Private Equity
Refresher reading access
Introduction
Private equity remains the dominant form of private market investment. According to the global management consultant firm McKinsey, nearly two-thirds of the almost USD12 trillion in private market assets under management globally are held in private equity. While the classification of private equity investments varies among markets and participants, our focus will be on three distinct areas across the company life cycle, namely, venture capital used to launch high-potential startups, growth equity to assist young companies during periods of rapid growth, and buyouts in which investors take control of and restructure mature underperforming companies, which are also referred to as leveraged buyouts (or LBOs). Later readings address the use of debt financing in private market strategies and special situations such as distressed debt investing.
This reading first addresses different private equity strategies across the company life cycle, from new firms attracting minority shareholders to develop a business idea to the full takeover of an established firm seeking to add value by streamlining operations for an eventual sale. We address the distinct characteristics of these three private equity areas, including forms of investment and economic drivers as well as common features and differences in valuation methods applied to venture capital, growth, and buyout situations. Differences among private equity investments and with other markets contribute to distinctive risk and return features that influence their role in strategic asset allocation.
Learning Outcomes
The candidate should be able to:
- discuss private equity strategies over the company life cycle;
- discuss characteristics of venture capital and growth equity investments;
- discuss characteristics of buyout equity investments;
- estimate and interpret key inputs and calculate the value of a private equity investment for venture capital, growth equity, and buyout situations;
- discuss the risk and return among private equity investments as well as versus other investments as part of a strategic asset allocation.
Summary
- Private equity strategies over the company life cycle include venture capital for startups and their initial development, growth equity to expand operations, and buyout equity, which is used to a quire, control, and transform mature companies later sold to private or public investors.
- Venture capital is deployed in a company’s initial, pre-revenue phase when cash flow is usually negative to launch a business, create a product, and establish a market.
- Growth equity is used by later-stage firms with a proven market to fund expansion with established products.
- Buyout equity investments, or leveraged buyouts, involve the purchase of a controlling stake in a mature company by investors who see an opportunity to increase valuation and improve cash flow. A company is usually purchased with equity and debt and then restructured with incremental cash flow used to repay debt, followed by a sale to generate returns.
- Investment valuation across private equity uses entry and exit values to determine return on investment (ROI) and internal rate of return (IRR). The venture capital (VC) method uses the exit value of equity and ROI to determine firm value before new equity is sold, whereas the growth equity method includes cash flow projections for profitable growth over an investment horizon. LBO model inputs, on the other hand, are derived from financial statement analysis for both the entry and exit value of equity with significant debt usage over the investment period, which is paid down over time.
- The role of private equity in a strategic asset allocation is to achieve high-risk-adjusted returns and diversification benefits relative to holding public market equities among other investments that more than adequately compensate investors for the added risks and costs of venture capital, growth equity, and buyout equity investments.
2 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.