WCM Educational Recap #8 — Introduction to Private Equity
Recapped by Amy Zado
Welcome back to the WCM! To start off the new year, we dove into the buy-side (firms that make investments or purchase securities in public and private companies) with an in-depth exploration of private equity, and a reminder to sign up for Week in Reviews and keep an eye out for more WCM events!
The Four Main Arms of the Buy-Side
- Focuses on investing in early stage companies with high growth potential (either product innovation or high growth industry)
- Use pure equity or convertible debt
- Generally holds <40% of equity in the company for a 5–10 year holding period
- Mainly invests in companies that have a proven business model in more mature or emerging markets
- Generally hold a minority of controlling stake with an average holding period of 3–7 years
- They look for highly scalable companies with potential for profitability and revenue growth
- Firms that buy, sell, and manage a portfolio of stocks and investments on behalf of private or institutional clients
- Mainly purchase mature companies in well-established industries
- These companies typically have high cash flows and investors make improvements over 3–10 years before selling for a return
- Generally highly leveraged buyouts
Let’s Focus on Private Equity
Three Main Phases
- Fundraising: raising funds from institutional investors to invest in private companies
- Diligence: search for new transaction opportunities and validate their potential
- Returns: achieve above-average profit through leverage, growth, and operational improvements
The key tasks during this process include raising capital, performing valuations, engaging in due diligence, and portfolio management.
Traditional Investment Criteria and Company Characteristics
The main three criteria traditional PE firms look for is consistently high cash flow yield (using EBITDA as a proxy), turnaround potential, and a sustainable advantage or a defensible market position. To achieve the turnaround they’re looking for, they must identify either growth or efficiency opportunities for example through operational strategy changes, product innovation, or changing the management team. Low maintenance capital expenditures will often also yield a higher return.
In order to minimize a PE firm’s risk, a lot of due diligence is conducted. This is the process of collecting and analyzing information on factors such as business model, management, product design, target market, and operating history to determine if a company holds the above characteristics. PE firms will also look for quality of margins, earnings and growth, competition and industry trends, management capabilities and plans, and key risks and catalysts for the business.
Investment Vehicles: Leveraged Buyouts (LBO’s)
Although there are many private investment vehicles such as growth capital, mezzanine financing, and distressed buyouts, we’re going to focus on the mechanisms of a leveraged buyout.
Leveraged buyouts use as much debt as possible for both the buyout and company improvements to achieve a higher IRR. The benefits of debt funding are 1, it reduces the upfront cost of acquiring a company and 2, it allows the PE firm to use the cash flows from the company’s operation to make interest and principal payments on the debt. Also, interest is tax deductible which helps retain more cash flows.
To determine how well the PE firm did, they look at two things: the money-on-money multiple and the internal rate of return. The MoM multiple represents the gross value (found through the net cash flows) being created in terms of the initial purchase price. The IRR instead shows the year over year value being created.
Transaction Overview (6–8 months)
Marketing (10 weeks)
- Sourcing and Testing: finding potential investment opportunities and sending a summary of the company available to purchase
- NDA Signed: target company provides confidential information
- Confidential Information Memorandum (CIM) Sent by Bankers: investment thesis, financials, projections, and capital structures alongside other key information about the target company
Valuation and Due Diligence (20 weeks)
- Initial Due Diligence: researching target company and industry
- Investment Proposal: presented to investment committee
- First Round Bid: Interested PE firms provide a valuation range
- Some important things that occur in this phase are researching key margin drivers and industry trends, developing a capital protection plan, and building a value creation plan and financial model
Negotiations and closing (20 weeks)
- Internal Operating Model: revenue and cost breakdown
- Preliminary Investment Memorandum: 30–40 page document that summarizes investment opportunities
- Final Investment Committee Approval: final investment memorandum (FIM) created
Final (6 weeks)
- Final Binding Bid: includes final price and preliminary merger agreements
- Signing the Deal: a Purchase Agreement alongside other documents are created
Opportunities in PE
Search Funds: Investment firms where an entrepreneur raises funds to acquire a company and assume day-to-day leadership. Examples include Ashbridge Partners, Auxo Management, and Turtle Holdings Limited.
Middle Market: PE firms that typically invest $100M — $5B in capital commitments. Examples include Altas Partners, Birch Hill Equity Partner, and Vista Equity Partners.
Megafunds: The largest PE firms that typically invest >$5B per fund. Examples include Blackstone, KKR, and Apollo.
Pension Funds: Capital accumulated from contributions from employers, employees, or both. Examples include CPP Investment Board, Omers, and Ontario Teachers’ Pension Plan.