NOTEBOOK

PRIVATE EQUITY
2022/2023

AUTHOR1 | Vasco Ribeiro Tamen

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Based on Prof. Luis Mota Duarte’s Classes, “My PE Bible” Notebook from last semester and other
resources.
TABLE OF CONTENTS
I. Introduction to Private Equity (PE) .................................................................................. 3
1. Private Equity Strategies ................................................................................................... 3
1.1. How a PE fund makes money? ............................................................................................... 4
1.2. PE Lifecycle ........................................................................................................................... 4
1.3. Types of PE Investment for Limited Partners......................................................................... 5
1.4. PE Fund Performance Metrics ................................................................................................ 6
2. Basics of Leverage Buyouts (LBO) .................................................................................. 6
3. Key Drivers of PE returns ................................................................................................. 7
II. Due diligence .................................................................................................................... 8
1. Key areas of Focus and Objectives ................................................................................... 8
2. Comercial DD ................................................................................................................... 9
3. Technical DD .................................................................................................................. 10
III. Deal structuring ............................................................................................................. 12
1. Sources and Uses............................................................................................................. 12
1.1. Uses ...................................................................................................................................... 12
1.2. Sources ................................................................................................................................. 12
1.2.1. Debt Sourcing............................................................................................................................. 12
1.2.2. Equity Sourcing.......................................................................................................................... 17
1.3. Conclusion and Pratical Example ......................................................................................... 20
2. Debt Terms ...................................................................................................................... 21
3. Valuation ......................................................................................................................... 25
3.1. Determining Equity Value .................................................................................................... 25
3.2. Locked-Box & Completion Accounts .................................................................................. 27
IV. Leverage Buyout Model (LBO) .................................................................................... 29
V. Governance & Exit ............................................................................................................ 31
1. Governance and Portfolio Management .......................................................................... 31
2. Exit .................................................................................................................................. 32

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 I. INTRODUCTION TO PRIVATE EQUITY (PE)
Private equity capital is equity capital that is not quoted on a public exchange. Private equity
investors or funds make:
• Investments directly into private companies
• Buyouts of public companies that result in a delisting of public equity (P2P)
Investments are generally made through a Fund Partnership (except with Angel Investors2) with
the following characteristics:
• Closed-end3 investment structures
• Terms and conditions defined in a Limited Partnership Agreement (LPA)
• The term of a fund ranges between 10 and 12 years

1. Private Equity Strategies

Capital for private equity is raised from retail and institutional investors and can be used to fund:
• Start-ups (Venture Capital): Acquiring minority interests (holds < 50% of voting stocks)
in the early stage. Promising companies exhibiting CFs<0 (high growth).
• Make acquisitions (growth equity, buyout): acquisition of a controlling interest (holds the
majority of voting stocks) in a company with a significant amount of debt.
• Strengthen a balance sheet (special situations)

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rich people that use their own capital
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type of mutual fund that is closed to new investments as all were made through a single IPO (in this case,
since PE are private, it is through an LP Agreement). Its shares can then be bought and sold directly to the
initial LPs (“Limited” Partners), but no new shares will be created.

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 1.1. How a PE fund makes money?
A private equity firm is called a general partner (GP) and its investors that commit capital are
called limited partners (LPs).
GP invests the fund’s committed capital in public and private companies, manages the portfolio
of investments, and seeks to exit the investments in the future for sizable returns.

Fees
General partners generally charge both a management fee and a performance fee.
• Management Fee: 1.5-2% of total capital commitments until the end of 5 years, and then
2% of unreturned funded capital thereafter (declining as investments are sold or realized)
• Performance Fee (or Carried Interest): incentive payment that will be paid (after a
Preferred Return is obtained by Limited Partners) to create an 80/20 split in profits
between Limited Partners and General Partner
Portfolio Companies usually pay directly to the private equity firm some fees or expenses.

1.2. PE Lifecycle

Intense fundraising period while searching for new investment opportunities (typical 10 to 20 per
fund). Avoid concentration of vintage4. It is usually the recruiting period also.
Bridge between Investment and Divestment Period: “Busy” 4-6 years with overlap of new
investments, portfolio management, exits (of initial investments) and new fundraising.

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year in which a fund began making investments.

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Investment Process

1.3. Types of PE Investment for Limited Partners

Secondary Investments
A private equity secondary market enables Limited Partners and new investors to buy and sell
private equity investments or remaining unfunded commitments to funds.

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 1.4. PE Fund Performance Metrics

Discount rate that makes investment 𝑁𝑃𝑉 = 0

IRR Standard performance measure for PE investments due to its capturing of timing
effect of CFs.

Used to value PE funds. The NAV is often referred to as a fund's residual value,
as it represents the value of all investments remaining in the portfolio.
Net Asset Since private equity investments are not listed, the NAV relies on estimates made
Value by general partners, who re-evaluate the underlying assets periodically (typically
(NAV) audited by third parties), using DCF, comparables and multiples methods.
It’s a bottom-up technique where portfolio firms are valued separately and then
summed up to reach PE Fund’s value

Express an LP’s returns of an investment as multiple of its costs, however it does

not consider the timing of CFs.
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑
𝑀𝑀 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑆𝑝𝑒𝑛𝑡
Two commonly used multiples:
Money
Multiple • Total value to paid in (TVPI): fund’s total value as a multiple of its cost.
(MM) 𝛥 𝑁𝐴𝑉
𝑇𝑉𝑃𝐼 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡
• Distributed to paid in (DPI): distributions relative to capital called5.
𝐶𝑢𝑚. 𝐷𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠
𝐷𝑃𝐼 = 𝐶𝑎𝑝. 𝐶𝑎𝑙𝑙𝑒𝑑
⟹ 𝐷𝑃𝐼 > 1 ⟹ Investor has broken even

It’s a performance measure net of man. fees and carry.

PE performance is best measured coupling IRR with Multiples as together they measure
performance and allow timing considerations.

2. Basics of Leverage Buyouts (LBO)

Acquisition of an operating company with a significant amount of borrowed funds to create value
by realizing opportunities and improving efficiencies, etc. (use debt as financial leverage).
• The purchased company's balance sheet is leveraged to reduce the investor's cash equity
commitment using the assets of the firm as collateral.

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amount of funds from the commitment that is called up by the PE fund for making investments (and paying
the fund fees).

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 • The LBO firm will seek to exit their investment within 3-7 years. Exit strategies are
principally M&A sales or IPOs.
Targeted IRRs are >20-25% or Money Multiples >2.5x
• Prospective LBO candidates:
− Divisions of large corporations become free-standing.
− Private companies acquired from founders.
− Publicly held companies that are taken private.
− Secondary transactions

3. Key Drivers of PE returns

Deleveraging Effect: cash generation of the company throughout the ownership period.
Growth in EBITDA: operating growth in revenues and/ or cost benefits throughout the
ownership of an asset
Multiple arbitrage: improvement in the valuation multiple applied to the sale of the specific
asset. This can reflect non-company specific dynamics and might be a result of general macro
movements and/or specific sector movements/cycles.

Example:

Initial investment of 350 resulted in final proceeds of 1,250:

• 400 were originated from operating growth (EBITDA grew from 100 to 150),
• 300 from an increase in general sector valuations or improvement in the Company’s
competitive position (from 8x to 10x)
• 200 from cash generation in the business (net debt decreased from 450 to 250)

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 II. DUE DILIGENCE
Due Diligence (DD) is a process whereby a buyer conducts a comprehensive appraisal of a
business, especially to establish its assets and liabilities and evaluate its commercial potential.
• Long (4-12 weeks) and resource-heavy (costs 1-3% of EV, rule of thumb)
• It is conducted only after an agreed buyer and seller degree of commitment
• DD is permanent. You are always assessing the business and its team
• Full-blown DD only starts after a non-binding offer.

1. Key Areas of Focus and Objectives

Main areas of focus are Commercial, Financial, Legal, Tax, and Operational.

Key Objectives

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2. Commercial DD
Commercial due diligence is the process through which a buyer analyses a target company to
investigate the overall context of the company, based on its positioning in its market(s), and how
that is likely to evolve in the years ahead.
Key Areas
Target’s real business
• Segments and Products
• Profitability: Historical and Current Op. and Fin. performance
Market structure, size, and growth of target’s key businesses
• Size of the overall market and key segments
• Growth drivers of key segments: Outlook in 5y of those growth drivers
• Revenue growth: outlook of the overall market in 5y
Competitive position of the target
• Scenario of competitiveness in each segment: Barriers to entry (and protection measures)
• Market share in each key segment: current and expected
• Customer satisfaction/attraction compared with the competition
Forecasts & Risks, target and ours
• Target’s Management 5y forecasts and assumptions
• Your 5y Base, Low & High forecasts considering Market and Competition outlook
• Major risks in these 5y forecasts
Value Creation opportunities and respective implementation process
• Major opportunities: Strategic, Operational (Revenue, Cost, Cash), Organizational, and
Financial
• Degree of value creation available in major 5y full-potential levers
• Main requirements to deliver these main levers (e.g.cash, people, time, focus)

Good Commercial DD

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Value Creation Strategies

3. Technical DD

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 III. DEAL STRUCTURING

When a private equity company

acquires a target company, they
first must create a EquityCo (new
company) with 80/20 split between
Fund and Management.
EquityCo, in turn, purchases the
target company through DebtCo,
another created company.

1. Sources and Uses

1.1. Uses
First, PE firms need to compute the value needed to perform the transaction (Uses), so that they
can find ways to source it.
• Purchase Price: 𝐸𝑉 = 𝐸𝑛𝑡𝑟𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 × 𝐸𝐵𝐼𝑇𝐷𝐴
The first step is to figure out the entry multiple and the appropriate financial metric.
• Fees: Bank, DD, Arrangement, Banking, or even to GP. Usually around 3% EV.

1.2. Sources
We need to Source funds for a transaction. Where does the money come from?
• Debt Sourcing
Senior debt: Term Loan A, Term Loan B, Term Loan C
Subordinated debt: Mezzanine Debt, last to be paid before Equity holders
• Equity Sourcing
Fixed Return Instrument (FRI): Preferred Shares - Non-Tax Deductible, or Sub Loans -
Tax Deductible
Ordinary Equity: Institutional Orders (Ordinary shares) and Sweet Equity.

1.2.1. Debt Sourcing

Leverage Effect

Higher Debt ⟹ Higher Equity Growth Potential ⟹ Higher Returns but Higher Risk
Debt decreases nominal taxes because tax shields ⟹ Higher Enterprise Value

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Key Factors to determine leverage:

Types of Debt Sourcing

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Additional Concepts
RCF: Revolving Credit Facility is financing arrangement that provides a borrower with access to
a line of credit that can be drawn upon as needed. It is kind of a credit card for companies…
Liens: legal claims to collaterals. They have different levels based on the type of lender.
LIBOR: London Interbank Offered Rate, interest rate index used to adjust floating rate loans.
LIBOR floors are usually established to protect lenders from falling interest rates.
Loan Underwriting: To underwrite is to access how much money an entity can borrow and what
is the risk for the lender. There are multiple ways to do so:
• Underwriter deal: Underwriter guarantees to purchase all securities offered for sale by
issuer regardless of whether they can sell them to investors. It is the most desirable
agreement because it guarantees all the issuer's money right away.
• Best effort syndication: Arranger(s) uses its “commercially reasonable efforts” to arrange
a syndicate6 of lenders but does not commit to funding the entire loan amount.
− Reverse flex: when the arranger has more lenders willing to commit to the loan
facility than the borrower needs (Demand > Supply).
In this case, the arranger can alter the economic terms of the proposed facility
(interest rate margin, LIBOR floors, OID7) to make it more favorable to the
borrower and then ask whether the interested lenders will recommit to the facility
with its modified terms.
− Market flex: instead of used to decrease demand, it’s used to increase it.
• Club deal: Refers to a deal that involves two or more private equity firms.

Best effort
Underwritten deal Club deal
syndication

Medium (+ risk of failure

Certainty High Low
but certain if taken forward)

Confidentiality High, info only shared Medium, info shared with Low, info shared
of commitment with underwriter enough club members with all lenders

Credit Ratings Required Not required Highly preferable

MLA8 Role Control negotiation Only Provides capital Lead negotiation

Uncertain due to the Some, no underwriting fees Lower underwriting

Cost volatility of flex but club fees, which are fees (uncertain
provisions higher Market OID)

Small to EBITDA of
Size EBITDA of +$25m EBITDA of +$25m
$100m

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To syndicate: To provide a loan in group (group lending).
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OID: Original Issue Discount, is the ratio of the excess (if any) of the stated redemption price at maturity
(SRPM), over the issue price (IP). I.e., shows difference between a bond’s original FV and discounted price
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MLA: Mandated Lead Arranger, is the investment bank or underwriter firm that facilitates and leads a
group of investors in a syndicated loan for major financing.

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Loans vs. Bonds

Loan Agreements

Contractual Subordination
• Senior and Junior creditors will have their loans on the company that directly purchases
the Target, aligning it with an Intercreditor Agreement
• Equity holders (PE) will own the company that subscribes to the Senior and Junior loans
company (owner of the target)

Structural Subordination
• Senior creditors will have their loans on the company that directly purchases the Target
• Junior creditors will have their loans on the company that subscribes the Senior loans
company.
• Equity holders (PE) will own the company that subscribes the Junior loans company
(owner of the target)

Intercreditor Agreement: Governs relationship between different credit groups (order of priority,
subordination, control, standstill periods payment blocks).

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Lender protection mechanisms

Examples:

Financial Covenants
Covenants are a set of agreed-upon conditions or restrictions that are included in loan agreements
or bond indentures. These covenants serve to protect the interests of the lender and ensure the
borrower's compliance with certain financial and operational obligations.

Cash Cover Leverage Cover Interest Cover

𝐿𝑇𝑀9 𝐶𝐹 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝐿𝑇𝑀 𝐸𝐵𝐼𝑇𝐷𝐴

𝐶𝐹 𝐷𝑒𝑏𝑡 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐿𝑇𝑀 𝐸𝐵𝐼𝑇𝐷𝐴 𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠

Borrower should maintain a

level of CF that allows to pay The borrower should maintain a minimum level of EBITDA
its debt obligations (interest to service its debt (set as agreed % headroom to EBITDA).
and principal repayments).
Indicates the ability to service the debt.
Should be around 1 to 1,2

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Last twelve months

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 1.2.2. Equity Sourcing
A key success factor in Private Equity transactions is the alignment of interests between the PE
fund and management. This alignment is achieved through appropriate remuneration packages:
• The fund ensures downside protection.
• Management Package: Salary, Sweet Equity, Co-Investment

Thus, Equity now subdivides into, at least two components. Check the following example:

Institutional Strip (Co-investment)

Total capital provided by PE investors to facilitate leveraged buyout. That is the cash injected into
EquityCo from the PE company. This investment may come from the Fund Investment or
Management Team which has a stake in the company.

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It can take various formats, but these are the most common:
• Fixed Return Instrument (FRI): financial instruments that provide a predetermined fixed
rate of return to investors. They are used to assure a constant source of CFs.
Example: Preferred Shares10 or Sub Loans

• Institutional Orders: allocation of shares or securities to institutional investors, such as

mutual funds, pension funds, and large investment firms.
Rollover is the Management’s investment in EquityCo. Instead of cashing out their entire
ownership interest, the prior management team may choose to roll over a portion of their equity
into the newly formed entity or the acquiring company.

Sweet Equity
Form of compensation in which individuals contribute their time, effort, or expertise to a business
or project in exchange for equity ownership or a share of the company's future profits. In PE it is
used to motivate Management and compensates for the cash investment (co-investment) usually
demanded by PE.
Usually represent 10-20% of Ordinary Equity financing in PE deals.

Due to transaction fees, management equity and part of FRI do not have value on Day 1:

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Preferred equity holders receive their dividends before common equity holders and have a higher priority
in the event of liquidation or sale of the company.

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The better the growth/success the higher the Sweet Equity and incentives for Management

Envy Ratio
In private equity, the envy ratio is a ratio that shows the price paid by investors relative to the
price paid by the management team for their respective shares of the company's common equity
𝐼𝑛𝑠𝑡𝑢𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟 𝐸𝑞𝑢𝑖𝑡𝑦
𝐸𝑛𝑣𝑦 𝑅𝑎𝑡𝑖𝑜 (𝐸𝑅) = 𝐼𝑛𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛𝑎𝑙 𝑆𝑡𝑎𝑘𝑒
𝑆𝑤𝑒𝑒𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑆𝑤𝑒𝑒𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆𝑡𝑎𝑘𝑒
Stakes are % of ordinary shares.
MIN: Management should invest 1 year of salary

99.4+0.8
0.8
Consider the example at the beginning of the sub-chapter: 𝐸𝑅 = 0.2 = 125
0.2

Alternative Management Incentives

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 1.3. Conclusion and Practical Example
"Sources and Uses" refers to the breakdown diagram of where the funds for a transaction come
from (sources) and how those funds are allocated (uses).

Step to build:
1) Purchase Price: 𝐸𝑉 = 𝐸𝑛𝑡𝑟𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 × 𝐸𝐵𝐼𝑇𝐷𝐴 in Uses.
2) Total Debt (dividing it in tranches) in Sources and corresponding Fees in Uses.
When determining how much debt capacity a company has, investor judgment is required
to gauge the amount of debt the company could handle. Typically, a private equity firm
attempts to raise as much senior debt (i.e., from bank lenders) before raising any other
types of debt that tend to be costlier.
The total debt multiple should never surpass 6,0x since it is unrealistic.
3) Get Total Uses = EV + Fees
4) Total Sources = Total Uses and then get Total Equity = Total Sources−Total Debt
5) To divide the equity value between Sweet Equity and Institutional Strip we need to make
some assumptions.
Determine the value of Sweet Equity and assume % Ordinary Equity that is Sweet Equity
(usually 20%). The rest of the total equity is considered FRI.

Note: Maximum leverage and covenants are set on the Bank Case – a more conservative case only
used for these purposes. Nevertheless, the proposed debt structure should also be tested on the
Investment Case and Management Case

However, to value the target firm, we still need to get the following input and outputs working:

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2. Debt Terms
Usually, it depends on the banking institution discussions but we should forecast it accordingly.
Check the following example:

Step 01: Define the Debt term and pricing.

• The maturity of each debt is an assumption. However, bear in mind that usually the higher
seniority of the debt element, the higher will be the maturity. As a result, Tranche B debt
often has a longer maturity than Tranche A to reflect the increased risk.
In practice, the maturities are determined based on factors such as the creditworthiness of
the borrower, market conditions, investor demand, and the overall risk profile of the
transaction.
• Each debt amounts and respective EBITDA multiples are taken directly from the Sources
and Uses.
• 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = 𝑆𝑤𝑎𝑝 𝑅𝑎𝑡𝑒 + 𝑆𝑝𝑟𝑒𝑎𝑑
The swap Rate is a benchmark interest rate as EURIBOR or LIBOR
Spread is the margin of the lender.
• When the type of debt can have cash and non-cash payments (such as Mezzanine) we
usually have a cash and PIK (payment in kind) interest rate.
• Fixed Return Instruments (FRI) is equity injected into the company from the PE firm's
perspective. However, from the company's perspective, this money is seen as a loan since
it will have to pay interest (PIK only - banks do not allow a cash interest) and repay it at
maturity. For simplicity, this line is shown here.

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Step 02: Define the debt repayment schedules.

• Adjust the amortization schedule and maturity of each type of debt. This schedule is an
assumption, although, in fact, it comes from the bank.
For instance, Tranche B is a bullet debt so there is no principal repayment over the years,
i.e. the principal is all paid at maturity.
• 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒
• 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 % × 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐴𝑚𝑜𝑢𝑛𝑡
Recall that at maturity 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 < 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡. Thus, you only
pay the 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒.
• 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒𝑡+1 = 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒𝑡 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑡
• For amortizing types of debt, the average life of the bank facility is the weighted sum of
the % of total facility amortized. It represents the length of time the principal of a debt
issue is expected to be outstanding.
For the example above it is: 1 × 15% + 2 × 15% + ⋯ + 6 × 25% = 3.75
• For types of debt that allow non-cash payments, we need to add the PIK interest. This is
then summed up in the closing balance, then the facility amount will increase over time.
At maturity, the company has to pay the initial balance + PIK Interest.

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Step 03: CAPEX facility Terms

• Maximum CAPEX needed is the sum of the Expansion CAPEX forecasted by the
company for the drawdown period.
• Drawdown Period: duration during which the borrower can access the funds from the
CAPEX facility. The drawdown period is typically specified in the loan agreement and
can vary depending on the terms negotiated between the borrower and the lender.
Until the end of the Drawdown Period: 𝐷𝑟𝑎𝑤𝑑𝑜𝑤𝑛 = 𝐶𝑎𝑝𝑒𝑥 𝐹𝑎𝑐𝑖𝑙𝑖𝑡𝑦 × % 𝐹𝑢𝑛𝑑𝑒𝑑.
Recall that in the last year, you can only pay the rest of the facility funded.
During this period, we need to pay:
− Commitment Fee: fee charged by the lender to the borrower for the unused
portion of the facility. It compensates the lender for keeping the facility available
to the borrower, even if the borrower does not fully utilize the entire amount.
− 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒
• Repayment Period: Period to repay the fund “draw downed”. Now the procedure is the
opposite. The way it is repaid is explained in the repayment terms.
In the example above, they used a fixed repayment schedule (i.e. 1/3 each year).

Step 04: Forecasting Financial Statements with the debt structure proposed.

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 • Retained Earning is always last year + Net Income.

• Changes in NWC and Maintenance CAPEX are allocated as % Sales

• Total Cash Interest does not include PIK elements.

Step 05: Compute the Covenants

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3. Valuation

3.1. Determining Equity Value

To compute the Enterprise Value (EV) we can use the following models:
• Core valuation methodologies: LBO Valuation, Trading, and Transaction Comparables
• Other valuation methodologies: DCF, Consensus share price, Regression analysis
• Multiples Analysis: EV/EBITDA, EV/EBIT, EV/(EBITDA-Maintenance Capex).
EBITDA is the best market proxy for cash, that’s why it’s used.
− Reported EBITDA: Directly taken from accounts.
− Normalized/Adjusted EBITDA = Reported EBITDA – Nonrecurring items
− Run-rate EBITDA: Normalized EBITDA taking into account the full-year and/or
maturity effects of new stores/functions/operations.

To compute the Equity Value, which is in fact the price that one shareholder would pay for a
company, we need to do the following adjustments:

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Net Debt
𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐵𝑒𝑎𝑟𝑖𝑛𝑔 𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ

Other debt-like items are usually not easy to recognize and have to be derived through additional
calculations (check “Notes to financial statements” in Annual Reports).
• (Un)Funded Pension liabilities • Bank overdrafts
• Industry-specific long-term liabilities • Tax accruals
• Potential claims/contingent liabilities • Employee stock options
• Litigation • Golden parachutes
• Provisions • Exit bonuses

Working Capital Adjustments

The purchase price depends on two key factors:
• Enterprise Value: fixed price based on certain working capital assumptions.
• Net Debt can change over time and is influenced by a changing level of working capital.

As working capital changes continuously, the level of working capital at the effective date is most
likely different from the assumed level. But how will this affect the Equity Value?

Imagine the example above, where 𝑁𝑊𝐶 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠.

If we buy the company in the middle of the year my level of working capital will be the maximum,
which means that I used cash to buy inventory. If cash decreases, Net Debt increases, therefore
the equity value will increase.
In fact, the movement in cash is opposite to the movement in working capital, which causes
changes in the purchase price for shares.
Thus, one way to avoid this effect of ∆𝑁𝑊𝐶 is by adding/subtracting the difference from the
average level (reference level).

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Conclusion
The Equity Value of a Business (i.e. Proceeds for
the seller) will be determined using the Equity
Bridge, which deducts all debt and debt-like items
from EV and adds any cash and cash-like items
Significant value can be “hidden” in the Equity
Bridge and the level of subjectivity and negotiable
items is significant.

3.2. Locked-Box & Completion Accounts

EV is computed based on the actual financial statements of the Locked-

Box date (before signing). No further adjustments are required post-
completion.
• Risk transfer happens before completion.
• Seller has full control over accounts ⟹ Seller Friendly
• Buyer typically receives a cash payment (“interest on equity”) to
compensate for the time between locked-box and competition.
• After BS is locked, there are no transfers to shareholders. Typically,
Locked-Box an indemnity is sought, and leakage definitions are extremely tight.
Key advantages:
• Speed/certainty of execution/price
• Simplicity and relatively cheaper (no completion account
adjustment)
Key disadvantages:
• Significant level of assumptions
• Increased level of warranties/indemnities

EV is computed based on the estimated financial statements. Debt and

Cash adjustments are done post-completion.
• Risk transfer happens post-completion.
• Typically, cash is held in escrow to ensure sufficient funds.
• Buyer has full control over accounts ⟹ Buyer Friendly
Completion Key advantages:
Accounts
• Accurate true-up at the completion
• Seller gets cash generation until completion.
Key disadvantages:
• Delay in completion
• Room for dispute (and implied costs)

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The choice of structure goes to the heart of equity value, the certainty of the transaction, and the
speed of completion. Whilst, theoretically both options should yield similar values, in practice,
the difference can be material

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 IV. LEVERAGE BUYOUT MODEL (LBO)
Once an operating model is finalized, it is linked through to an LBO model, which overlays the
acquisition statistics and its respective financing structure onto the operating model, providing
a complete picture of all the variables feeding into the returns analysis.

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Consider the following example. Taking the Sources and Uses and Operating Model into account
we can build this:

Management Proceeds is the 𝑆𝑤𝑒𝑒𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑎𝑛𝑔 𝐼𝑛𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛𝑎𝑙 𝑂𝑟𝑑𝑠

Institutional Investor is the 𝐹𝑢𝑛𝑑 𝐹𝑅𝐼 + 𝐹𝑢𝑛𝑑 𝐼𝑛𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛𝑎𝑙 𝑂𝑟𝑑𝑠

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 V. GOVERNANCE & EXIT
1. Governance and Portfolio Management
Value Creation
Private Equity companies are active asset managers, who provide businesses with additional
resources and other aspects of value add to enable a faster, structurally sound, and more profitable
growth model.
Define the road map to value creation!
• Extensive due diligence, including strategic DD
• Define strategy and value creation plans
• Prioritize initiatives, define responsibilities
• Push for tangible results
• Conduct extensive business planning and scenario analysis

Implement Superior Governance Model

• Active owner mentality, all throughout
• Independent board, with no conflicts or hidden agenda, closely and informally interacting
with the management team
• Management incentive structure
• Alignment of interests
• Analytical, fact-based yet informal and fast decision-making process

Monitor and accelerate performance!

• KPIs, financial and operational consistent with value creation and investment thesis
• Revamp reporting for real-time information
• Invest in resources
• Focus on results and performance
• Implement and manage change when required

Work LBO economics to its full

• Use of leverage – creates positive pressure on management and results
• Rationalize investments in capex, demand adequate returns in an appropriate timeframe
• Optimize working capital, often a black box left untouched
• Sell non-core or non-productive assets
• Time your exit well!

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In general, these are the areas where PE can add value:
2. Exit
Exit Strategies
Strategic Sale
Strategic Sale is when the company you
have invested in is sold to another
suitable company, and then you take
your share from the sale value.
This is one of the most popular exit
routes for private equity funds.
Secondary Sale
Secondary sale is when the private
investors sell their stake in the business
to another PE firm.
Initial Public Offering (IPO)
IPO is when you take the company
public and sell its shares.
This is a way to increase valuation and
liquidity.
Other
• The buyer has a strategic advantage as this
strategy may lead to synergies (economies of
scale and scope), by integrating operations or
business lines.
• For this reason, the buyer will often pay a
premium to acquire such a business.
• Easy diligence process
• New buyer needs to have a solid investment
thesis for future value creation.
• Less risk and a faster method to sell the
business. It is characterized by a full exit,
control, and short regulatory process.
• There are no synergies, therefore the
transaction has lower relative purchase
prices and thus often generates lower returns
than trade sales.
• Support from the management team since they
won’t lose their positions.
• This strategy provides uncertain returns and a
larger exposure to market risk.
• Uncertain timing: depends on capital markets
conditions.
• This strategy is time-consuming, associated
with high costs and regulatory obligations.
• Recapitalizations
• Insolvency
• Multiple partial sales…
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Exit Multiple
A highly sensitive core assumption of any investment.
Basic (most used) methodology: Exit multiple = Entry multiple
Other methodologies:
• Cycle analysis
• Future Trends or new competition set
Future multiple to reflect value creation plan and repositioning strategy (if applicable)
Type of buyer/type of exit strategy

Remember:
Assuming multiple arbitrage growth is plausible but requires hard evidence and a strong rationale
Assuming a reduction in multiple at exit might mean you over-paid or that the market/asset is
becoming less attractive…or that you are just being conservative (be cautious…)
Do sensitivity analysis and consider returns on a risk-adjusted basis (even including the exit
multiple risks)

Contractual Mechanism

Buyers are often looking for complete control of a company. To ensure 100% of the Company is
sold, there must exist contractual mechanisms between minority and majority shareholders:

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