Intro to Private Equity and LBO

 Private Equity:

  • Funds and investors that directly invest in private companies or that engage in buyouts of public companies, resulting in the delisting of public equity
  • VC and growth equity are under the PE umbrella
LBO Overview:
  • Acquisition where a significant part of the purchase price is funded with debt. The remaining portion is funded with equity from financial sponsors (PE firms)
  • After the acquisition, the company will be fully controlled by the PE firm and will have a leveraged capital structure
  • Companies acquired by PE can be either private or public
  • Key difference between a PE firm's acquisition and a normal company's acquisition: PE never plans to hold a company forever
Timeline of an LBO:
  1. PE firm searches for undervalued companies that could yield high returns if managed properly
  2. PE firm uses cash (equity) and leverage (debt) to buy the company
  3. PE firm will run the company for several years and make improvements
  4. After a period of 3-5 years, the PE firm will sell the company, ideally for a higher price, and use the proceeds to repay the debt. If goes well, it will earn back a multiple of the cash it invested and get a high IRR (internal rate of return)
Leverage:
  • In normal M&A deals, we use a combination of cash, debt, and stock to acquire other companies. But LBO only uses debt and cash. PE firms prefer to use as much debt as possible because:
    1. Debt has an amplifier impact on returns
      • Whether you make a profit or not, the amount of debt/interest you need to pay remains the same
    2. The risks of additional debt will be limited to the acquired company itself; the PE firm never takes on any risk from the additional debt
What actually happens in an LBO:
  • The target company raises debt to purchase a certain number of its own shares
  • Then the PE firm uses its Cash (called Investor Equity) to purchase the remaining shares
  • The PE firm will own the target under a holding company


Interview Questions:

What are some qualities of an ideal LBO candidate?
  • Most important: stable cash flow. This is important because LBOs are funded mostly by debt. Interest payments are very high, and you need to make payments over time
  • Company with strong market position compared to others in the industry
Explain LBO to someone not in the finance industry (real-life LBO example):
  • Borrowing money to purchase an apartment to rent out
  • The down payment is equivalent to the PE firm's equity investment, while the mortgage loan is the debt or "leverage" in LBO
  • The interest payments on mortgage would be like interest payment on debt
  • Finally, the sale of property, hopefully for a gain
How does an LBO model value a company? Why is it a floor valuation?
  • Set a PE targeted IRR and in excel blackout the purchase price required to achieve this IRR
  • It is a floor valuation because a PE firm has a high target return and usually pays less for a company than a strategic acquirer would

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