Fundamentals of Private Equity and Venture Capital - PEI Media

GETTING THE MOST OUT OF THIS MODULE
Welcome to Module 5 in the Fundamentals of private equity series. This module
focuses on management and leveraged buyouts. It is designed to work both as a
stand alone section and as part of the whole series. It necessarily draws upon topics
reviewed in earlier modules, and seeks to avoid repetition of their content.
However, for the benefit of the stand alone reader, a comprehensive glossary has
been incorporated, which explains the background and use of private equity terminology.
All terms which may require explanation or expansion are printed in
bold, to indicate that there is a glossary entry for them.
The explosive growth in buyouts over the last
three decades is a direct result of the natural,
inherent strengths of the buyout model. The
essential elements of this model are:
• a close partnership between the management
team of a buyout company and the investors
and lenders who finance its acquisition;
• precise and careful tailoring of the buyout’s
financial structure to the cash and profit generation
characteristics of the company;
• clear objectives, shared between management
and investors, which enable a high degree of
focus in setting the company’s strategic and
operational priorities; and
• ownership structures which reinforce the
management team’s motivation to achieve
these objectives by sharing the rewards.
The buyout principle – three
different routes to value creation
The underlying principle behind a buyout is the
use of a target company’s assets and – more
importantly – future cashflow as the basis on
which to fund its acquisition.
Creating value in buyouts
There are three routes to creating equity value in
a buyout company, and whilst most investments
demonstrate a blend of all three, modern market
conditions have profoundly altered the mix; we
shall return to this topic after reviewing the basic
principles.
These principles can be demonstrated through a
simple example. DemCo is the subject of a buyout
at a total cost (acquisition price plus professional
and arrangement fees) of €100 million, which is a
multiple of 10 on its annual earnings before interest
and tax (EBIT) of €10 million. Adding back non
cash expenses – depreciation and amortisation – of
€4 million per year gives us an EBITDA, which is a
rough proxy for the company’s surplus operating
cashflow, of €14 million. This clearly provides the
capacity to service debt, and for this example we
assume that equity investors provide €30 million
of the acquisition cost, with the balance, €70 million,
coming as a combination of loans with an
overall interest cost of seven percent.
By running the company with a tight focus on
cash generation, not only is the interest cost covered
but debt principal repayments can be made
– for this simple example we have assumed a €5
million repayment at the end of year 1, increasing
by €1 million per year thereafter as the reducing
interest burden helps free up more cash for
debt repayment.
As Exhibit 1 overleaf demonstrates, each debt
repayment enhances the equity value even if the
company itself does not grow in value. After four
years, if the company, still generating €10 million
EBIT a year is sold for the same €100 million
price at which it was bought, so that the EBIT
multiple is unchanged, equity investors have
nearly doubled the value of their investment,
which produces an internal rate of return (IRR)
of 22 percent per annum (before allowing for the
fact that some of this upside will have been
shared with the management team).
This approach to generating equity returns by
using the cash generation capacity to repay debt
is referred to as the financial engineering
approach to value creation.
However, any management team unable to produce
some degree of profit growth is unlikely to
COPYING WITHOUT PERMISSION IS UNLAWFUL
THE FUNDAMENTALS OF PRIVATE EQUITY 5