Structuring the Equity 4Calculating the IRR of an investment this way is only possible in the case of two cash streams, one cash investment and one cash divestment. We assume no Recapitalization of the company during the holding period that would increase the IRR. A Recapitalization is a change in a company’s capital structure during the holding period by bringing in additional debt, e.g. after year 2 or 3, and receiving a special dividend, hence “cashing out” a part of the interim equity value before the final exit.INSPECTION COPY
Note on Valuation and Mechanics of LBOs Tim Jenkinson –Ruediger Stucke 9To align interests between the private equity fund and the management of a portfolio company, the management is expected to invest alongside the private equity fund into the equity of an LBO. At this point it becomes relevant how much of its own wealth the management puts into an LBO and how their equity investment is structured to incentivize appropriate behavior. If the management puts too much of its own wealth into the company, it might become excessively risk-averse. If the management’s contribution is too small, it might not focus enough on necessary changes and implementation. As a rule of thumb, management is often expected to contribute around 50 percent of its own wealth into a deal. In the case of public-to-private LBOs, management usually rolls-over a part or all of its shares and stock options into the equity of the post-LBO company. To sweeten the upside potential for the management beyond the IRR earned by the private equity fund, a combination of common stock and preferred stock is often used to give management the chance to multiply their investment many times over if there is a successful final exit. Exhibit 5 shows an example of a typical structure. In this case the overall equity contribution from the Private Equity fund and the management is split into a larger fraction of preferred stock and a smaller fraction of common stock. The private equity fund holds the $250m tranche of preferred stock and $40m, i.e. 80 percent, of the common stock. Preferred stock is rewarded with rolled-up dividends of 12 percent in this case. Its final value after five years equals $3,172m. INSPECTION COPY
Note on Valuation and Mechanics of LBOs Tim Jenkinson –Ruediger Stucke 10Exhibit 5: Structure of the equity contributions Source: Own illustration. The value of the common stock at exit, which is the true residual for equity holders, equals the enterprise value at exit minus all other claims. In this case the final value of the company’s common stock has increased to $3,328m from its initial value of $200m. As a result, the $20m, or 10 percent of common stock, contributed by the company’s management increases to an equal fraction of the common stock’s value at exit, which is $333m or 16.7 times the management’s initial investment. Hence, by improving the company’s value and bringing the whole LBO to a successful exit, management has the chance to earn handsome profits. The equity contribution by the private equity fund of $1,980m has a final value of $6,167m, which is a multiple of 3.1 times. Over the 5 years period of this example, this results in an IRR of 25.5 percent. INSPECTION COPY
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- Fall '18
- Finance, Privately held company, Public company, LBOs, Tim Jenkinson