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Chapter 10

Valuation in a
Private Equity
Setting
Chapter Outline

• Introduction
• Overview of the Market for Private Equity
• Valuing Investments in Start-ups and Deal
Structuring
• Valuing LBO Investments
– Build-ups and Bust-ups
– Limitation of the LBO Valuation Approach
• Summary

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Introduction

• Private equity firms are a vital source of capital for start-ups


as well as more operationally mature firms
• Venture capital investors value “hoped-for” cash flows by
implementing high discount rates to account for the high risk
and illiquidity of these investments
• Entrepreneurs have certain options which can reduce the
required rates of return (ROR) and equity stakes given to
venture capitalists in exchange for financing
• Leveraged Buy-outs (LBOs) are investment strategies used to
magnify returns through the use of high debt levels

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What is Private Equity?

• A private equity firm is a financial intermediary


that is involved in raising pools of capital to invest
in companies that need financing
– PE firms take ownership stakes in either private
companies or shares of public companies
– Ownership is restricted so that stakes cannot be sold for
some specified period of time
– Generally, a PE investor is an active investor who
acquires some measure of control over the invested
firms

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Parties
Involved
• There are three parties
involved in the PE
market: Suppliers of
funds, PE investment
companies, and the
business that use the
funds.

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Types of Financing

• PE firms tend to
specialize in
companies which
operate in similar
life cycle stages

• Seed Capital –
typically supplied by
wealthy individuals
for brand new companies
• Venture Capital – early stage financing for established start-up companies
• Growth and Expansion Capital – provided by PE and venture capital firms for
developing companies
• Restructuring or Reorganization Capital – LBO firms provide financing to break
apart or reconfigure mature companies

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The Cost of Capital for Venture
Capital Financing
• Valuating a start-up requires finding the “present value” of
“hoped-for” cash flows using a “hoped-for” rate of return
• “Hoped-for” cash flows are those that materialize in the
best case scenario
• Instead of trimming the opportunistic cash flow goals of
the entrepreneurs who run the companies, Venture
capitalists require a rate of return high enough to offset
the “hoped-for” cash flow estimates

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DCF Valuation – Application to
Venture Capital
• The venture capital evaluation approach requires two primary
inputs: a discount rate and an estimate of future cash flows.
– The first is the traditional DCF approach to valuation, which discounts expected
future cash flows using the expected rate of return from a comparable-risk
investment (i.e., the opportunity cost of capital).
– The second method is the optimistic or hoped-for DCF valuation approach (the VC
method falls into this category).

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Required Rates of Return for
Venture Capital
• Required rates of return (ROR) vary depending on the stage
of investment
– Start-up stage (seed) financing requires high ROR
– Required ROR declines as the invested firm develops
operationally
• Required ROR are determined based on a number of factors
and are not always achieved
– ROR reflects the opportunity cost of capital which is in turn
determined by the ROR of alternative investments
– Greatly affected by the supply and demand of capital in the
firm’s specific sector
– Required ROR takes into account the counsel and advice a
venture capitalist provides the invested firm

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Valuing a Venture Capital Investment
& Structuring the Deal

• In most cases, venture capital is exchanged


for stock in the invested firm. The key to
the structure of the deal is the valuation of
the entrepreneur’s business
– The venture capitalist must determine the value
of the company at the point of exit
– Depending on the required ROR, the venture
capitalist must calculate the equity stake needed
to realize expected return over the investment
horizon

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Valuing a Venture Capital Investment
& Structuring the Deal (Continued)

• Step 1: Investor determines the ROR that


he or she hopes to realize from the
investment

= kHoped-for VC Return

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Valuing a Venture Capital Investment
& Structuring the Deal (Continued)

• Step 2: Based on the required ROR at the end of the planned


holding period (typically 4 to 7 years), the investor calculates the
expected dollar value realized in order to justify making the initial
investment
– H = number of years in holding period

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Valuing a Venture Capital Investment
& Structuring the Deal (Continued)

• Step 3: Next, the investor estimates the value of the firm’s


equity at the end of the planned holding period using a
multiple of the firm’s projected EBITDA in year H
– EBITDA multiple calculated using comparable transactions

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Valuing a Venture Capital Investment
& Structuring the Deal (Continued)

• Step 4: Investor calculates the fraction of the


firm’s future value that will satisfy the total dollar
required return

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Pre- and Post-Money Value of the
Firm’s Equity
• Venture capitalists also estimate the value today for the businesses
in which they invest. The implied value of the equity of the firm
today is captured by something called the post-money investment
value.
– The post-money investment value is the focal point for negotiations between the
entrepreneur and the VC. Basically, it provides a shorthand way to describe the
structure of the VC deal.

• Venture capitalists also use the term pre-money investment value to


refer to the difference between the post-money implied value of the
firm’s equity and the amount of money that the venture capitalist
puts in the firm.

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VC Method Example: Bear-
Builders
• The entrepreneur started the business last year
with an initial investment of $1 million, and now
needs an additional $2 million to finance the
expansion of its already profitable operations. To
raise the funds, the entrepreneur approaches
Longhorn Partners, a hypothetical venture capital
firm located in Austin, Texas.

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VC Method Example: Bear-
Builders
Investor Expectations
• Longhorn Partners believes the opportunity is good
and is willing to provide the $2 million, in exchange
for a share of the common equity in the company.
Now the key question is, “How much stock will the
entrepreneur have to give up to acquire the
needed funds?” This is first-stage financing, so
Longhorn Partners’ required (i.e., hoped-for) rate
of return is 50% per year based on a 5 year
investment horizon.

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VC Method Example: Bear-
Builders
Valuation Assumptions
• Forecast of EBITDA for Bear-Builders in year 5:
$6million
• Comparable companies EV/EBITDA 5.0x
• Bear-Builder’s projected Balance Sheet at year 5
includes $300,000 in cash and $3million in
interest-bearing debt.
• Calculate Ownership Interests based on this VC
financing, also consider impact of staged investing.

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VC Method Example: Bear-
Builders

• Computing Ownership
Interests: Under this deal
structure, the founder will
own the remaining 44% of
the common stock (100% -
56% = 44%), which would
entitle him or her to shares
worth $12,112,500 in five
years.

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Pre- and Post- Money Value of
the Firm’s Equity

• Venture capitalists also


calculate the implied value
(post-money investment
value) of the firm’s equity
after the investment
• The post-money investment
value is used to calculate the
pre-money investment value
of the firm and thus provide
a shorthand way to describe
the structure of the deal

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Refining the Deal Structure

• Negotiations between the venture capitalist and


entrepreneurs are vital for both sides. Investors
want to see maximum return on their money while
entrepreneurs want to retain as much ownership
as possible while obtaining the maximum invested
capital.
• Two possible alternative deal structures are
discussed:
– The use of staged financing commitments
– The issuing of different types of ownership securities

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Refining the Deal Structure
(Continued)
• Using staged-financing commitments
– The risky nature of entrepreneurial ventures and the
overly optimistic cash flow forecasts require venture
capitalists to set required returns very high
– In order to reduce some of the investor’s risk, financing is
made in partial payments which are dependent upon
performance measures
– If the committed performance measures are not met, or if
the investment no longer looks favorable, the investor
may choose to not make further investments into the
business
– By giving the investor the option to pull out of the
business, the venture capitalist is willing to provide
financing at a lower rate of return

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VC Method Example: Bear-Builders
Staged-Investment Alternative

• Now assume VC invests $1 million initially (still requiring a 50%


ROR) but invests the second $1 million two years later, on the
condition that the firm has achieved certain performance
benchmarks. Because the second-stage investment is less risky than
the first, we assume that the VC requires only a 30% return on this
second infusion of capital.

• The VC now requires $9,790,750 for his or her $2,000,000


investment, which represents $9,790,750/$27,300,000 = 36% of
the value of the firm’s equity at the end of five years.

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Refining the Deal Structure
(Continued)

• Using debt or preferred stock


– Issuing debt or preferred equity is another way
for entrepreneurs to reduce the venture
capitalists risk exposure
– The first place position of debt and preferred
shares reduces the financing need and thus
equity stake taken by the venture capitalist

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VC Method Example: Bear-Builders
Preferred Stock Alternative
• Assume company issues convertible preferred stock with a dividend rate of
8%, or an annual dividend of $160,000 ($2 million × .08 = $160,000). The
preferred stock can be converted into the firm’s common stock at the
discretion of the VC. If the VC wants a 40% return and the investment
horizon is five years, the cash flow stream to the VC consists of the
following:

• If the preferred shares can be converted into $9,003,386 worth of common stock, then the VC’s $2
million investment will realize the VC’s desired 40% annual ROR. The VC will be given 32.98% of the
firm’s shares that were earlier valued at $27,300,000—a substantial savings over the 56% ownership
share that was required when using common stock.

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LBOs – Overview

• LBOs represent a business acquisition strategy


whereby an investor group acquires all the equity
of a firm and assumes its debts
– The investment is predominantly financed with debt (50-
80% of total capital structure)
– The leveraged nature of the acquisition structure forces
management to run operations at maximum efficiency to
service debt
– The lure of leveraged returns attract investors

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Alternative LBO Acquisition
Strategies
• Bust-up strategy
– Once control of company is complete, assets are
sold off to repay debt used to finance the
acquisition
– Objective is to increase efficiency in operations
– Very popular in the 1980’s
• Build-up strategy
– Objective is to create a large public company
through the purchase of a “platform company”
upon which further acquisitions are made
– Gained popularity in the 1990’s

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Valuing LBO Investments

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LBO Example: PMG

• The principals of our hypothetical private equity firm, Hokie


Partners LP, are considering the acquisition of PMG Inc., an
electronics firm that manufactures printed circuit boards used
in a wide variety of applications. PMG is a wholly owned
subsidiary of a large chemical company that has decided that
the business is no longer critical to the firm’s future success
and seeks to sell PMG to the highest bidder.
– PMG current EBITDA of $100 million; expected
purchase price equal to 5x the current level of
EBITDA, or $500 million.

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LBO Example: PMG

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LBO Example: PMG

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LBO Example: PMG

Table 10.2 (cont.)

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LBO Example: PMG

• Transaction requires an investment of $500 million, and if all works as


planned, it will produce an EBITDA of $161.05 million in 5 years.
• Under this scenario, Hokie Partners will sell PMG for the projected 6x
EBITDA, which implies a value of $966.31 million and an equity value of
$715.37 million (net of the outstanding debt in Year 5 of $250.93 million).
• Given these projections, the equity investor’s original $125 million
investment grows to $715.37 million in 5 years, which represents a
compound annual rate of return of 41.75%.
– This should be viewed as a hoped-for (rather than expected) return, based on a
scenario where EBITDA grows quite quickly and the firm is sold for a higher
multiple than was paid for it.
– The returns are also quite high because they represent the returns to a highly
levered equity investment.

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LBO Example: PMG

• To understand the effects of financial leverage on


the equity return, we consider the unlevered
returns on this investment given this same
scenario.
– If the equity investor put up the full $500 million
acquisition price, then the investment would have thrown
off cash flows each year equal to the principal and after-
tax interest.
– Again assuming the firm sells for $966.31 million after 5
years, the compound annual rate of return is only 22.46%
per year.
– This rate of return is still high, but much lower than the
41.75% levered-equity rate of return.

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LBO Example: PMG

• We can consider the returns on this


investment under a much less favorable
scenario where the EBITDA growth rate is
4% rather than 10% and the EBITDA
multiple in Year 5 is only four instead of 6x.
– In this scenario, the equity holders realize a
value in five years of only $156.95 million,
which implies a levered return of only 4.66%.
– In this less-favorable scenario, the unlevered
return is 7.90%, which exceeds the levered
return but is not spectacular.

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“Add-On” Investment Example:
PowerPak
• This acquisition differs from the platform-company acquisition in two important
respects. First, it is a much smaller company, with annual EBITDA of only $12 million in
the current year. Small companies are often acquired for lower price multiples, and we
will assume that in this case, Centex can be purchased at 3x EBITDA, or $36 million.
Adding the relatively cheap assets of the add-on firm to the more highly valued
platform company and selling them for the higher multiple of the platform company in
five years provides added value, which private equity firms refer to as multiples
expansion.

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“Add-On” Investment Example:
PowerPak

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“Add-On” Investment Example:
PowerPak
• If no debt had been used and the combined purchase price of $536 million had been
raised through equity financing, the combined Equity FCFs for the platform and add-on
investment would have been the following:

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“Add-On” Investment Example:
PowerPak

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“Add-On” Investment Example:
PowerPak
Table 10.5 (cont.)

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Valuing PMG Inc. Using the
Hybrid APV Approach

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Valuing PMG Inc. Using the
Hybrid APV Approach

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Valuing PMG Inc. Using the
Hybrid APV Approach
Table 10.6 (cont.)

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Private Equity Value Drivers

There are five drivers of value in the example just discussed:


1. Estimate of the first year’s EBITDA
2. The anticipated rate of growth in EBITDA for each year of the
planning horizon
3. The level of capital expenditures required each year
4. The EBITDA multiple used to estimate the terminal value in
five years
5. The unlevered cost of capital

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Private Equity Value Drivers

• The simplest form of sensitivity analysis involves calculating the critical


values of each of the five value drivers to determine the level of each
required to produce an equity value for the investment equal to the $125
million investment. The results are as follows:

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Summary

• Private equity firms are becoming an increasingly


important source of capital
– start-up firms
– more mature firms going through transition
• Private equity firms evaluate their investments
using a variant of the hybrid valuation approach
focused on the valuation of equity investment
– Since there are generally no planning period cash flows to
the equity holders, the focus of the valuation is on the
firm’s terminal value, which is usually calculated as a
multiple of EBITDA

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Summary

• Private equity firms take use very high discount rates, reflecting the
fact that they are used to discount cash flows that are likely to be
overly optimistic.
• These investments should have high expected rates of return, given
their high risk and illiquidity.
• Investors often evaluate optimistic hoped-for cash flows.
– Valuation approaches taken in practice often differ from those
recommended by academics.
• We recommend that in situations where private equity investors
have estimates of expected cash flows, rather than hoped-for cash
flows, they evaluate the investment using the APV approach.
– Although this approach is not widely used in the private equity industry,
it is appropriate, given that most of these transactions involve a
substantial amount of initial debt that is paid down fairly quickly over the
planning period.

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