R45 Private Equity Valuation Edited IFT Notes PDF

R45 Private Equity Valuation IFT Notes
1. Introduction ............................................................................................................................. 2
2. Introduction to Valuation Techniques in Private Equity Transactions.................................... 4
2.1. How Is Value Created in Private Equity? ............................................................................ 6
2.2. Using Market Data in Valuation .......................................................................................... 7
2.3. Contrasting Valuation in Venture Capital and Buyout Settings .......................................... 7
2.4. Valuation Issues in Buyout Transactions ............................................................................. 9
2.5. Valuation Issues in Venture Capital Transactions ............................................................. 11
2.6. Exit Routes: Returning Cash to Investors .......................................................................... 12
2.7. Summary ............................................................................................................................ 13
3. Private Equity Fund Structures and Valuation ...................................................................... 13
3.1. Understanding Private Equity Fund Structures.................................................................. 13
3.2. What Are the Risks and Costs of Investing in Private Equity? ......................................... 16
3.3. Due Diligence Investigations by Potential Investors ......................................................... 17
3.4. Private Equity Fund Valuation........................................................................................... 18
3.5. Evaluating Fund Performance............................................................................................ 18
4. Concept in Action: Evaluating a Private Equity Fund .......................................................... 19
5. Appendix: A Note on Valuation of Venture Capital Deals ................................................... 19
6. Summary................................................................................................................................ 20
This document should be read in conjunction with the corresponding reading in the 2017 Level II
CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2016, CFA Institute. Reproduced and republished with permission from CFA Institute.
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1. Introduction
Private equity includes the entire asset class of equity investments that are not quoted on the
stock market.
There are two perspectives on private equity valuation:

1. The perspective of an outside investor who is evaluating a fund sponsored by the private
equity firm.
2. The perspective of a private equity firm that is evaluating investments (portfolio
companies).
The two broad types of private equity firms are:

1. Venture capital firms: Involved in early stage financing. Buy companies that may not
have revenues, but have a potentially good idea or technology.
2. Buyout firms: Involved in later stage financing. Buy privately owned companies or a
particular division of an existing company.
Exhibit 1 from the curriculum provides a classification of private equity in terms of the stage and
types of financing of portfolio companies.
Broad Category Subcategory Brief Description

Seed stage Financing provided to research
business ideas, develop prototype
products, or conduct market
Venture capital research.
Start-up stage Financing to recently created
companies with well-articulated
business and marketing plans.


Expansion stage Financing to companies that have
started their selling effort and
may be already breaking even.
Financing may serve to expand
production capacity, product
development, or provide working
capital.
Replacement capital Financing provided to purchase
shares from other existing
venture capital investors or to
reduce financial leverage.
Acquisition capital Financing in the form of debt,
equity, or quasi-equity provided
to a company to acquire another
company.
Leverage buyout Financing provided by a LBO
Buyout
firm to acquire a company.
Management buyout Financing provided to the
management to acquire a
company, specific product line,
or division (carve-out).
Mezzanine finance Financing generally provided in
the form of subordinated debt
and an equity kicker (warrants,
equity, etc.) frequently in the
context of LBO transactions.
Special situations Distressed securities Financing of companies in need
of restructuring or facing
financial distress.
One-time opportunities Financing in relation to changing
industry trends and new
government regulations.


Others Other forms of private equity
financing are also possible (i.e.,
activist investing, etc.).
A unique feature of private equity investment is that it has a buy-to-sell orientation. Most private
equity fund investors expect to receive their money back, within 10 years of committing their
funds.
2. Introduction to Valuation Techniques in Private Equity

Transactions
The choice of an appropriate valuation methodology for private equity depends on the stage of
development of the portfolio company. Exhibit 2 from the curriculum provides an overview of
some of the main methodologies used.
Valuation Technique Brief Description Application

Income approach: Value is obtained by discounting Generally applies across the broad
Discounted cash flows expected future cash flows at an spectrum of company stages.
(DCF) appropriate cost of capital. Given the emphasis on expected cash
flows, this methodology provides the
most relevant results when applied to
companies with a sufficient operating
history. Therefore, most applicable to
companies operating from the
expansion up to the maturity phase.


Relative value: Application of an earnings Generally applies to companies with a
Earnings multiples multiple to the earnings of a significant operating history and
portfolio company. The earnings predictable stream of cash flows.
multiple is frequently obtained May also apply with caution to
from the average of a group of companies operating at the expansion
public companies operating in a stage.
similar business and of comparable Rarely applies to early stage or start-up
size. companies.
Commonly used multiples include:
Price/Earnings (P/E), Enterprise
Value/EBITDA, Enterprise
Value/Sales.
Real option The right to undertake a business Generally applies to situations in
decision (call or put option). which the management or shareholders
Requires judgmental assumptions have significant flexibility in making
about key option parameters. radically different strategic decisions
(i.e., option to undertake or abandon a
high risk, high return project).
Therefore, generally applies to some
companies operating at the seed or
start-up phase.


Replacement cost Estimated cost to recreate the Generally applies to early (seed and
business as it stands as of the start-up) stage companies or
valuation date. companies operating at the
development stage and generating
negative cash flows.
Rarely applies to mature companies as
it is difficult to estimate the cost to
recreate a company with a long
operating history. For example, it
would be difficult to estimate the cost
to recreate a long established brand
like Coca-Cola, whereas the
replacement cost methodology may be
used to estimate the brand value for a
recently launched beverage (R&D
expenses, marketing costs, etc.).
Apart from these methods, there is one more method the venture capitalist method, which is
covered in the case study that follows this reading.
2.1. How Is Value Created in Private Equity?

Private equity has the following advantages over public equity:
1. The ability to re-engineer the firm to generate superior returns.
2. The ability to access credit markets on favorable terms.
3. A better alignment of interests between the private equity firm owners and the managers
of the firms they control.
Private equity firms are able to achieve better alignment of interests by:
Allowing managers to focus on the long term perspective, as compared to short term
quarterly earnings targets in public companies.
Effective structuring of investment terms:
o Tag-along, drag-along rights (any future acquirer has to extend acquisition offer

to all shareholders, including management of the company)

o Corporate board seats (ensures private equity control in case of a major corporate
event)
o Non-compete clause (prevents founders from restarting same activity during a
predefined period of time)
o Preferred dividend and liquidation preference (private equity firms are paid first,
before other shareholders)
o Reserved matters (some domains of strategic importance are subject to approval
by private equity firm)
o Earn-outs (mechanism linking the acquisition price paid by the private equity firm
to the companys future financial performance over a predetermined time horizon)
2.2. Using Market Data in Valuation

Generally market data cannot be applied directly in private equity valuation. However, most
valuation techniques indirectly use market data.
Multiples for comparable public companies such as EV/EBITDA are frequently used.
Relevant transaction data such as recent M&A transactions for comparable companies is
used.
Pure-play method to evaluate beta. is estimated for comparable companies and then
adjusted for financial and operating leverage.
In DCF valuation, forecasts are available only for a few years ahead. Hence it is
necessary to estimate a terminal value
o To do this we can apply a perpetual growth assumption.
o Or we can use multiple-based approach, take a multiple from public markets and
apply it to the last years forecast value.
2.3. Contrasting Valuation in Venture Capital and Buyout Settings

Exhibit 3 from the curriculum presents some of the key differences between venture capital and
buyout valuations.
Buyout Investments: Venture Capital Investments:

Steady and predictable cash flows Low cash flow predictability, cash flow
projections may not be realistic
Excellent market position (can be a niche player) Lack of market history, new market and possibly
unproven future market (early stage venture)
Significant asset base (may serve as basis for Weak asset base
collateral lending)
Strong and experienced management team Newly formed management team with strong
individual track record as entrepreneurs
Extensive use of leverage consisting of a large Primarily equity funded. Use of leverage is rare
proportion of senior debt and significant layer of and very limited
junior and/or mezzanine debt
Risk is measurable (mature businesses, long Assessment of risk is difficult because of new
operating history) technologies, new markets, lack of operating
history
Predictable exit (secondary buyout, sale to a Exit difficult to anticipate (IPO, trade sale,
strategic buyer, IPO) secondary venture sale)
Established products Technological breakthrough but route to market
yet to be proven
Potential for restructuring and cost reduction Significant cash burn rate required to ensure
company development and commercial viability
Low working capital requirement Expanding capital requirement if in the growth
phase
Buyout firm typically conducts full blown due Venture capital firm tends to conduct primarily a
diligence approach before investing in the target technology and commercial due diligence before
firm (financial, strategic, commercial, legal, tax, investing; financial due diligence is limited as
environmental) portfolio companies have no or very little
operating history
Buyout firm monitors cash flow management, Venture capital firm monitors achievement of
strategic, and business planning milestones defined in business plan and growth
management

Returns of investment portfolios are generally Returns of investment portfolios are generally
characterized by lower variance across returns characterized by very high returns from a limited
from underlying investments; bankruptcies are number of highly successful investments and a
rare events significant number of write-offs from low
performing investments or failures
Large buyout firms are generally significant Venture capital firms tend to be much less active
players in capital markets in capital markets
Most transactions are auctions, involving multiple Many transactions are proprietary, being the
potential acquirers result of relationships between venture capitalists
and entrepreneurs
Strong performing buyout firms tend to have a Venture capital firms tend to be less scalable
better ability to raise larger funds after they have relative to buyout firms; the increase in size of
successfully raised their first funds subsequent funds tend to be less significant
Variable revenue to the general partner (GP) at Carried interest (participation in profits) is
buyout firms generally comprise the following generally the main source of variable revenue to
three sources: carried interest, transaction fees, the general partner at venture capital firms;
and monitoring fees transaction and monitoring fees are rare in
practice
2.4. Valuation Issues in Buyout Transactions

Value is created in a typical leveraged buyout transaction from a combination of factors such as:
Earnings growth due to operational improvements and improved corporate governance
Multiple expansion depending on pre-identified potential exits
Debt reduction, repayment of part of debt with operational cash flows before the exit.
Exhibit 4 from the curriculum shows a typical leveraged buyout value creation chart.

Exhibit 5 from the curriculum provides an example of a 5,000 (amounts in millions) investment
in private equity transaction. This is financed with 50 percent debt and 50 percent equity. The
2,500 equity investment is further broken into 2,400 of preference shares owned by the private
equity fund, 95 of equity owned by the private equity fund, and 5 of management equity. The
preference shares are promised a 12 percent rolled up dividend (paid at exit). The private equity
firm equity will receive 95 percent of the residual value of the firm after creditors and preference
shares are paid, and management equity holders will receive the remaining 5 percent.
If we assume that the exit value after five years is 1.6 times the original cost, the payoffs to the
different stake holders will be:

The larger the exit multiple, the larger the upside potential for both the management equity
program and the equity held by private equity firm. Leverage is very important in buyout
transactions. As debt is gradually paid off, a larger proportion of operating cash flows is
available to equity investors. However, these high levels of debt significantly increase the risk to
equity investors. This increased risk should be taken into consideration, when comparing the
returns with other classes such as stock market.
A series of scenario analyses is conducted with different levels of cash exits, growth assumptions
and debt levels. Inputs used are the required rate of return for each stakeholder. This analysis
provides an understanding of the buyout firms flexibility in conducting the deal.
2.5. Valuation Issues in Venture Capital Transactions

Two important concepts in venture capital are:
PRE: Agreed value of a company prior to a round of financing or
POST: Value of a company after the financing or investing round

The relationship between the two is POST = PRE + I
The proportionate ownership of the venture capital investor is equal to I/POST.
Refer to Example 1 from the curriculum.
In a VC deal, both the pre-money valuation and the level of the venture capital investment are
subject to intense negotiation between the founders and the venture capital firm.
IN VC transactions, there is significant uncertainty regarding future cash flows. Hence, DCF
cannot be used. Also, start-ups are unique and it is difficult to find comparable companies.
Hence, comparable companies approach cannot be used. Generally, the appraisal of intangible
assets, comprising the founders know-how, experience, licenses, patents, and in progress
research and development, along with an assessment of the expected market potential of the
companys product or products in development form the basis for assessing a pre-money
valuation.
2.6. Exit Routes: Returning Cash to Investors

Private equity investors have the following exit routes for their investments:
Initial Public Offering (IPO): The key points are -
o Highest exit value relative to other methods
o High liquidity, access to capital, and attracts good management
o Less flexible, more costly, and complex
o Used when company has strong growth prospects, operating history, size
o Timing of IPO is an important consideration.
Secondary Market: Sale to other financial investors or strategic investors. The advantages
are
o Highest value in absence of an IPO
o Bring portfolio companies to next level by restructuring, merger, new market etc.
and sell them to a strategic investor or to other PE firm
Management Buyout: Firm is sold to management. Best alignment of interest, however if
significant leverage is used it can reduce the companys flexibility.
Liquidation: Sale of firms assets. This option is used if the company is no longer viable.

2.7. Summary
Since it is difficult to value private companies, a variety of alternative valuation methods are
typically used to provide guidance on the appropriate range of values.
Valuation serves a dual purpose:

1. Assessing a companys ability to generate superior cash flows from a distinctive
competitive advantage.
2. Serving as a benchmark for negotiations with the seller.
3. Private Equity Fund Structures and Valuation

Two distinctive characteristics of private equity are:
Investors commit a certain amount to the fund initially. This is subsequently drawn by the
fund.
Private equity firms usually show a J curve effect, where low or negative returns are
reported in the early years, followed by increased returns thereafter.
3.1. Understanding Private Equity Fund Structures

Most PE firms are structured as limited partnerships, where the fund manager is the general
partner (GP) and the funds investors are limited partners (LP). The GP has management control
over the fund and is jointly liable for all debts. The LPs have limited liability; they do not risk
more than the amount of their investment in the fund.
Two core functions of a PE firm are: (1) to raise funds and (2) To manage investments.
Therefore, PE firms start their marketing efforts well in advance of the launch of their funds to
ensure that the announced target fund size will be met successfully. Exhibit 6 from the
curriculum shows the funding stages for a private equity firm.

Fund terms are contractually defined in the fund prospectus. The objective is to ensure alignment
of interests between the GP and LPs and defining the GPs incentives.
Economic terms - The most significant economic terms are:

Management fees represent a percentage of committed capital paid annually to the GP.
Transaction fees are fees paid to GPs in their advisory capacity when they provide
investment banking services for a transaction (mergers and acquisitions, IPOs) benefiting
the fund.
Carried interest represents the general partners share of profits generated by a private
equity fund.
Ratchet is a mechanism that determines the allocation of equity between shareholders and
the management team of the private equity controlled company. A ratchet enables the
management team to increase its equity allocation depending on the companys actual
performance and the return achieved by the private equity firm.
Hurdle rate is the internal rate of return that a private equity fund must achieve before the
GP receives any carried interest.
Target fund size is expressed as an absolute amount in the fund prospectus or information

memorandum.
Vintage year is the year the private equity fund was launched. Reference to vintage year
allows performance comparison of funds of the same stage and industry focus.
Term of the fund is typically 10 years, extendable for additional shorter periods (by
agreement with the investors).
Corporate governance terms The most significant corporate governance terms are:
Key man clause: If a key executive leaves, the GP is prohibited from making new
investments until a new key executive is appointed.
Disclosure and confidentiality: Private equity firms have no obligations to disclose
publically their financial performance. Some terms limit the information available to
investors.
Clawback provision: If a fund makes profitable exits in early years, but the subsequent
exits are less profitable, then the GP has to pay back profits to ensure that the profit split
is in line with the fund prospectus. The two types of clawback provisions are
o Due on termination
o Annual reconciliation (true-up)
Distribution waterfall: Mechanism to ensure LPs are paid first before the GP receives
carried interest. The two main types are:
o Deal-by-deal waterfall Allowing distribution after each deal.
o Total return waterfall Distribution is calculated on the entire portfolio.
Refer to Example 3 from the curriculum. The highlights are:
In a deal-by-deal mechanism carried interest is distributed to GP after every deal.
In the first alternative of total return, GP receives carried interest only after the
fund has returned entire committed capital to LPs.
In the second alternative of total return, GP receives carried interest on any
distribution as long as the value of the investment portfolio exceeds a certain
threshold above invested capital.
Under a clawback provision with annual true-up, supposing that the deal-by-deal
method applies; if we incur losses on subsequent deals, the GP has to pay back
carried interest to LPs.

Tag-along, drag along rights: Any future acquirer has to extend acquisition offer to all
shareholders, including the management of the company.
No-fault divorce: A GP may be removed without cause, if a super majority of LPs
approve that removal.
Removal for cause: Allows removal of GP or early termination of fund for causes such
as gross negligence, key person event, felony conviction, bankruptcy, or material
breach of the fund prospectus.
Investment restrictions: Minimum level of geographic or sector diversification, or limits
on borrowing.
Co-investment: LPs have the first right of co-investing along with the GP if the GP
launches a new fund.
3.2. What Are the Risks and Costs of Investing in Private Equity?
The risks associated with investing in private equity are:
Illiquidity of investments: Since private equity investments are not traded on any
securities market, we may not be able to exit investments on a timely basis.
Unquoted investments: Investing in unquoted securities is risky compared to investing in
securities quoted on a regulated securities exchange.
Competition for attractive investment opportunities: Competition for finding investment
opportunities on attractive terms may be high.
Reliance on the management of investee companies (agency risk): There is no assurance
that the management of the investee companies will run the company in the best interests
of the private equity firm. This is a concern in earlier stage deals in which the
management may retain a controlling stake in the company and enjoy certain private
benefits of control.
Loss of capital: High business and financial risks may result in substantial loss of capital.
Government regulations: Investee companies product and services may be subject to
changes in government regulations that adversely impact their business model.
Taxation risk: Tax treatment of capital gains, dividends, or limited partnerships may
change over time.

Valuation of investments: Valuation of private equity investments is subject to significant

judgment and therefore may be subject to biases.
Lack of investment capital: Investee companies may require additional future financing
which may not be available.
Lack of diversification: Investment portfolios may be highly concentrated and may,
therefore, be exposed to significant losses.
Market risk: Changes in general market conditions (interest rates, currency exchange
rates) may adversely affect private equity investments.
The costs associated with investing in private equity are:

Transaction fees: Related to due diligence, bank financing costs, legal fees for arranging
acquisition, and sale transactions in investee companies
Investment vehicle fund setup costs: Includes legal costs for the setup of the investment
vehicle
Administrative costs: Custodian, transfer agent, and accounting costs
Audit costs: A fixed annual fee
Management and performance fees: A 2 percent management fee and a 20 percent
performance fee are common in the private equity industry.
Dilution: Dilution may come from stock option plans granted to the management and to
the private equity firm and from additional rounds of financing.
Placement fees: Fundraising fees may be charged up front or by means of a trailer fee. A
trailer fee is charged annually on the amount invested by limited partners. An upfront
placement fee of 2 percent is common in private equity.
3.3. Due Diligence Investigations by Potential Investors

Due diligence is important because:
Private equity funds show a strong persistence of returns over time. This means that top
performing funds tend to continue to outperform and poor performing funds tend to
continue to perform poorly.
Difference between performances of funds is extremely large. For example, the
difference between top quartile and third quartile fund IRRs can be about 20 percentage

points.
Liquidity in private equity is low and LPs are locked for the long term. On the other
hand, when private equity funds exit an investment, they return the cash to the investors
immediately. Therefore, the duration of an investment is typically shorter than the
maximum life of the fund.
3.4. Private Equity Fund Valuation

The value of a fund is based on NAV. The funds assets are valued by GPs in the following
ways:
At cost with significant adjustments for subsequent financing events or deterioration
At lower of cost or market value
By a revaluation of a portfolio company whenever a new financing round involving new
investors takes place.
At cost with no interim adjustment until the exit
With a discount for restricted securities
More rarely, marked to market by reference to a peer group of public comparables and
applying illiquidity discounts
3.5. Evaluating Fund Performance

Analysis of private equity funds financial performance includes the following:
Gross IRR: Relates to cash flows between the fund and its portfolio companies. It is
considered a good measure of the investment management teams track record in creating
value.
Net IRR: Relates to cash flows between the fund and LPs. It measures the returns to
investors.
PIC (paid in capital): The ratio of paid in capital to date divided by committed capital.
DPI (distributed to paid in): Cumulative distributions paid out to LPs as a proportion of
the cumulative invested capital. DPI is presented net of management fees and carried
interest.
RVPI (residual value to paid in): Value of LPs shareholding held with the private equity
fund as a proportion of the cumulative invested capital. RVPI is presented net of

management fees and carried interest.

TVPI (total value to paid in): The portfolio companies distributed and undistributed
value as a proportion of the cumulative invested capital. TVPI is the sum of DPI and
RVPI. TVPI is presented net of management fees and carried interest.
Refer to Example 4 from the curriculum. The highlights are:
Vintage year can provide hints for a funds success or failure. It signifies the economic
environment that the portfolio companies were subject to.
4. Concept in Action: Evaluating a Private Equity Fund

Refer to Section 4 from the curriculum. The highlights are:
High distributed value, high residual value, rank in the top quartile, high gross and net
IRR represent good performance.
If a fund is not performing, it is likely that the fund is experiencing a J curve effect.
5. Appendix: A Note on Valuation of Venture Capital Deals

Refer to the Appendix section form the curriculum. The highlights are:
The general case formulae are:
General Case/Formula
1. Post-Money Valuation POST = V/(1 + r)t
2. Pre-Money Valuation PRE = POST I
3. Ownership Fraction F = I/POST
4. Number of Shares Y = x [ F / (1 F) ]
5. Price of Share P1 = I/y
Sensitivity analysis shows how the value of a company changes if we change our
assumptions.
IRR and NPV method give the same answer as the venture capital method.
Terminal value is typically estimated by multiple of earnings. Sometimes multiples of
sales or assets are also used. In principle, better methods would be to use NPV, CAPM,

APT or whatever equilibrium valuation model fits the available data best.
The different methods to account for risk include:
o Using a very high discount rate
o Using a normal discount rate but assume a probability of failure for each year
o Allowing a variety of scenarios and then taking a probability weighted terminal
value
Cases with multiple rounds of financing can be solved using the same approach but be
careful about dilution and number of shares.
The actual deal is not really driven by the valuation method, but rather by the outcome of
bargaining power between the entrepreneurs and the venture capitalists.
6. Summary
LO.a: Explain sources of value creation in private equity.
The sources of value creation in private equity are:
1. The ability to re-engineer the firm to generate superior returns.
2. The ability to access credit markets on favorable terms.
3. A better alignment of interests between the private equity firm owners and the managers
of the firms they control.
LO.b: Explain how private equity firms align their interests with those of the managers of
portfolio companies.
Private equity firms are able to achieve better alignment of interests by:
Allowing managers to focus on the long term perspective, as compared to short term
quarterly earnings targets in public companies.
Effective structuring of investment terms:
o Tag-along, drag-along rights (any future acquirer has to extend acquisition offer
to all shareholders, including management of the company)
o Corporate board seats (ensures private equity control in case of a major corporate
event)
o Non-compete clause (prevents founders from restarting same activity during a

predefined period of time)

o Preferred dividend and liquidation preference (private equity firms are paid first,
before other shareholders)
o Reserved matters (some domains of strategic importance are subject to approval
by private equity firm)
o Earn-outs (mechanism linking the acquisition price paid by the private equity firm
to the companys future financial performance over a predetermined time horizon)
LO.c: Distinguish between the characteristics of buyout and venture capital investments.
Buyout Investments: Venture Capital Investments:

Steady and predictable cash flows Low cash flow predictability, cash flow
projections may not be realistic
Excellent market position (can be a niche player) Lack of market history, new market and possibly
unproven future market (early stage venture)
Significant asset base (may serve as basis for Weak asset base
collateral lending)
Strong and experienced management team Newly formed management team with strong
individual track record as entrepreneurs
Extensive use of leverage consisting of a large Primarily equity funded. Use of leverage is rare
proportion of senior debt and significant layer of and very limited
junior and/or mezzanine debt
Risk is measurable (mature businesses, long Assessment of risk is difficult because of new
operating history) technologies, new markets, lack of operating
history
Predictable exit (secondary buyout, sale to a Exit difficult to anticipate (IPO, trade sale,
strategic buyer, IPO) secondary venture sale)
Established products Technological breakthrough but route to market
yet to be proven
Potential for restructuring and cost reduction Significant cash burn rate required to ensure
company development and commercial viability
Low working capital requirement Expanding capital requirement if in the growth
phase

Buyout firm typically conducts full blown due Venture capital firm tends to conduct primarily a
diligence approach before investing in the target technology and commercial due diligence before
firm (financial, strategic, commercial, legal, tax, investing; financial due diligence is limited as
environmental) portfolio companies have no or very little
operating history
Buyout firm monitors cash flow management, Venture capital firm monitors achievement of
strategic, and business planning milestones defined in business plan and growth
management
Returns of investment portfolios are generally Returns of investment portfolios are generally
characterized by lower variance across returns characterized by very high returns from a limited
from underlying investments; bankruptcies are number of highly successful investments and a
rare events significant number of write-offs from low
performing investments or failures
Large buyout firms are generally significant Venture capital firms tend to be much less active
players in capital markets in capital markets
Most transactions are auctions, involving multiple Many transactions are proprietary, being the
potential acquirers result of relationships between venture capitalists
and entrepreneurs
Strong performing buyout firms tend to have a Venture capital firms tend to be less scalable
better ability to raise larger funds after they have relative to buyout firms; the increase in size of
successfully raised their first funds subsequent funds tend to be less significant
Variable revenue to the general partner (GP) at Carried interest (participation in profits) is
buyout firms generally comprise the following generally the main source of variable revenue to
three sources: carried interest, transaction fees, the general partner at venture capital firms;
and monitoring fees transaction and monitoring fees are rare in
practice
LO.d: Describe valuation issues in buyout and venture capital transactions.

Buyout transaction:
Value is created in a typical leveraged buyout transaction from a combination of factors such as:
Earnings growth due to operational improvements and improved corporate governance
Multiple expansion depending on pre-identified potential exits
Debt reduction, repayment of part of debt with operational cash flows before the exit.

Leverage is very important in buyout transactions. As debt is gradually paid off, a larger
proportion of operating cash flows is available to equity investors. However, these high levels of
debt significantly increase the risk to equity investors. This increased risk should be taken into
consideration, when comparing the returns with other classes such as stock market.
Venture capital transaction:

In a VC deal, both the pre-money valuation and the level of the venture capital investment are
subject to intense negotiation between the founders and the venture capital firm. There is
significant uncertainty regarding future cash flows. Hence, DCF cannot be used. Also, start-ups
are unique and it is difficult to find comparable companies. Hence, comparable companies
approach cannot be used.
LO.e: Explain alternative exit routes in private equity and their impact on value.
Private equity investors have the following exit routes for their investments:
Initial Public Offering (IPO): The key points are:
o Highest exit value relative to other methods
o High liquidity, access to capital, and attracts good management
o Less flexible, more costly, and complex
o Used when company has strong growth prospects, operating history, size
o Timing of IPO is an important consideration
Secondary Market: Sale to other financial investors or strategic investors. The advantages
are
o Highest value in absence of an IPO
o Bring portfolio companies to next level by restructuring, merger, new market etc.
and sell them to a strategic investor or to other PE firm.
Management Buyout: Firm is sold to management. Best alignment of interest, however if
significant leverage is used it can reduce the companys flexibility.
Liquidation: Sale of firms assets. This option is used if the company is no longer viable.
LO.f: Explain private equity fund structures, terms, valuation, and due diligence in the
context of an analysis of private equity fund returns.

Fund structure:
Most PE firms are structured as limited partnerships, where the fund manager is the general
partner (GP) and the funds investors are limited partners (LP). The GP has management control
over the fund and is jointly liable for all debts. The LPs have limited liability; they do not risk
more than the amount of their investment in the fund.
Terms:
The most significant economic terms are:
Management fees
Transaction fees
Carried interest
Ratchet
Hurdle rate
Target fund size
Vintage year
Term of the fund
The most significant corporate governance terms are:

Key man clause
Disclosures and confidentiality
Clawback provision
Distribution waterfall
Tag-along, drag along rights
No-fault divorce
Removal for cause
Investment restrictions
Co-investment
Valuation:
The value of a fund is based on NAV. The funds assets are valued by GPs in the following

ways:
1. At cost with significant adjustments for subsequent financing events or deterioration
2. At lower of cost or market value
3. By a revaluation of a portfolio company whenever a new financing round involving new
investors takes place
4. At cost with no interim adjustment until the exit
5. With a discount for restricted securities
6. More rarely, marked to market by reference to a peer group of public comparables and
applying illiquidity discounts
Due diligence:
Due diligence is important because:
PE funds show strong persistence of returns over time.
Difference between performances of funds is extremely large.
Duration of an investments is typically shorter that the maximum life of the fund.
LO.g: Explain risks and costs of investing in private equity.

The risks are:
Illiquidity of investments
Unquoted investments
Competition for attractive investment opportunities
Reliance on management of investee companies
Loss of capital
Government regulations
Taxation risk
Valuation of investments
Lack of investment capital
Lack of diversification
Market risk
The costs are:

Transaction fees
Investment vehicle fund setup costs
Administrative costs
Audit costs
Management and performance fees
Dilution
Placement fees
LO.h: Interpret and compare financial performance of private equity funds from the
perspective of an investor.
Analysis of private equity funds financial performance includes the following:

Gross IRR: Relates to cash flows between the fund and its portfolio companies. It is
considered a good measure of the investment management teams track record in creating
value.
Net IRR: Relates to cash flows between the fund and LPs. It measures the returns to
investors.
PIC (paid in capital): The ratio of paid in capital to date divided by committed capital.
DPI (distributed to paid in): Cumulative distributions paid out to LPs as a proportion of
the cumulative invested capital. DPI is presented net of management fees and carried
interest.
RVPI (residual value to paid in): Value of LPs shareholding held with the private equity
fund as a proportion of the cumulative invested capital. RVPI is presented net of
management fees and carried interest.
TVPI (total value to paid in): The portfolio companies distributed and undistributed
value as a proportion of the cumulative invested capital. TVPI is the sum of DPI and
RVPI. TVPI is presented net of management fees and carried interest
LO.i: Calculate management fees, carried interest, net asset value, distributed to paid in
(DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private
equity fund.

Refer to Section 4 from the curriculum.
LO.j: Calculate pre-money valuation, post-money valuation, ownership fraction, and price
per share applying the venture capital method 1) with single and multiple financing rounds
and 2) in terms of IRR.
Refer to the appendix section from the curriculum. The highlights are:
The general case formulae are-
General Case/Formula
1. Post-Money Valuation POST = V/(1 + r)t
2. Pre-Money Valuation PRE=POST I
3. Ownership Fraction F = I/POST
4. Number of Shares Y = x [ F / (1 F) ]
5. Price of Share P1= I/y
IRR and NPV method give the same answer as the venture capital method.
Cases with multiple rounds of financing can be solved using the same approach but be
careful about dilution and number of shares.
LO.k: Demonstrate alternative methods to account for risk in venture capital.

The different methods to account for risk include:
Using a very high discount rate
Using a normal discount rate but assume a probability of failure for each year
Allowing a variety of scenarios and then taking a probability weighted terminal value

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R45 Private Equity Valuation IFT Notes

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There are two perspectives on private equity valuation:

The two broad types of private equity firms are:

Broad Category Subcategory Brief Description

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Broad Category Subcategory Brief Description

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Broad Category Subcategory Brief Description

2. Introduction to Valuation Techniques in Private Equity

Valuation Technique Brief Description Application

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Valuation Technique Brief Description Application

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Valuation Technique Brief Description Application

2.1. How Is Value Created in Private Equity?

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to all shareholders, including management of the company)

2.2. Using Market Data in Valuation

2.3. Contrasting Valuation in Venture Capital and Buyout Settings

Buyout Investments: Venture Capital Investments:

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2.4. Valuation Issues in Buyout Transactions

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2.5. Valuation Issues in Venture Capital Transactions

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The relationship between the two is POST = PRE + I

The proportionate ownership of the venture capital investor is equal to I/POST.

Refer to Example 1 from the curriculum.

2.6. Exit Routes: Returning Cash to Investors

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Valuation serves a dual purpose:

3. Private Equity Fund Structures and Valuation

3.1. Understanding Private Equity Fund Structures

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Economic terms - The most significant economic terms are:

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Valuation of investments: Valuation of private equity investments is subject to significant

The costs associated with investing in private equity are:

3.3. Due Diligence Investigations by Potential Investors

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3.4. Private Equity Fund Valuation

3.5. Evaluating Fund Performance

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management fees and carried interest.

4. Concept in Action: Evaluating a Private Equity Fund

5. Appendix: A Note on Valuation of Venture Capital Deals

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predefined period of time)

Buyout Investments: Venture Capital Investments:

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LO.d: Describe valuation issues in buyout and venture capital transactions.