1.2.3 Private Equity

Welcome to On Judgement. A company’s enterprise value rises from £100 million to £120 million. Does every investor make a 20% return? List the financing and cost information you would need. Take a first view. You can change it when you have considered the evidence.

Private equity includes several private ownership strategies; this lesson focuses on buyouts of established businesses. A sponsor may acquire control, including through a take-private, a founder sale, a corporate carve-out or a purchase from another sponsor. The route does not by itself establish value creation. Limited partners commit capital to a fund. The general partner or manager arranges investments under agreed terms, calls capital, oversees holdings and seeks realisations. Commitments are not identical to cash already invested. Fund interests can sometimes transfer through secondary transactions, but consent, pricing and limited buyers can restrict liquidity.

Operating improvements can include stronger customer retention, revenue growth, efficiency, better capital allocation and governance. They require evidence, investment and execution. Cutting a cost today can harm future service or capability. EBITDA is a measure before several important charges; it is not free cash available to owners. An enterprise-value-to-EBITDA multiple links an operating measure with the value of claims on operations. To estimate equity proceeds, consider debt, cash and other relevant claims consistently. A higher exit multiple can increase proceeds without a matching operating improvement, and a lower multiple can offset good execution.

Borrowing finances part of the purchase and introduces interest, covenants and repayment or refinancing needs. If enterprise value rises, the remaining equity can grow faster in percentage terms. If it falls, equity losses can also accelerate. Debt repayment may increase equity value, but requires cash that has other possible uses. Do not count a company cash flow both as a distribution and as debt repayment unless the numbers allow both. An attractive upside MOIC is incomplete without a downside case, financing costs, investment horizon and the capital required after purchase.

A simplified closed-end fund raises commitments, invests during an investment period, supports businesses, and realises holdings through sales or other routes. Timing varies, extensions may be possible and an IPO need not give immediate unrestricted liquidity. A continuation vehicle transfers an asset into a new arrangement and requires attention to valuation and conflicts. MOIC compares value received plus remaining value with invested capital under a clearly defined basis. IRR is sensitive to the timing of cash flows; a high IRR can accompany a modest multiple over a short period. Fees and carried interest reduce investor proceeds under contract-specific rules. A shorthand “2 and 20” does not describe every fee basis, hurdle, waterfall or clawback.

Let's work through From business value to equity proceeds. A fictional buyout costs £100 million enterprise value, financed with £40 million debt and £60 million equity. On exit, enterprise value is £120 million, debt is £30 million and cash is zero. Ignore fees, tax, distributions and other claims. Pause here and try the calculation or reasoning before continuing.

Exit equity value = £120 million − £30 million = £90 million. Equity MOIC = £90 million ÷ £60 million = 1.50×. Equity gain = 50%, compared with the 20% increase in enterprise value. If exit enterprise value were £70 million with debt still £40 million, equity would be £30 million: 0.50×, or a 50% loss.

Debt and its repayment change equity outcomes. The £10 million debt paydown must be financed from actual resources. These are gross simplified equity outcomes, not net LP fund returns.

Now try the choices in this lesson. If your answer changes, identify the reason. Separate operating improvement, leverage and changes in exit multiples. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.