Unlocking the Path to Profitability: Navigating the Dynamic Landscape of Private Equity Investments

Private equity deals occur daily and are of significant value, with the average buyout being above $1 billion since 2021. But what exactly are the stages leading up to such a deal? This article will lay out the 12 stages, which can broadly be categorized into sourcing, preliminary due diligence, negotiation of terms and valuation, structuring of the transaction, drafting of legal documents, signing and closing the deal, and pos-closing activities, such as integration and management of the acquired company.

The first stage of a private equity deal is sourcing and teasers. This comprises finding potential investment opportunities, evaluating them, and pitching them to a committee or partner within the private equity firm. Private equity investors often actively seek investment opportunities in order to achieve high returns for their investors. Procurement can be done either through personal contacts (sourcing) or through intermediaries, such as merchant bankers, lawyers and accountants, which make use of teasers. Sourcing can be done via various methods, the most common being equity research, also known as securities research. In such a process, equity analysts will produce reports, which lay out expectations for the equity in question, and its investment benefits for the management, the business, and from a greater perspective for the industry/economy. Other methods include networking, cold-calling the target companies, or reaching out to industry experts. A teaser, on the other hand, is generally a two-page summary about a firm that is up for sale, produced by a financial intermediary, such as merchant bankers, lawyers and accountants.

The second stage of a private equity deal is often the signature of a Non-Disclosure Agreement, also referred to as an NDA. If the investment opportunity is sourced, the private equity firm will sign an NDA directly with the company in question. If, on the other hand, a private equity firm is interested by the teaser that an intermediary firm provided about a target company, then the two former firms will sign an NDA agreement. Upon this, the private equity firm will be provided with a Confidential Information Memorandum (CIM), which contains further financials and projections about the target company that is up for sale. Following the NDA agreements, the target firm will generally share confidential information about its business with the private equity firm, such that the latter can make an informed decision regarding the acquisition opportunity.

After the signing of an NDA, initial due diligence is a necessary and important step when signing a Private Equity deal. It is conducted in order to form a better understanding of the target company prior to making a proposal. Target companies are usually not publicly listed and therefore there is less information available, making the due diligence process more challenging. The first part of the due diligence process is thorough research of the industry in which the company operates. Industry analysis often includes the position of the company in the industry, competitive dynamics, key industry ratios and recent transactions and multiples. It is possible that during this process the PE buyer identifies other attractive target companies.

Operational due diligence aims at identifying all opportunities that exist at the target company to make value-generating operational improvements. Such improvements may be: the development of new technologies, cutting off certain products, closing underperforming stores, etc. Finally, the ultimate aim of due diligence is finding profitable exit opportunities. PE buyers must identify possible exit strategies before moving on with the proposal. Most common exit strategies include trade sales, secondary buyouts and IPOs. 

When the initial due diligence is done, the investment team presents an investment proposal to their investment committee. The investment proposal includes a concise summary or overview of the project including important numbers and details of the transaction. It also includes a business timeline with the respective exit strategy. During this phase of the deal, the investment committee decides whether the investment is worth it. On many occasions, a certain budget is discussed and the investment committee gives the Green light for the first proposal. 

After the investment proposal is made, a letter of intent is submitted. The Letter of Intent is a non-binding document entered into by potential sellers and buyers of a company. The primary objectives of the letter of intent are to establish a transaction value and to secure exclusivity. In many cases, the LOI includes only a valuation range rather than a specific amount. It also includes whether the offer is made on a cash-free or debt-free basis. The target company and its advisors will select a few bids from the ones submitted to the next round in the auction process. The Letter of Intent typically addresses employment agreements for key members of the management team, non-compete clauses by the buyer, indemnifications, etc. 

As a part of a risk-based approach further Due Diligence must be pursued by a Private Equity firm (stage 6).

Due diligence is divided into: Simple Due Diligence (SDD), Customer Due Diligence (CDD) and Enhanced Due Diligence (EDD).

Enhanced Due Diligence (EDD) is an intensive approach to Know Your Customer (KYC) requirements, it is required by the Financial Action Task Force (FATF), a global watchdog focused on money laundering. It is particularly important because it can expose a fraudulent business.

EDD is applied to individuals (through research on details on the source of wealth (SOW)) and corporations (searching for details of company background and activities, ultimate beneficial owners (UBO), directors, officers and senior management, director and shareholder information, indicators of financial crime risk⁠—including money laundering, corruption or other criminal activity⁠—as well as other adverse media).

Documents for due diligence, in the old days, were stored and shared in physical rooms, from the early 2000s Virtual Data Rooms (VDR) emerged as document storage and sharing transitioned online and from physical to electronic files. A ‘VDR’ is a website using an online database, providing a secure space for document storage and distribution. This innovation guarantees: 24/7 multiple access to sensible information from potentially anywhere, major security than physical documents as there is no risk of loss during transit or being destroyed accidentally, and limitations on actions like copying, printing, and forwarding.

A Private Equity firm needs to be aware of the potential of a targeted company, breaking down an operating model could help highlight its key strengths, weaknesses, opportunities, and threats. This stage (stage 7) is fundamental, it gives the PE firm’s decision-makers a clearer picture of the major factors that drive return for the acquisition.

If the firm decides to proceed with the acquisition, core elements to target (to boost its capital gain) are: technology and platforms, data and insights, and organization and culture. For example, shifting to modern platforms can help firms reduce their excess technology, automate manual tasks and integrate end-to-end systems (delivering complex systems or services in functional form after developing it from beginning to end), generating cost savings up to 10 percentage points (according to BCG).  The modular architecture makes it easier for firms to integrate systems end to end, allowing data to be shared across systems and manual tasks to be automated.

The eighth stage focuses on drafting the Preliminary Investment Memorandum (PMI, stage 8), so a Private Equity firm committee has a 30-40 page document that summarizes the investment opportunity.  An investment memorandum can be written by a company’s management, but more often an external team of investment bankers or intermediaries will be hired to draft the document. The reason behind this decision is experience, investment bankers or intermediaries will have more experience in how the information within should be structured and communicated.

The Preliminary Investment Memorandum usually consists of 7 steps: executive summary, company, market & industry and valuation overviews, risks and key areas (identified by due diligence) exit details (options when it comes to an investment exit and its timing) proposed project plan (recommendations on how to proceed with the project).

After the approval of the Preliminary Investment Memorandum, the buyer performs the remaining and final due diligence. This is carried out usually by the deal team and focuses exclusively on the project. The deal team interacts directly with the investment bank and the management of the target company in order to address any remaining issues such as calls with suppliers, customers, and sales personnel day to day visits.

Final due diligence has the primary purpose of reducing risks while maximizing value for investors. When investing in an illiquid asset or company, since exiting opportunities are not easy, it is crucial to get it right at the beginning. 

During this time the buyer usually starts negotiating with several banks about different financing options aiming to secure the cheapest debt from a group of banks. 

Once all the due diligence has been performed and the investment team has approved the deal they must create a final investment memorandum.

This document includes any key issues discovered during the due diligence process and also recommendations on the specific valuation to use to acquire the target company. Finally, it specifies exactly what funds will be used and how they will be used. The final investment memorandum serves as a final confirmation that the investment team is comfortable with the deal and ready to make a Binding bid. 

The final binding bid is proposed to the seller, it consists of a formal contract between the buyer and the seller. It is worth mentioning that the binding terms may differ from those included in the First Round Bid. Indeed, the final due diligence might have revealed important information which was previously undisclosed.

If the seller accepts the binding bid, the deal is signed and the buyer is bound by the terms of the contract. A purchase agreement is written after negotiations between the lawyers of the two parties involved.

MONITORING IN PE FIRMS

Over the lifecycle of a company which is backed by a PE firm, the Portfolio Manager is responsible for monitoring the financial performance of the portfolio company.

Such portfolio monitoring refers to the way in which critical performance metrics are collected, monitored, and tracked across the portfolio. 

The process is largely the same for all the companies, such that all data and relevant information are used to produce quarterly reporting which all stakeholders use to assess the success of the value creation plan.

However, while there is no perfect science to value a PE portfolio, there are common Key Performance Metrics or Indicators (KPI’s)  accepted within the industry including:

Gross and Net IRR

The internal rate of return is a metric used by investors to measure and compare returns on investment. It is defined as the rate of discount that makes NPV = 0. So, in order to find the IRR for an investment plan lasting T years, we must solve the IRR in the following expression:

Generally, such an investment is profitable if the NPV is greater than 0. 

Multiples Calculations or TVPI

TVPI(Total Value to Paid In) measures the overall performance of a PE fund with a ratio of the fund’s cumulative distributions and residual value to the paid-in capital. It calculates what multiple of the investment would be returned to investors if the unrealized assets were sold at the current valuation and added to distributions that had already been received.

VALUE

PE firms create value in three distinct ways:

Multiple Expansion

Multiple expansion is a form of arbitrage that employs the purchase of a security at a lower valuation multiple and selling a security at a higher valuation multiple. PE firms apply special techniques to increase the operational efficiency and cash flow generation during the life of the investment, monitor the current valuation multiples and proactively seek the best exit time of the investment (which occurs at the highest valuation multiple).

Leverage

Leveraging is the essence of maximizing the internal rate of return (IRR), since the less equity a buyout firm has to fork out, the better its potential gains. One of the main drivers of this debt financing decision is the fact that the cost of debt is typically much cheaper than the cost of equity, so PE firms are better off financing at least a portion of their investment with loans. However, beyond a certain level of indebtedness, the risk of default or distress exceeds any gains derived from the lower cost of debt. One more important feature of leverage is the benefit related to taxes, then borrowing helps a company reduce its tax liability. 

Operational Improvements

The aim of these operational improvements is to build on established strengths but also to look to measures which can lead to a permanent release of cash or raise EBITDA margins which have not previously been given emphasis. Some examples could be working capital control and the adoption of more sophisticated pricing strategies. The table below shows the typical measures for Operational Improvement and their potential money multiple uplift. 

We have analysed the different phases of a private equity transaction, looked at key metrics to evaluate the investment and detailed the most common strategies to create value. It is interesting to observe how these different aspects of private equity are impacted by the current macroeconomic conditions. Indeed, as the cost of capital is rising, the careful selection of investments combined with an efficient due diligence process is essential. Private equity firms must be more selective, and have a clear value creation plan as relying only on the cheap cost of debt belongs to the past. 

EXITING

The exiting refers to the process by which PE firms sell the business previously acquired through several strategies. The main options for an exit strategy are:

Initial Public Offer (IPO)

One of the common ways is to come out with a public offer of the company and sell their own shares as a part of the IPO to the public.

Strategic Acquisition

Through this strategy, the company you have invested in is sold to another suitable company, and then you take your share from the sale value seeking for a share value appreciation.

Secondary Sale

In a secondary sale, the PE firm will sell its shares to another private equity firm. This strategy can happen for several reasons, for example, the business may have reached a stage that the PE wanted it to reach, and other equity investors want to take over from here.

Repurchase by the Promoters

In this strategy, the management of the promoters of the company buys back the equity stake from the private investors. This could be a very efficient exit option for both investors and management.

Liquidation

This is recognized as the least favorable option but sometimes it is necessary if the company and the investors have not been able to successfully run the business.

By Pedro Albin, Sophie Ziegler, Nicola Prezioso, Louis Paget and Filippo Biban

Sources:

• DealRoom 

• Pitchbook 

• Investopedia

• FT

• HBR

• INSEAD Knowledge