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Lecture 8:
Private Equity
Outline 2

0. Motivation

1. Economic Framework

2. In Practice
 Motivation
Problem: Private equity is a growing asset class that is controversial, yet
highly sought after…. 3
 Motivation 4
There are many questions we want to answer:
• How does the market for private equity work?
• How well does this market function? Create or destroy or just transfer value
across stakeholders?
• What are the institutional features of the PE industry?
• How do PE firms make money? How does PE affect non-investor stakeholders?
• Should private equity be governed like public equity?

Why should I care about answering these questions?

1. Relevant for many careers
 Operations / Consulting – improve operations with PE firms and/or to preempt
PE buyouts!
 Sell side / buy side – leveraged transactions are becoming more common
2. Helpful for forming your own views on many world events
- for example, should private equity by regulated?
 Motivation 5
There are many questions we want to answer:
• How does the market for private equity work?
• How well does this market function? Create or destroy or just
transfer value across stakeholders?
• What are the institutional features of the PE industry?
• How do PE firms make money? How does PE affect non-investor
stakeholders?
• Should private equity be governed like public equity?

Can we answer these questions using intuition alone?

 Intuition is insufficient; much of the controversy surrounding PE (such
as dividend recaps) reflects a poor understanding of the key issues

Can we rely on statistical approaches to understanding PE?

 Statistics are widely used for valuation purposes, but other aspects of the
industry require deeper tools for understanding
Economic Approach
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Because intuition and statistics are helpful, but not fully

sufficient for understanding private equity, we will use
economics to help guide us.

1. We will first understand the institutional setting of private

equity.

2. Then we will develop an economic framework to answer

key questions in the PE space.

3. Finally, we will examine how this framework can be used

in practice.
Institutional Background
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Institutional Background
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How to value portfolio companies?
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 Our economic approach to valuation (APV, WACC) can help us

understand how PE firms generate profits for themselves, and whether
they create / destroy / transfer value

 Example 1a: The Singer Corporation has a debt-to-value ratio of 10%.

The firm’s revenues are $500,000 per year forever and its operating
costs are $360,000 per year forever. The firm’s cost of debt is 10%
and its cost of equity is 21%. The firm has 100,000 shares outstanding.
The corporate tax rate is 34%.

What is the firm’s value? Its stock price?

How to value portfolio companies?
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 Example 1b: You are a partner at CCR, a well-known leveraged buyout

firm. You believe that Singer is highly underleveraged. Precisely, you
believe that Singer’s optimal debt-to-value ratio is 25%. The firm’s cost of
debt at this debt-to-value ratio is 12%. You are considering buying all of
Singer’s shares and increasing the firm’s leverage until it has reached its
optimal capital structure.

What is the maximum premium you are willing to pay for Singer’s shares?
Use APV and WACC to solve this problem.

** Is the PE firm creating value or simply transferring value from another

stakeholder?
Valuation in practice
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 In practice, PE firms infrequently use APV or WACC methods of

valuation

 Why?

 There are many reasons that stem from PE’s institutional setting:
 Leverage is very high/complex -> hard to estimate discount rates
 Distress is very likely -> ignoring this is costly
 Closed-end fund structure -> liquidity risk
 Short time horizon -> long term growth rates hard to calculate
Alternative Approach: Equity Cash Flows +
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IRR’s/Multiples
 Instead of using free cash flows, you can directly estimate the cash flows
that equity holders expect to receive
 As an aside: you can show the equivalence between this method and APV

 Examples 1a and 1b: Use equity cash flow to value the PE investment

 Rather than use DCF analysis, PE firms will rely on IRR’s and multiples
Practical Approach to valuation
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 In practice, PE investors will look for target companies and…
 Formulate an investment hypothesis: Spell out the economics of a potential
deal: how would the buyer and the seller benefit? What are the main risk
factors? What are the drivers of returns for the PE firm? Typically PE firms
look to benefit from tax shields, operating improvements, and pricing
inefficiencies
 Construct a simple LBO model based on equity cash flows and IRRs/cash
on cash multiples
 We’ll see an example of this with the Dupont performance coatings sale
 A typical PE interview consists of industry case studies and a
demonstration of LBO model mechanics…to see if you will be able to help
the firm identify and manage profitable deals
Governance in private equity
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 Private equity is not subject to the same government regulations as

public equity.

 This has caused some controversy, as major PE funds have

collapsed in recent history due to fraud

 What are some of the pros and cons of equity regulation?

 Summary
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Private equity is a rapidly growing asset class

Controversial: Dividend recaps, layoffs, liquidations

We have studied:
- Institutional setting of PE
- Economics of value creation in PE
- PE valuation in practice and why it differs from standard valuation methods
- Governance issues in PE

Economic framework for understanding private equity can help us make sense of the
controversies and workings of this important asset class