The Private Equity Asset Class

Chapter 2: PE Value Chain

Private Equity funds are institutional and privately owned investment vehicles managed by highly skilled and multidisciplinary teams that invest equity and quasi equity, for a limited period of time, in growing businesses, usually unlisted, with potentially high returns. Since these funds make the major part of their profits when the owned stake in a firm is sold out, the «portfolio firm valuation» is the central piece for assessing the total return on investment.

Capturing indeed a «firm value» is the beacon and the final aim of every Private Equity management team. Yet, what «value» are we discussing here? There are in fact two different values: the value paid to buy the firm stake and the one received when this stake is sold out. Both values are paramount to Private Equity funds.

Yet, to better understand the meaning of these values, let's first breakdown the investment process in a specific «value chain sequence» that will help the reader go through the dynamics of «value creation» in Private Equity.

Six stages could be laid out to describe this process even if on a practical hand each of these stages could be broken down in turn in more sub stages, but we're not going to go through this detailed process since it's not the main topic of this paper. The six subsequent stages are:

1- Selection: Firm prospects are selected to form a book of potential valuable investments.

2- Pre Valuation: From the selected prospects, few would go through a complete «valuation process» since this will determine which companies would «strike a deal».

3- Due Diligences: Once the selected prospects are pre-valued, the choice is narrowed down again and the final selection would go through a complete audit (technical, financial and legal).

4- Closing: After the results of the audit, one or more companies will receive both the fund team agreement to enter in the fund portfolio for a determined period of time.

5- Portfolio Management: These portfolio firms will be actively managed by the inside managerial teams with the full support of the fund team to reach the operational and financial objectives set at the closing stage.

6- Post Valuation: When a portfolio firm has reached the objectives and goals set at the closing stage, generally after 5 years of operations, the fund team starts looking again at the new value of the firm in order to prepare the selling of the company. A new valuation is then undertaken by the fund analysts' team.

7- Exit: After a period of time, generally 5 years, the portfolio firm stake initially invested will be sold out to a strategic or a financial buyer, the fund then makes its return on investment and creates value for its shareholders.

Naturally, all the stages participate in their way to create value and generate returns for the investments undertaken:

Ø The «Selection» stage allows the funds to wisely select its prospects through an adequate fundamental and environment analysis.

Ø The «Pre Valuation» stage through a specific «financial analysis» precisely values the retained target companies.

Ø The «Due diligences» stage allows through a thorough audit of the technical/operational, financial and legal aspects of the company to alleviate the investment risk and target only healthy firms.

Ø The «Closing» stage is a check point that allows the funds to form a potentially valuable portfolio.

Ø The «Portfolio management» stage enables the firms already in the fund portfolio to reach the goals and objectives set and agreed at the «closing» stage.

Ø The «Post Valuation» also values trough a specific «financial analysis» the portfolio companies that will very soon exit the fund perimeter.

Ø The «Exit» stage is another check point that allows the funds to realize and «cash in» its returns.

Our main purpose in this paper is to distinguish through the different stages of the Private Equity «value chain sequence» what are the stages that contribute to the «intrinsic value creation» compared to the stages that don't but rather create value through «investigation and negotiation dynamics».

Hence, we came up to a simple classification here laid down in the next diagram. The «Selection», «Pre Valuation», «Post Valuation», and «Portfolio Management» stages are part of the «intrinsic valuation» process in the sense that they all contribute to the inception, determination and build up of the «intrinsic value».

Whereas the mechanisms driving the «Due diligences», «Closing» and «Exit» involving both «technical and operational expertise» and «corporate legal and financial engineering tools» that are beyond the scope of this paper, are stages that help, throughout the «investigation and negotiation process», transform the «intrinsic value» in a «real» or «strike value» that is the value agreed upon whether at the investment or at the divestment phase.

Here after is laid down a graphic that summarizes and synthesizes the concepts of the value chain process and its sequence as we explained in this chapter.

Negotiation or Strike Value

Intrinsic Value

Investigative Value

Economic Value

Check Points Value

Private Equity Value Chain Breakdown

Selection

Due Diligences

Potential Valuable Portfolio

Pre Valuation

Closing

Portfolio

Management

Portfolio Value Maximized

Post Valuation

Exit

Fund Returns Maximized

The following will be a dig in the different stages that make up the intrinsic value of the firm, which we consider the main parameter that fund managers should look at when dealing with an investment in a company and also when looking at the fund as a whole.

We absolutely don't say here that the other stages laid down in the PE value chain process are not important or less important, each stage has its own importance that is equally weighted compared to the other, because if it is no the case, there will no «chain» process, as we know in a chain each ring is equal with all the rest. These stages have also a clear impact on the «intrinsic value», whether it is the «due diligences», the «closing» or the «exit» stage because they can or increase or decrease the «intrinsic value» with the results and outcomes of the «investigation and negotiation dynamics». Our purpose in the following sections is indeed to point out how this «intrinsic value» is located and monitored through the value chain process to enable a PE fund to collect the maximum amount of intrinsic value in its portfolio thus creating the maximum wealth for its shareholders.

The «Selection» stage:

Let's now delve into our first stage and try to answer how Private Equity fund teams should select their prospects. From a «security» perspective, the proper price for a firm stock is based on a forecast of the future dividends and earnings that can be expected from the firm. This master part of the valuation process is called the «fundamental analysis».

Yet, because the prospects of the firm are tied to those of the broader economy, «fundamental analysis» must also consider the «business environment» in which the firm operates. Hence, «macroeconomic» and «industry» circumstances must be examined in order to assess the environment in which the firm involves. Briefly outlined, the «environment analysis» includes (Bodie, Kane, Marcus, 2007):

A- Macroeconomic Analysis

· The Global Economy

· The Domestic Macro economy

· Demand and Supply Analysis

· Government Policy: Fiscal, Monetary and Supply-Side policies

· Business Cycles and Economic Indicators

B- Industry Analysis

· Definition of the Industry

· Sensitivity to the Business cycle

· Sector Rotation

· Industry Lifecycles

· Industry Structure and Performance

Traditionally, the «security analyst» works out this analysis throughout the «valuation process» so that investors are well informed about the future expected returns of the stock in consideration. In Private Equity, the «investors» are the fund shareholders that gave a proxy to the fund management team to administer and manage the fund in order to reap the maximum returns allowed under the specific circumstances. Hence, fund managers should consider their private targets as «securities» or «stocks» to be analyzed prior to any investment decision. In this case, «fundamental analysis» remains the most rigorous and most reliable process to analyze an investment prospect.

Indeed, «environment analysis» due to its rigorous and orderly approach would help financial analysts in Private Equity funds apply a «market methodology» to private and closely held firms that:

- Will mitigate investment risks by deeply looking into all the financials and economics that drive a firm future value.

- Will pave the way for extracting a higher value in the future.

Yet, the exercise could seem more complex when a firm involves in an «emerging market» (see annex for a detailed definition of «emerging market») environment where economies are less efficient, less transparent and more volatile than in the «developed markets». This «asymmetry» problem in itself is sufficient to emphasize the enforcement of an aggressive «environment analysis» using all the means and tools at hand (national reports and studies, international organizations data centers and reports, central banks notes and reports...).

The fact here is that due to this high volatility, «environment analysis» should be emphasized as for a «traded security» in order to allow mitigates the incremental risks associated with the expected higher returns. But because financial and economic data are often hard to define due to the lack of transparent and exact available information, the market driven methodology would spur the managers and analysts involving in these «emerging markets» deals to keep more than an eye on the importance of «environment analysis» which in turn would stimulate more efforts and research to look at and determine what stands in and behind the economic and industrial drivers for the firm and the sector targeted.

To conclude on this part, through an adequate screening of the sectors, their industry drivers and macroeconomic factors, we came up to qualify this «selection process» as the inception stage of «intrinsic value» for a private equity portfolio. Indeed, a wary and wise choice for future investments is the start point for «value creation» in private equity funds. The following parts dealing with the next stages will say more about how «intrinsic value» is build up.

The «Pre Valuation» & «Post Valuation» stages:

In this part, our analysis will only focus on both «valuation». In other terms, the «valuation» stages will answer these two questions:

a. How these funds value businesses to find bargains for their future investments (Pre Valuation)?

b. And how they value again these investments when comes the time to sell them out (Post Valuation)?

The answer is that these funds should look every time to the «intrinsic value» or «technical value» of the firms before deciding on whether or not they should invest in the firms prospected and selected and also after having invested and managed the portfolio firms. It is only by looking at the «intrinsic value» of the firms before and after investments that the funds would maximize its opportunities to realize the required returns by its shareholders.

At the «Pre Valuation» stage, after having selected some potential targets probably involving in different business segments and different environments, the main challenge of the fund team is to decide from its prospects the right «bargains» to «strike» for. Another challenge awaits the fund team after having invested some potentially interesting companies and managed them throughout the portfolio for a limited period of time; it is the «Post Valuation» stage. At both stages, the funds analysts' teams work out the «intrinsic value» of the firms under scrutiny. From the latter analysis, some potential interesting firms start to show up in different environments and different sectors.

Now, the challenge of the fund team is to select from its prospects the right bargains to strike for. The analysts' team starts then figuring the «intrinsic value» of the firms targeted; this is what we called earlier the «valuation» stage. Many valuation techniques and models exist (e.g. DCF, Multiples & Comparables, Real Options) when the exercise is to value companies and each situation requires a specific set of tools; a framework describing each situation and what method to employ for valuation purpose exists in the financial literature; but the «fundamental discounted cash flows» (DCF) is by far the most used by the professionals and the one that best fit the valuation of closely held companies targeted by Private Equity funds.

The «Portfolio Management» Stage:

Getting into the last part of this paper, everyone agrees that the fundamental goal of a firm's financial management is to maximize shareholders wealth. This obviously applies to Private Equity funds, where as we said earlier, the ultimate goal of the fund management team is to create the maximum value for its shareholders.

But how shareholders wealth and value are created in a business? The answer is that when a firm makes an investment that will return more than the investment costs in today`s value. Said differently, a firm is constantly expanding its operations through capital investments to finance new projects and the underlying new assets. These new capital assets make the production capacity of the firm. These investments will also determine how efficiently the firm will operate and how profitable it will be in the future.

In real life, as a firm has more than one project in its «project portfolio», its management is always confronted with a crucial choice: what projects should be undertaken now and what projects should be delayed? As these projects are typically expensive, their implementation will determine the competitive position and the long term survival of the firm in the marketplace. Hence, no one can doubt that deciding on what, when and how it costs to implement a specific project could be absolutely critical for a firm future health. Facing this decision, the firm management should therefore be at the same time prudent and wise without losing insight on the opportunity costs if a project is not undertaken. In another words, these decisions are highly challenging.

That's when financial «capital budgeting» should become the «science» for the managers faced with these challenges. Indeed, several methodologies are at hand when dealing with capital budgeting, although we can safely state that the «Net Present Value» (NPV) discounted cash flow (DCF) model is the most achieved technique in modern finance. The NPV of a capital expenditure in a specific project is the present value of all cash inflows, including those at the end of the project's life, minus the present value of cash outflows. The NPV rule is to accept a project if NPV > 0 and to reject it if NPV < 0 (Eun and Resnick, 2007).

Additional methods exist (IRR, Payback, Profitability Index...) for analyzing capital investments and each of them can provide pieces of information for decision making, but the NPV is considered to be superior when dealing with capital budgeting decisions.

Turning back to our firm management faced with this decision making process, we can safely assume that if a firm «projects portfolio» is prioritized according to the NPV rule that is the first project that will be undertaken is always the one with the higher NPV, the firm management is taking the right and wise decisions regarding its expansion aiming to maximize the shareholders value. Said differently, if a firm undertakes its capital investments according to the NPV rule, it means that it has prioritized its expansion stages and «disciplined» its «growth» in order to achieve the highest shareholders wealth.

Let's just translate all this methodology to Private Equity funds. If the fund management team is actively involving in the management of its portfolio firms with a unique goal that is maximizing its shareholders value, then the fund managers should accompany and support the whole portfolio firms' management to adopt this «disciplined growth» by obeying to the NPV rule. The aggregate result would be a maximization of the fund portfolio value.

A diagram presenting the portfolio «intrinsic value» maximization mix in a Private Equity fund is laid down in the next page.

Maximization of the Fund Total

Intrinsic Value

Portfolio Intrinsic Value Maximization Mix in Private Equity

1^st: Prospects Selection via Environmental Analysis

3^rd: Portfolio Management through Capital Budgeting & Disciplined Growth

2^nd: Firm

Pre Valuation using DCF