Private equity (PE) is funding for investment held by a limited partnership structure that reorganizes and streamline companies that are not traded publicly on stock exchanges. Private equity is a form of equity consisting of equity securities and debt. Investments made in business by private equity investors are typically focused on acquiring ownership, reorganizing the company, and then selling it at a profit. Private equity is often categorized under private capital, which primarily supports an illiquid and long-term investment approach.
The objective of private equity investment is to nurture a company by providing working capital that funds growth and product diversification and restructuring its operations, ownership, and management. Equity funds can be sourced from a venture capital firm, private equity fund, or an angel investor.
Structure of a Private Equity Fund
The structure of a private equity fund can be broadly classified as follows.
- Limited Partnership – This is where limited partner investors holding domestic or offshore funds pool their contributions in the equity of private companies and other illiquid assets. Investors expect a profitable rate of return on capital. Typically, the fund’s duration is ten years by when returns are fully realized, and the company is sold.
- Management Company – The Company looks after the operational aspects and incurs all costs of running the fund. In return, the company receives a management fee, regardless of the performance of the fund. The fees range from 1.5 to 2 percent of the investment.
- General Partner – Takes a more proactive role in investment decisions and is accountable for returns and the fund’s performance. In turn, the partner receives carried interest after the operating expenses are taken into account. Limited Partner (LP) investors get back the capital invested as well as preferred returns.
Functions of a Private Equity Fund
The functions of a private equity fund are limited to acquisitions and restructuring and targeted at lending their expertise to startups and small businesses to optimize their operational efficiencies.
Here are some of them
- The manager of a private equity fund utilizes the investments of pension funds, hedge funds, and even that of wealthy individuals to finance companies’ acquisitions.
- Usually, innovative techniques and the introduction of advanced technologies are outsourced by startups and fledgling business organizations to avoid infrastructure setup costs. On the other hand, private equity helps to set these up, thereby creating value and savings by avoiding agency costs. The savings are then distributed among the shareholders or plowed back into the business for further growth and development. It is especially true for small firms as equity funds act like venture capital, enabling the company to reach a wide market.
- A private equity fund’s goal is to acquire firms and resell at an enhanced value, thereby getting high returns on investments. While doing so, the tendency is to prune the workforce and reduce costs, and everything else that can have an immediate positive effect in the short-term though long-term goals might be adversely impacted.
- Private equity acquisitions were known as leveraged buy-outs in the past because the funds make far-reaching use of debt financing. The debt financing is a preferred route to lower tax burdens as interest payments are tax-deductible. Hence the profits made by equity funds are increased.
Private equity funds are a great boon to small businesses and startups that do not have access to traditional financial institutions to raise funds.
Valuation Approaches to Private Equity Fund
The most important aspect of determining the approach to valuing a private equity fund is understanding the intricacies of the management architecture and the inputs that power the valuation process.
There are three approaches to private equity fund valuation.
In the asset approach, the value set is low for businesses simply because the value of tangible assets is taken, and the goodwill is left out of the calculations. This can significantly lower the valuation as goodwill is a critical component of a company’s standing in the market and business growth. However, this approach is mostly opted when the general partner’s interest in the fund has to be valued, and the general partner is usually required to hold some assets at risk.
Even though the market approach is often followed for valuing private equity funds, it is not appropriate for several reasons. Large publicly traded private equity companies with a wide asset base have an unmatched market diversification, lacking in private equity companies. Hence accurate and precise market data is not available for the correct valuation of private equity funds through this approach. Using data from public companies as a reflection of data from private equity funds can throw up many problems.
This approach is entirely based on the business’s ability to generate income, and hence it is the most applied approach among the three to value private equity funds. At the core, projected cash value flows through carried interests for PE funds and any fees collected by the management company. The general partner has to keep some money at risk in the fund, and the potential returns on the investment are taken for valuation too.
There are two ways in the Income Approach by which valuation is done of PE carried interests.
- Discounted Cash Flow Method (DCF) – This method projects the generation of cash flows through carried interests or performance fees. These are then discounted at a rate that is proportionate to the risks faced in generating cash flows. A few hypothetical considerations have to be taken into account in DCF, like the fund’s ROI (Rate of Return), GP cash flows discounted to current values, and the investment holding period. The steps to be taken for the application of the DCF method are projecting management fees, AUM of the fund, management fees, and developing the discount rate for receiving management fees and carried interest distributions.
The DCF model discount rate cannot be accurately predicted, and hence the inputs have to be credible based on experienced decisions. The discounted return rate for projected cash flows is linked with the expected return of the entire fund. It has to be ensured that the projections in this method stand up to scrutiny and litigation.
- Option Pricing Method – The discounted cash flow method, apart from private equity fund valuation, is also used to evaluate GP entities in hedge funds while receiving the performance fee. The Option Pricing Method is not applicable in hedge funds but is in the valuation of a PE fund GP’s carried interest. Therefore, the standard option pricing may be used to value a carried interest since it gives the right to the asset’s value to the holder over the strike price for a predetermined period. The strike price is the capital of the investors plus the preferred return.
The option pricing model rests on the assumption that if there are the same payoffs for two assets, they will also have the same prices to eliminate the possibility of arbitrage or riskless profit. The most common model in this private equity fund niche is the Black-Scholes-Merton, one with five parameters for calculating the standard call option price – asset price, strike price, risk-free ROI, time to maturity, the risk and price volatility of the asset.
This model of placing a value on equity funds is preferred as it is simple and easy to use. There is no need to make projections of discount rates, future private equity returns, or the investments’ timing. The key inputs required are the instability of the private equity fund’s future investment and the likely period of the equity funds. The minimalism of the private equity valuation is often considered a drawback as it might not precisely capture the volatility of the private equity funds over its life.
Valuation of Non-controlling Interests in Private Equity Firms
The valuation of non-controlling interests has many aspects to it. For general partner and/or management entities, critical components for valuation of equity funds include the jurisdiction, applicable standard of value, venue, and the purpose of valuation of the equity funds. All these taking together will determine whether valuation discounts will apply for want of market or control.
There are several benchmarks to consider the tax valuation of private equity firms. One is Fair Market Value, which takes into account the valuation discounts when arriving at the value of non-controlling interest. But if there is any dispute by the shareholders of equity funds, it is the state statutory provisions that will decide whether the benchmark will be Fair Market Value or simply Fair Value. For example, in the State of New Jersey, it is fair value only for equity firms, and valuation discounts are not granted while in New York, it is the Fair market value. Therefore, fund managers have to follow the law applicable to the state for the valuation of private equity firms.
Mistakes to Avoid in Valuation of Private Equity Fund
Valuation of private equity companies is a complex and intricate process, and various factors have to be taken into account. Hence, it is critical to hire a seasoned expert and a professional with the required expertise or a company in this field to carry out the valuation. But even the best of valuation companies make mistakes, and it is necessary to follow the process and ensure that they are avoided carefully.
Here are some of the most common mistakes made during the valuation of private equity funds.
- Calculating Investment Returns based on historical data – Investment returns have always been a bone of contention amongst individuals and private companies valuing private equity funds or hedge funds, and most experts disagree on the assumptions made in the process. Many experts think that if equity firms are showing high returns now, the trend will continue in the future too. In most cases, this is not likely to happen and is the reason why prospectuses of financial firms boldly declare that past performance is not an indicator of future results.
Firms that assume that the current performance fees to be received by the general partner are powered by expecting the same cash flow, as reflected by historical data, are taking a huge unwarranted risk. Valuation experts and firms often assume that the current prevailing high investment returns will stay on, resulting in irrational valuation conclusions.
- Not using a Multi-Period Projection Valuation Model – When valuing private equity funds or hedge funds, experts often use the single period valuation method that relies on capitalization of earnings to arrive at a value for management structures and investment. This is done because the process is relatively simple. While it is a valid and legit method to value equity firms, it is only accurate when there are stable, predictable earnings by private companies projected to continue leading to capital growth and sustained development. Although, in reality, while this trend is common amongst publicly traded and public companies, it is hardly so for private equity management companies.
On the other hand, the DCF method carries interest’s projected and expected cash flow and then discounts them at a rate of return in proportion to the cash flow over the holding period. This is right for the valuation of private equity firms.
- Not Considering Assets Under Management (AUM) – Assets under Management (AUM) is one of the benchmarks for publicly traded companies, private equity funds, companies private, hedge funds, and other financial institutions. The Income Approach is the most common route for determining private equity funds’ value and the Option Pricing Method. AUM takes into account the prospective investment returns of companies in the future, new launches of private equity funds, and investors’ contributions and redemption from the private companies. Hence, AUM is an integral component of performance fees and management fees.
Regrettably, the role of AUM as basic value drivers for a private equity company is often overlooked by the experts setting a value on the firm. The valuation process should consider AUM as both a historical and futuristic parameter, and if this is not done, the value results projected of various aspects such as capital and cash flow will not be accurate and not have the desired internal consistency. For example, if raising capital has slowed and the private equity company is not optimally marketed, the AUM might stabilize, but the inflows will not reflect the historical rates. Therefore, there should always be a backlink to AUM of any cash flow projections and income statements.
- Treating Mature and New Funds at par – Valuation experts often fail to distinguish the risk differential while placing a value on a new fund as against a mature fund. It is an acknowledged practice to take into account the historical data to value mature hedge funds or private equity firms that show a specific trend. This is also true for private equity funds that have completed capital deployment.
But the real challenge arises when implementing financial valuing of recently-formed management structures as these have extra inputs that have to be integrated into the valuation model. It includes the size of the firm and the private equity funds and the time of the capital employed. Overvaluation is a possibility if the uncertainty of data is not accounted for. Valuation experts of public companies, hedge funds, and private equity funds have to incorporate the risk factors associated with new funds into their work. This is usually done by considering projections that have various probability-weighted outcomes and a host of possibilities.
Another acceptable valuation method of a public company or a private equity firm is to increase the discount rate as it will bring back the cash flow projections to current values.
- Not differentiating between Capital and Economic interests – Valuation professionals who do not have the required experience working with public companies and equity financial firms’ management structures usually assume that an employee’s K-1 tax form confirms their ownership in the general entity of the firm. In most public companies, firms, or business organizations, K-1 is issued to an owner to confirm ownership of equity in the company. But a hedge fund or equity firm employee has to be issued an economic right to share. In many cases, this economic right share denotes the profits interest with no equity ownership in the fund. Hence, when evaluating a general partner’s interest in private companies, it is critical to consider these finer points.
To get the true value of investors’ interest in an equity firm and business, it is important that these areas in financial results and general interest are carefully considered and the mistakes avoided.
Private company and equity firm management structures can considerably increase income earnings, capital formation, and investors’ wealth for a fund’s general partners and the employees. It is usually in the form of performance fee compensation or carried interests even though these are only received sometime in the future. As different from public companies and other financial business organizations, the cash flows and capital accumulation is subject to many risks as to whether the capital flows will ever happen, especially in private companies that do not have an excellent track record.
Projecting cash flows and valuing any alternative asset class, regardless of it being hedge funds, private equity funds, public financial companies, or any other, is always a challenging activity and requires considerable experience and expertise in this business. A host of parameters and scenarios must be taken into account, such as accurate projections and estimates.
How do you value private equity?
There are primarily three types of valuation for private equity or a company. They are the Discounted Cash Flow (DCF) method, comparable companies, and historical data, also known as the precedent transactions. These methods hold for public business and companies, investment banking, corporate development, buyouts of financial companies, and are ways to evaluate companies’ net worth.
Knowing the value is relatively simple for public companies, and investors can check on the stock price. But this approach does not apply to private companies as the stock value is not listed in public, the capital base is not often carefully defined, and the accounting records are informal, making the valuation of private equity quite difficult.
How do you value a fund?
There are various approaches to valuing a private company and fund against the relatively simpler valuation of a public company where the price of the listed stocks is the defining factor. The Income Approach is the most appropriate and is based entirely on the fund’s ability to generate income on the capital base. The method involves projecting cash flows through carried interests for PE funds and fees collected by the management company and are generally the focus of investors to ascertain a fund’s value.
One approach is the DCF method, and the other is the Option Pricing Method. In the first, the cash flow is generated through carried interests or performance fees, and in the second, a right is given to the holder of the asset over the strike price for a given period.
How do you structure a private equity fund?
A private equity fund is not listed on public exchanges and is closed-end funds. The fees for operating the fund are performance fees and management fees. The partners of the equity fund are called limited partners, general partners, or investors. The roles and responsibilities of limited partners in the company are somewhat different from others. In their agreement, clear outlines are given about the fund’s duration and the amount of risk. In an equity fund structure, limited partners are liable only to the extent of money invested while general partners are fully liable to the public and the market.
Is CFA useful for private equity?
CFA is a globally recognized institute for investment and financial professionals and offers the Chartered Financial Analyst (CFA) course. CFA’s have great opportunities in any financial company and the field of investment banking, a private equity firm, a public listed firm as a financial analyst, and any similar company. A private equity company hires CFA’s for guidance on investment strategies, valuation, and running of management structures. Overall, a CFA has a significant role in the smooth operation of a private equity company.