cycle. Indeed, unlike in any other previously mentioned stage, the investor requires a majority position in the company. Therefore the amount of money required to fund this phase is significantly higher than in any other stage. Thus it usually relies on a combination of equity and debt called the LBO.

The later stage generally takes place when a company has at least three years of Earnings before interest, taxes, depreciation and amortization (EBITDA) tracking record. Since the fund executing the LBO owns a majority of the company they can decide to install their people on the board but also renew the management team.

The last possible phase is called the "Distressed Capital Investment". It only happens when a fund or investor acquire a majority stake in a company with negative EBITDA. The ambition behind this strategy is to be able through capital injection to turn the current situation around. Few investors only use this strategy since it represents a high risk. Indeed, to successfully invest in unprofitable company you have to perfectly target every problem the target company faces during the due diligence process. Failing to do so can easier result in the loss of your invested capital than with other stage of investment.

Overall, according to FACI, "Private Equity can meet the capital needs of businesses, allocate resources and facilities best suited for growth and performance, participate in defining a clear and long term strategy for the company, prepare for growth internal or external medium and long term and intelligently guide financial institutions to fund businesses."

The Leverage Buy-out (LBO)

Let’s dig a little more details about the LBO, process that many consider as the key of the Private Equity these days. The process of acquiring a mature company with strong growth potential using debt defines it. The LBO funds use this strategy in order to maximize their investment possibility; indeed it allows them to leverage their cash and their potential return. Ideally, LBO funds seek for holding investment no longer than ten years and try to maximize the acquired company EBITDA before exiting. The chart below shows the percentage of deals exited within different period of time. As you can see after only ten years, approximately 3 out of 4 deals are already exited.

% of deals exited within

24 months

12%

60 months

42%

72 months

51%

84 months

58%

120 months

76%

Additionally, there are three principal exit solutions: the Initial Public Offering (IPO) of the company, the sell off to another financial buyer or the sell off to a corporate buyer. The graph below shows you the exit characteristics of LBO and you can clearly see the dominance of the three solutions previously mentioned.

Source: Journal of economic perspective

A recent study led by "Constantin Associés" concluded that companies under LBO presented a revenue growth 8 times higher than other companies. Moreover the staff growth was 7 times higher in companies under LBO than in others.

Although LBO does not represent the whole Private Equity range of existing operations, these days one out of four operation is a Leverage Buy-out. Dominique Nouvellet, co founder of the FACI explained in 2006 the growing importance of the LBO by saying: "Private Equity has long had the unique vocation of acquiring small companies. It is only recently that it focused in bigger and bigger operations that used to previously occur in the public stock market."

However, the private equity is not restricted to multi billion, with media overexposure deals, as we will see in the next part.

History of the Private Equity

Even though "Private Equity" is a term that has only been used starting in the 80’s, the origin of this market actually goes back to the creation of group such as, in Europe, Charterhouse Development Capital in 1934 and 3i in 1945 and in the USA American Research and Development Corporation (ARD) in 1946.

For instance 3i, initially named Industrial and Commercial Finance Corporation, aimed to satisfy small companies capital need on a long-term perspective.

Entrepreneur in the Silicon Valley as well as famous universities such as Stanford and the MIT have then developed this capital investment activity after the WWII.

After its expansion in the US, it became famous in Europe during the 70’s. However the Private Equity really became famous under the impulsion of the LBO during the 80’s with funds such as KKR (Kohlberg Kravis Roberts) that closed emblematic transaction like the acquisition of RJR Nabisco for more than thirty six billion dollars.

For more than thirty years now, this investment activity has developed cyclically, depending on the stock market conditions, the fiscal policy in place and the creation of new tools aiming at stimulating and facilitating the fund raising process.

In France for instance, the combination of low inflation rate in the 1990’s and creation of tools such as the Common Fund of Innovative Investment in 1996 has allowed the development of this activity, however, much smaller than in North America.

Nonetheless, the Private Equity industry has been impacted by several economic crises and mostly by the Internet bubble burst. The chart below shows the drastic decrease in investment from Venture Capitalist over the Internet bubble.

Source: http://www.nvca.org

As you can see in the chart above, in 2000 when the bubble was at its top, the VC activity reached 8,000 deals and more than $100 billion invested. Only three years after the bubble burst you can see that the number of deals decreased by 62.46% and the amount invested by more than 80%.

Nevertheless it did not prevent a diversification of sources of capital. Indeed, the spectrum of investors in the Private Equity industry has rapidly grown to include more and more varied investors. The number and the diversification of investors that have invested in this market prove that it is a mature market. The graph below represents the different sources of investment for Private equity fund these days.

Source: www.evca.com

In conclusion the Private Equity industry has undergone a cyclical evolution over the last 30 years with a peak during the beginning of this century.

The Private Equity Industry nowadays

Overview

From 2007 to 2012, the private equity market has known a consistent downturn in term of number of deals as well as capital invested. This condition can easily be explained by the financial crisis that squeezed the world’s economy and the credit crunch that we have endured. As a matter of fact, the growing importance of the LBO also explains a lot on this downturn. Actually, this process lies on the principle of leveraging your acquisition through debt. During the credit crunch, most financial institutions put their loan activity on hold and it created a strong decrease in leverage possibility for the capital investment activity.

However as we entered 2012 most analysts thought the private equity would finally bounce back from the crisis. Indeed, debt financing was becoming more accessible and the amount of "dry powder" (amount of non-invested capital under PE firms control) was at its highest.

Unfortunately according to the chart below, extracted from "Pitchbook" 2012 annual report for the private equity industry, you can see that the amount of deal closed and the capital invested kept going down during 2012.

This unexpected result can be explained by many factors such as:

-Political uncertainty materialized by the November presidential election.

-Regulatory uncertainty materialized by the Federal bank politic over the year.

-The ongoing Eurozone crisis that has not been resolved yet and could have a systemic impact worldwide.

-And finally a decrease in quality deal opportunities.

Although the 2012 overview for the industry is disappointing, it could have been worse if the threat of tax rate increases in the new year had not reversed the course in the last quarter.

Additionally, 2012 was the third consecutive year of increase in the percentage of buyouts by foreign PE firms. As you can see on the chart below, this percentage more than doubled over the last 10 years going from less than 4% to almost 8%. This statistic can be explained by both a restored confidence in the US economy and the result of trouble other country experienced throughout the year (GDP decrease in China, Eurozone crisis etc…).

b. Trends

For 2013, analysts underlined some interesting trends that could set the new standard for the Private Equity industry:

1st/ the add-ons % of buyout seems to have stabilized around the 50%. The term add-on by opposition to the term platform defines a small investment generally south of $5 million EBITDA that is acquired in order to grow a bigger company. Back in 2004 this type of deal also represented 37% of the buyouts.

2nd/ for the first time ever, PE firms exited more companies through secondary buyout than corporate buyout. As a result, 17% of the deal closed last year had for target companies already PE-backed.

3rd/ the private equity industry experience a longer and longer holding time of their investment and that is an important structural change. As shown in the chart below, the median holding time went from only 4years in 2008 to almost 6 years last year. This change has to be taken in consideration by fund manager when evaluating their potential investment since they might require longer-term strategies and more capital injection to reach their IRR objectives.

To conclude, although activity has decreased significantly over the last few years for the private equity market we can point out that this investment is still a strong alternative for investors. Indeed, even during the subprime crisis fund managers succeeded to outperform the public market by finding new valuation methods and strategies.

The next part of this memoire will be dedicated to the strategy used by fund managers to decide whether or not they want to invest/divest a specific company.

II/ Investment valuation, selection criteria and how it evolved

What is the fair value of an investment?

Since the fund manager is the one who takes the final decision on whether or not to invest in a specific opportunity he holds a crucial role.

The objective of this part will be to study the different tools a fund manager has at his disposition in order to:

Evaluate the fair value of a potential investment

Decide whether or not it is a good investment for his fund performance.

The principle of fair valuation

The first important concept I would like to address is what is considered to be a fair valuation. According to International Financial Reporting Standards (IFRS) the fair value is "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction."

Thus, the fair value is a concept that does not necessarily require an existing market for the valued asset. It does not imply for instance that during a valuation process, the target company is actually for sale or the owner actually wants to cash out. The objective is really to estimate what would be the price that both parties in a hypothetical market would agree to exchange.

Obviously depending on the willingness of both parties to enter into the transaction the market value of a target investment can fluctuate from its fair value. For instance, if an owner wants to retire quickly and is highly motivated to sell his company, he will probably agree to an asking price reduction. At contrary, the buyer will have to propose a higher bid if he knows that the owner does not want to sell his company at this time.

Now that the concept of fair valuation is settled, let’s take a look at the different methods of valuation used in the private equity industry.

Different methods of valuation

For private equity the valuation process most likely takes in consideration a whole company instead of just a part of it. In most of the case, the fair value of the target company will constitute the base for decision-making.

On one hand, although it may be seen as a science, the company valuation process is actually an art. Indeed, the subjective nature of the valuation cannot be denied. During the process that we will detail later on, the assessor has to forecast a lot of uncertain criteria such as industry growth, macro-economic change and micro-economic changes. The fact that there is no formal rules to determine what will be the risk free rate for the next 5 years for instance force assessor to make subjective choices that can bring to different valuation. This subjective nature explains why fair valuation often comes with sensitivity analysis (see annex 1) that shows how a certain fluctuation in assumption can impact the fair value of the company. Nevertheless, even with this sensitivity analysis the only thing that will tell if the valuation was accurate is time.

On the other hand, it is not rare for private equity fund to radically change the strategy, management and operations of an acquired company. This change will impact the value of the company and also require capital investment that may change your investment’s assessment.

Despite all this uncertainties, private equity firms came up with several standardized methods that help them to value as precisely as possible the fair value of a company.

-The market approach: I would divide this approach in three main ways.

1st/ if you are extremely lucky during your valuation process and found out about a similar company to yours that has been sold recently you can set your valuation upon this. This approach is not used often because as previously said two companies can rarely be the same. However in some small business cases this approach is sometimes used.

2nd/ if the company you are trying to evaluate has been recently bought. This case is more and more likely over the last few years since we saw in the current market trends that secondary buy-out happen more often. This allows you to base your valuation process on the former valuation and to adjust it with the recent change.

3rd/ the use of industry multiples. This method is based on the observation of companies within the same industries and how they have been valued compared to their revenue, EBITDA, EBIT.

During the process you can for instance realize that every companies sold over the last 3 years in your industry have been valued for a 5.0 EBITDA multiple. Therefore you can confidently assert that the fair value of your company will be somewhere in the range of 5 times its EBITDA. However this type of valuation is barely applicable to companies with very high growth since your value will tend to fluctuate too fast. In case you try to use the multiple approach with a high growth company it would be appropriate to take the normalized revenue for instance. Normalizing the revenues means to adjust them by taking out element that are exceptional or only punctual and would therefore distort the fair value.

To conclude, the market approach is generally used in order to roughly evaluate an investment and to decide whether or not the fund wants to pursue the opportunity by doing the due diligence.

-The Discounted cash flow approach (DCF): In this method the assessor tries to evaluate the company according to the present value of its future cash flow. You can find in annex 1 an example of DCF valuation that I developed for one of my project at work (for confidential reasons all the information that could lead to the company identity have been deleted).

Going back to the idea of subjectivity, this method is highly concerned. Indeed as you can see in the annex, there are a lot of criteria that one need to assume during the analysis.

The first assumption is the risk free rate. This rate is basically the percentage you can earn every year with a financial instrument that does not represent any risk. Most of the time it is assimilated to the 10-year Treasury bond but different investors have different preferences. This rate is essential when you compute your cost of equity with the Capital Asset Pricing model (CAPM) equation.

Additionally, in order to use this model you also need a beta that can vary depending on the method you use. Some investors use 60 months of data while others use 120 months. It may seem irrelevant but at the end of the valuation you can find variation of 10% depending on your assumptions.

The last crucial assumption that you need to make while using this method is what is called the perpetuity growth rate. This one is also very tricky since it impacts widely the valuation. Actually you can see on the sensitivity analysis (annex 1) that a 1% change in the perpetuity growth estimation leads to a 10% variation in the value. For some transaction it can represents tens of millions of dollar. In order to determine it one can use different criteria depending on the company’s sector. You can for instance use the demographic growth or the normalized growth of the industry over the last 10 years etc… Once again there is no good or wrong estimation since every single one can be properly justified.

To conclude, the high level of subjectivity involved in the DCF valuation forces assessor to use it more as a double-check method than as a unique method to come up with an accurate value.

-The asset valuation approach: This method consists in valuating a company upon the value of its net assets. Generally this method is used for companies such as real estate companies that hold most of their value through their assets.

This approach can also be used for companies that are not profitable. Indeed, it is complicated to use the DCF model when a company generates negative cash flows. Thus this method will likely be used by funds that do "Distressed capital investment". The principle is straightforward since it is only about finding the asset value and subtracting debt from it.

Finally, there are a lot of secondary methods marginally used by funds in order to valuate companies that we will not address in this part since our goal is to focus on the criteria that manager uses to decide if an investment is good.

Selection of the appropriate method

This part will address the complexity of choosing the right value when the use of different method gave you widely spread valuation. The bottom line assessors need to keep in mind is that they need to use the valuation method that is appropriate for the company. As a matter of fact, when you value a company that you are trying to buy it is tempting to take the lowest value that your analysis gave you. However it may also not be the most appropriate one and it may cause some troubles on the deal later on. Therefore in order to end up with the best valuation possible the fund needs to take into account the nature of the industry, the economy’s condition and the nature of the company’s activity among others. It is also important to take into account the life stage of the company and its capability to generate cash flow. As previously stated you cannot use every method for a company that generates loss for instance.

Finally, the assessor may obviously opt for the use of several methods and the detection of a pattern. You can face a situation where all the methods converge to the same value for instance. At contrary you can find a situation where a method gives you an odd value and this, can allow you to detect an irrelevant method.

Additional considerations

While determining the fair value of an investment, additional considerations have to be taken into account. One of these considerations occurs when you use the market approach and more specifically when you refer to the value of a recent transaction. As a matter of fact, it is important to consider the circumstances in which the previous deal happened. For instance you cannot refer to a recent transaction if during the time frame a tipping point such as an industry profitability shift or a technology innovation that impacts your product’s attractivity occurred. Additionally, if the past deal was done internally through a management buy-out for instance, it is unlikely for its value to fully match the fair value of the investment. Indeed some settlement could have occurred between the former owner and the buyout entity to drive the price down under certain conditions. This case may happen with family owned business, when the owner is ready to sell for a low price to his management team if they agree upon following his general strategy for instance.

Another factor that one can consider during a valuation will be the use of a specific company risk premium. As explained in an article published by Highland Global in 2004 named "The Specific company risk premium" you can find a specific risk premium for each company depending on 7 factors.

The revenue growth: As revenue growth of a company increases, risk premium associated typically decreases as a result of greater prospects for increased earnings, dividends etc.…

The financial risk: According to the article, increased leverage in a firm’s capital structure also increases the threat of a possible bankrupt. Therefore in order to measure the financial risk, they recommend to take the debt-to-equity ratio of the company because it is the best way to quantify leverage.

The operational risk: In order to evaluate this one, you can use the ratio of fixed cost to sales of the company. It is an indication of a firm’s risk not to meet its fix costs in case of a sales decline.

Profitability: This is a clear indication of a firm’s associated risk. To quantify this one the article recommend to use the net profit margin since it is a strong indicator of how profitable a company is.

Industry risk: In order to estimate the industry risk the article recommends to take the ratio Firm ROA / Industry ROA. Indeed, it not only allows you to realize how the whole industries perform but it also puts your specific firm in perspective of it.

Economic risk: This one serves to adjust your valuation to the economy’s condition. In order to quantify it, the article recommends to use a ratio "Firm ROA/ Change in GDP". Obviously depending how developed your company is you will take a different GDP in consideration. As a matter of fact if the company operates worldwide it will be appropriate to take the variation in the worldwide GDP.

Customer concentration: This one needs to be carefully evaluated because it is crucial in term of risk for a company. The easiest way to quantify it is to take the ratio "Sales to top 5 costumer / Total sales". The highest this ratio will be the more impact the lost of one of this top costumer will have.

The chart below shows how to grant a note for each criteria and how to weight it in order to finally get a discount premium for the specific company risk.

SPECIFIC COMPANY RISK PREMIUM ANALYSIS

Factor Weighting Rating Weighting Rating

1 Revenue Growth 14%

0 8%+

1 7%<x<8%

2 6%<x<7%

3 5%<x<6%

4 4%<x<5%

5 3%<x<4%

6 2%<x<3%

7 1%<x<2%

8 0%<x<1%

9 No Growth/Flat

10 Declining Trend

2 Financial Risk 14%

(as measured by Total Debt Ratio)

0 No Leverage

1 0%<x<10%

2 10%<x<20%

3 20%<x<30%

4 30%<x<40%

5 40%<x<50%

6 50%<x<60%

7 60%<x<70%

8 70%<x<80%

9 80%<x<90%

10 90%+

3 Operational Risk

(measured by Fixed cost/Sales) 14%

0 No Operational Leverage

1 0%<x<10%

2 10%<x<20%

3 20%<x<30%

4 30%<x<40%

5 40%<x<50%

6 50%<x<60%

7 60%<x<70%

8 70%<x<80%

9 80%<x<90%

10 90%+

4 Profitability 14%

(as measured by Net Profit Margin)

0 17%

1 15%<x<17%

2 13%<x<15%

3 11%<x<13%

4 9%<x<11%

5 7%<x<9%

6 5%<x<7%

7 3%<x<5%

8 1%<x<3%

9 <1%

10 Net Losses

5 Industry Risk 14%

( Firm ROA/Industry ROA)

0 1.80+

1 1.60-1.80

2 1.40-1.60

3 1.20-1.40

4 1.00-1.20

5 0.80-1.00

6 0.60-0.80

7 0.40-0.60

8 0.20-0.40

9 0-0.20

10 Negative Firm ROA

6 Economic Risk 14%

(Firm ROA/GDP Change)

0 4.5-5.00+

1 4.00-4.50

2 3.50-4.00

3 3.00-3.50

4 2.50-3.00

5 2.00-2.50

6 1.50-2.00

7 1.00-1.50

8 0.50-1.00

9 0.0-0.50

10 Negative

7 Customer Concentration 14%

(Sales of Top 5 Customers/Total Sales)

0 Less than 1%

1 1%<x<10%

2 10%<x<20%

3 20%<x<30%

4 30%<x<40%

5 40%<x<50%

6 50%<x<60%

7 60%<x<70%

8 70%<x<80%

9 80%<x<90%

10 90%+

INDICATED SPECIFIC COMPANY RISK PREMIUM

Moreover for some transactions you also need to apply a size discount premium. As showed in the chart below extracted from Chapter 9 of the book "Business Valuation Approaches and Methods", the size premium can go up to 2.6% in case of micro-capitalization.

Size Premia*

Expected mid-capitalization equity size premium: capitalization between 0.5

$918 and $4,200 million

Expected low-capitalization equity size premium: capitalization between 1.1

$252 and $918 million

Expected micro-capitalization equity size premium: capitalization below 2.6

$252 million

Expected risk premia for equities are based on the differences of historical arithmetic mean returns from 1926-1998. Expected risk premia for fixed income are based on the differences of historical arithmetic mean returns from 1970-1998.

SOURCE: Chapter 9 of "Business Valuation Approoaches and Methods"

Finally, the appraiser can also apply to the valuation process a discount called the "Key man" discount. It is recommended when the assessor considers that part of the success of a company lies on a single member. For instance, Apple Inc. had a strong Key Man situation when Steve Jobs was at its head. However it is not necessarily a C-level of the company that is concerned. Indeed if a salesman represents an important part of the total company’s sales because of its network the company can be subject to a Key Man discount.

To conclude this part was dedicated to show how an investor can come up with a fair value for any investment. As explained, this process is time consuming and can be assimilated to an art because of all the subjectivity that comes into play. However the next part will explain how, once the fair value is known, to decide which potential investment is the most profitable for the fund.

Criteria used by fund managers to make their decision

There are numerous classic criteria that are used by fund managers to decide if an investment worth it or not. The Net Present Value (NPV), the Internal rate of return (IRR) and the payback period are the three criteria most widely used. Thus, in this part we will only consider these three criteria. Additionally we will also explain why the NPV is sometimes perceived as a non-accurate decision maker.

The Net Present Value

The Net present Value is basically the difference between the initial investment and the present value of the future cash flow a company would generate. Its goal is to indicate the created value that would come from the investment by discounting to today’s value all the future cash flows. The NPV can be used for the purpose of an entire company as well as for a simple project for instance. On a strictly financial standpoint a positive NPV is enough for any investment to be considered. Indeed it means that the initially invested capital will be at least recapture (if NPV=0) and maybe remunerated (if NPV>0).

Most of the time the NPV is expressed as below:

Where:

is the initial investment

is the cash flow generated by the company at period i

is the expected rate of return

is the investment holding period

The NPV’s most obvious advantage is that it takes into account the time value of money. Indeed as you can see in the formula above, the future cash flows are discounted with a discount rate known as expected return. Another advantage is its easiness to be calculated. Thus it allows the decision maker to have a quick idea on the quality of the investment. Nevertheless, this method also has its limits. First, it takes into account a fix and rigid future and cannot include different scenario. Second, it doesn’t provide the decision maker with a rate of return but only with a dollar value. Last, the required rate of return can sometimes be perceived as random and its impact on the final value is important.

Since this criterion is the most widely used, there will be a further part at the end of this chapter.

b. The Internal Rate of Return

The internal rate of return (IRR) is a rate that cancels the NPV, more precisely the rate for which the NPV is equals to the initial investment.

If we go back to the NPV formula expressed above:

The IRR is the value of r for which the NPV will be equal to zero.

This tool constitutes a criterion of investment since it measures a rate of return for any capital initially invested. Generally, an investment will be undertaken only if the IRR is higher than the expected rate of return.

The main advantage of this method is the same than for the NPV: it takes into account the time value of money. One of its disadvantages is that the calculation process is long and tedious. Additionally the IRR is sometimes misused as a comparison criterion to differentiate two potential investments. As a matter of fact it allows knowing if and how profitable a project is but surely not comparing between two different ones because it does not provide any time horizon.

Thereby, a project with a IRR of 20% over the next ten years can be more attractive than a project with an IRR of 25% over one year. This can be explained by the fact that an investor cannot have the guarantee that he will be able to invest its capital at the same rate after the first year. In other words a disadvantage of IRR is that all cash flows are assumed to be reinvested at the same rate, which is quite impossible in real world.

Nevertheless, it differentiates positively from the NPV because it does not include a subjective input such as the required rate of return in your calculations.

c. The Payback Period

The payback period represents the time needed for an investment to pay back its initially invested capital. The calculation process is straightforward since you just have to observe at what time the cumulated cash flow generated by an investment becomes positive.

Below is an example of payback period calculations where you can see that the payback period is equal to exactly 3 years. Most part of the time the cumulated cash flow equal to zero doesn’t occur exactly at the end of a year so you have to find the month when the value became positive.

Year

0

1

2

3

4

5

Cash Flow

-1,000,000

200,000

300,000

500,000

550,000

600,000

Cumulated cash flow

-1,000,000

-800,000

-500,000

0

+550,000

+1,150,000

Of course, the lower the payback period is the better. The main advantage for this criterion is obviously its easiness to calculate. Moreover it can be a measure of the inherent risk of a project. Indeed, since cash flows that occur later in a project are usually more uncertain it can indicate how certain the cash inflows are.

However as you can see this method does not take into account the time value of money since you just consider the future cash flows as it. In light of this lack of consideration, some investors started to use what is called the Discounted Payback period. The principle is the same but instead of using the cumulated cash flow, you now use the cumulated discounted cash flow. The advantage is that it takes in consideration the time value of money but it also inserts the subjective required rate of return in the calculation. The last disadvantages for both discounted and normal payback period is that it does not take the cash flow after the payback period into account. Thus you can be tempted to give preferential treatment to an investment with a lower payback period even though the potential cash flow after the payback period are significantly lower.

To conclude, before heading into a further discussion of the Net Present Value accuracy, it is important to note that fund managers usually use the three criteria above together in order to make their decisions. As a matter of fact, you will not find a specific fund that bases its decision exclusively on the NPV or the IRR. However because of the nature of these criteria it happens that some give contradictory information. For instance, investment A can have a higher NPV than investment B but a higher payback period too. In these specific cases, investors’ preferences come into play.

d. The NPV: an inaccurate measurement?

Methods of selection that takes into account the time value of money, the initial investment and the future potential cash flows; the NPV is the difference between the present value of the future cash flow and the initial investment. Its most common formulation as we saw before is:

Because r is the required rate of return determined by the assessor, this method already directly takes into account the selection criteria for investment in its formula. Therefore when the NPV is positive the investment can and should be considered since it allows to not only get the initial investment back but to generates revenues at least equals to the required rate of return. Contrariwise, if the NPV is negative, the investment should not be considered since it will not even allow the investor to get its initial investment back.

The biggest problem encountered with the NPV is the homogeneity between the cash flow and the required rate of return estimations. As a matter of fact the estimation of the future cash flows integrates the systemic risk and the specific risk. Therefore, the estimations of the required rate of return should also take these two risks into account. However, in reality the required rate of return is usually assimilated to the WACC of the company that takes into account the required rate of return of your equity by stockholders, the cost of your debt and the weight of each of them. You can find the formula of the WACC below:

where:

D is the total amount of debt

E is the total shareholder’s equity

is the post tax cost of debt

is the cost of equity

According to this formula if the only source of capital for the company is its equity, the required rate of return they will use in the NPV calculation will be equal to their cost of equity. This cost of equity is usually derived from the CAPM model, which states that the market should not remunerate an investor for a risk that can be diversified. The most commonly used CAPM model expression is:

Where:

E(is the cost of equity

is the risk free rate

is defined as

And E( is the expected return of the market

Sometimes, this part of the equation is also called the market risk premium since it shows what an investor can expect in term of return by investing in the market compared to the risk free rate.

The model contributes to divide in two components the risk associated with any investment:

The systematic risk also known as undiversifiable risk. This risk refers to the risk common to all securities on the market (the market risk). However, even though this risk has the same origin for each security, it value is not necessarily the same since it depends on its "beta".

As explained before the of any given security is described as:

.

The unsystematic risk also known as diversifiable risk or idiosyncratic risk. This is the risk associated with individual assets and it can be diversified away by including a greater number of assets in the portfolio. Indeed doing so will tend to average out the specific risks of every asset within the portfolio.

To conclude, an investor using the NPV criteria will most likely use the CAPM model to get its required rate of return. However even though unsystematic risk can easily be diversified in a stock portfolio by owning a large number of different stocks, most private equity firms does not own enough companies in their portfolio to diversify away their unsystematic risk.

Therefore we face an ambiguous situation where fund manager assume the presence of only systematic risk in their calculations while it is not actually the case. By doing so they create a lack of homogeneity between the future cash flow and the required rate of return estimations.

To solve this issues, lots of economists proposed different solutions over the last 30 years.

For instance a study realized by Fairchild in 2002 suggested that we could, to correct the NPV, adjust the future cash flow. Integrating the cost of potential financial troubles in the expected cash flows would do this.

Another option would be to adjust the required rate of return by using a new model called the Market-derived Capital Pricing Model (MCPM) instead of the CAPM. This model was formulated by McNulty JJ, Yes YD, Schulze W and Lubatkin MH in 2002. Instead of relying on "Beta" this new model uses option-pricing risk to value the equity risk premium. While CAPM uses volatility and correlation to evaluate the risk, MCPM uses only volatility. Moreover this model is considered as more useful because it is forward looking contrariwise to CAPM that is based on historical data.

In conclusion, after detailing the most widely used criteria in the industry, it seems like every single one of them reaches its limit at one point. Therefore, even though every criterion is governed by mathematical formula, we can confidently one more time state that the investment decision-making process is not an exact science. Thus, in the next part we will see how the investment criteria for Private Equity companies evolved along with the economic climate over the last 10 years.

How are these criteria adjusted with new risks?

In order to address this part, I decided to interview Gerald O’Dwyer, managing director of Blackmore Partners Inc. Blackmore Partners is a middle market private equity buy-side advisory as well as an independent/fundless sponsor based in Chicago, Illinois.

Gerald created the company back in 2006 when he realized that what PE firms needed was not executives that want job, but seasoned executives with actionable deals. Therefore Blackmore’s mission statement is to work with exceptional, experienced and proven executives and develop compelling and defensible business strategies, creating unique investment opportunities for private equity. Over the last 7 years, private equity firms have sought after the unique and proprietary deals that are formed via their unique partnership with executives.

Since Gerald has been working in the industry before the financial meltdown of 2008 as well as after, I found it relevant to ask him to share his insights on how the economic condition changed the private equity business. Gerald was my managing director during my 6-month internship at Blackmore and that’s how I convinced him to give me some of his precious time.

Below is the interview transcript detailing the questions I asked and Gerald’s answers.

Interviewer: Good morning Gerald and thank you for your time. Let’s start with our first question. What are the challenges that you perceive on a daily basis while doing business with Private Equity firms?

Gerald O’Dwyer: I would say that there are three main challenges that we started to perceive in our activity after the crisis.

-The first one is the low deal-closing rate. Indeed the environment for PE firm in the middle market is more and more competitive and as you can imagine PE firms really need to differentiate themselves in order to attract deals.

-The second one is the lack of deal source that we suffer of. Deal sourcing is a costly and time-consuming process for any PE firms even though it is the base of their business. We realized for instance that there was a deep communication gap between deal sources and PE firms. Specifically in the middle market where deals are usually not supervised by Investment Banks.

-The last one is the higher standard for due diligence that the crisis created in my opinion. Nowadays private equity firms are more diligent about this process and it creates a longer deal cycle when meanwhile we all know that time is a deal killer in this industry.

Interviewer: From your experience, how did the crisis impact the way private-equity firm evaluate a deal when you propose it to them.?

Gerald: more deal is necessary to close one blablabla

Interviewer: Do you see the excessive amount of dry powder on the market as a result of these strengthened criteria?

yes blablabla

Sources:

-Investopedia ,"Educating the world about finance", www.investopedia.com

-AFIC, The French Private Equity Association, www.afic.asso.fr

-NVCA, National Venture Capital Association, www.nvca.org

-Preqin, Private equity research, www.preqin.com/type/private-equity

-EVCA, Private equity and venture capitalist in Europe, www.evca.eu

-Constantin Deloitte, The social impact of LBO in France, link to the study

- Journal of economic perspectives Volume 22 Number 4,Leverage Buyout and private equity, Steven Kaplan and Per Stromberg, , link to the article

-Pitchbook, 2013 Annual Private Equity Breakdown, link to the report

-CFO Magazine, Ronald Fink, May 2003, Some experts contend that Option Pricing models give a better overview of cost of capital than CAPM, link to article

-Grant Thornton, Global Private Equity Report 2012: The search for growth. Hardcopy

-Harvard Business Review, What is your real cost of capital, by JJ McNulty, T.D Yeh, William Schulze and Michael Lubatkin, October 2002. link to the article

-Highland Global Strategy, The specific company risk premium: a new approach, July 2004. Hardcopy