A Practical Guide to Private Equity Transactions
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17
The Business Plan and financial returns
3.3 The financial model
The nancial model is at the core of the Business Plan. The model incorpo-
rates all of the nancial information that underpins the Plan in an integrated,
electronic form, using spreadsheet and accounting software. The model will
include historical nancial analysis and nancial projections along with the key
assumptions made. The projected gures usually encompass historic monthly
prot and loss statements, balance sheets and cash ows for three years and, at
the very least, quarterly projections for at least a further two years. Once the
operating model incorporating all of this historical data and current manage-
ment forecasts is complete, the deal structure agreed to fund the transaction
can be superimposed on the model, enabling private equity and debt funders
to analyse the envisaged returns. Inputs to the model can then be altered to
reect changing views on projections as the nancial due diligence exercise is
undertaken.
The nancial model will generally include a comprehensive sensitivity
analysis. The projections will be shown both as a ‘base case’ (which is based
on a conservative estimate of anticipated future sales and prots), and an
‘upside’ scenario (based on sales and prot forecasts reliant on more optimis-
tic assumptions). From there, different sensitivities (in simple terms, ‘what if?’
scenarios) can then be inputted into the model, showing the nancial impact
of each material risk associated with Target both in general terms, or specic
to the strategy itself. The number of scenarios presented can be tailored to suit
the particular situation; for example, where there is more than one approach
under consideration by the management team, the alternatives can be included
as different scenarios within the model, sensitivities can be run against each
scenario to demonstrate the implications for each, and then a nal strategy
chosen.
Responsibility for the production of the model usually falls to the nance
director in the management team. However, the corporate nance advisers
will again assist in its construction and presentation. This can be particularly
important in the later stages of a transaction, when the scope and extent of
the due diligence exercise, combined with the other demands on the nance
director’s time to facilitate the transaction (not to mention continuing to run
Target’s business), will see the nance director put under considerable strain.
Prior to the execution of the transaction, but most likely after exclusivity
has been granted, the private equity house will undertake extensive due dili-
gence to validate the content of the Business Plan and the nancial model. Due
diligence is considered in chapter 2.
3.4 Investor returns
The Business Plan will need to demonstrate that the private equity funders
can expect to achieve a return on their investment which is attractive when
compared to other opportunities in the market, and which will satisfy the
18
An introduction to private equity
requirements of their own investors. The measure generally used to assess
the return achieved is the internal rate of return (IRR). When fundraising,
independent and semi-captive private equity rms tend to market themselves
to their own investors based on the IRRs which they have delivered on their
previous investments.
Understanding the detailed calculations involved in determining the
IRR can be complicated. However, the basic principles applied are relatively
straightforward. In its simplest form, the IRR takes into account all of the
cash ows which the investor receives in connection with its investment, and
the timescale in which such cash ows will be received, and expresses those
returns as an average annual percentage return based on the amount of the
original investment.
A more technical denition usually states that an IRR is the discount rate
applied in order to ensure that the net present value of the relevant cash ows
is zero. This can be confusing to non-accountants – perhaps because they do
not understand the concepts of a discount rate or net present value, or why the
cash ows should ultimately amount to zero when it is applied. A discount rate
is an annual percentage rate which is applied to a cash ow which occurs in
the future in order to ascertain the value of that future cash ow today (such
discounted value being described as that cash ow’s net present value). For
the purposes of an IRR calculation, amounts invested are treated as a nega-
tive cash ow, and cash receipts as a positive cash ow. Accordingly, an IRR
calculation requires the calculation of the rate at which any cash invested is
discounted to produce a (negative) net present value for such investment which
is equal to the (positive) net present value of any cash returns to the investor
when discounted at the same rate – the aggregate sum of the positive and nega-
tive net present values will be zero when the correct IRR rate has been applied.
If it is assumed that the only negative cash ow (i.e. amount invested) is that
amount which is invested at the outset of a transaction, then the net present
value of that amount, as at the date of the original investment, is simply the
amount of that investment – meaning that the IRR is effectively an average
annual percentage return achieved on that initial investment when all the cash
returns the investor receives in the future, and the date upon which each is
received, have been taken into account.
Various cash ows may be received by investors during the life of the invest-
ment. As is explained in more detail in chapter 3, the investors typically invest
by way of a mixture of equity and debt, and may therefore be entitled to receive
interest on their loans, and possibly (although it is more unusual in modern
buyouts than was historically the case) dividends on their shareholdings. Cash
ows are also received by the investors in the form of arrangement and moni-
toring fees, although this is often ignored by investors when calculating the
IRR achieved. However, it should be borne in mind that interest and dividend
payments are often effectively deferred due to the restrictions imposed on the
investee company by its bank funders; by delaying the payment in cash terms,
19
The Business Plan and financial returns
the IRR achieved by the investors is effectively reduced, notwithstanding that
the interest paid is ultimately the same. The IRR is a measure which reects
the time value of money, as well as the money actually received.
The majority of the investors’ return, therefore, will generally take the form
of proceeds from the ultimate exit – whether by way of an IPO (or otation),
trade sale, a secondary buyout or some other route. The main exit transactions
are considered in more detail later in this book.
16
During times when bank debt
is readily available, it may also be possible for investors to achieve a partial
exit through a renancing – for example, by paying down existing debt from
prots earned during the initial life of the investment, and then renancing the
remaining debt later (with the investors, and possibly management, extracting
the additional cash raised). However an exit may be anticipated to arise, the
valuation of that exit and its timing will be critical for the investors to under-
stand the IRR they are likely to achieve.
Two different approaches to achieving an attractive exit (and therefore
IRR) might be considered:
(a) Growing prots, and therefore the enterprise value of the business on exit.
It would be unusual for any Business Plan to be prepared which does not
envisage some growth in prots over the lifetime of the investors’ holding.
Assuming that the strategy set out in the Business Plan will be successful
in achieving such growth, the investors would expect to sell (or other-
wise exit) Target at a more attractive valuation than that at which it was
acquired. That prot growth might be organic, or by way of acquisitions in
a ‘buy-and-build’ strategy.
(b) Multiple arbitrage. Protable businesses are typically valued by reference
to a multiple of prots; the precise accounting measure used varies, but is
most usually earnings before interest, taxation, depreciation and amort-
isation of goodwill. The multiple of prot paid will depend on current
market sentiment; generally speaking, far lower multiples will be paid for
businesses in an economic downturn when condence is low, whilst higher
multiples will be paid in better times. Multiples may also reect a shift-
ing perspective on the future prospects of a particular sector – witness the
high valuations attributed to internet-based companies at the end of the
twentieth century, followed by the bursting of the dot com bubble in 2000.
Therefore, investors may achieve an attractive exit simply by virtue of exit-
ing at a higher multiple than that used to determine the value of Target on
the original investment, even if the actual earnings remain the same.
The reality is that, whilst investors hope to achieve an element of both, mul-
tiple arbitrage is a factor outside their control. Most investors will want to
ensure they are paying a sensible valuation for an attractive asset – and the
impact of multiple arbitrage will often therefore be discounted by investors in
16 See chapters 12 and 13.
20
An introduction to private equity
assessing any Business Plan. Whilst many private equity rms have undoubt-
edly made spectacular returns as a result of arbitrage, it is not the case that
private equity deals grind to a halt in buoyant markets as investors recognise
that arbitrage may not be achievable; quite the opposite was true in the UK in
the boom period to 2007, when the availability of cheap debt fuelled higher
and higher multiples by private equity bidders, with trade buyers often being
priced out of the market as a result.
The IRR targeted by private equity investors is typically between 25 per
cent and 40 per cent per annum. Exactly what percentage is required by inves-
tors within this range will depend on the associated risk of the project, the
then prevailing market conditions, and the relative bargaining position of the
various funders and management.
To give a simple illustration of what the IRR means in practice, suppose
that a private equity investor requires a return of 25 per cent over a ve-year
period. This might be simplied to a statement that such investors need to
realise three times their original investment at the end of that period. Based
on this simple example, Figure 1.2 shows the cash multiple required on exit,
depending on when that exit is actually achieved.
A typical period for exit on a UK buyout is between three and ve years,
although, dependent on market conditions, an exit may well take longer in
practice. Certainly, most Business Plans will envisage an exit within that
period, and investors will be anxious to challenge the assumptions on timing
and deliverability of exit given the signicant impact this has on the IRR.
The example given above for determining an investor’s IRR is, of course,
oversimplied. There will be numerous cash ows involved, and the precise
timing of each cash ow must be taken into account to provide an accurate
measure. Future cash investments may also be necessary to nance future
growth and expansion in a positive scenario, or to enable continued trade
without a breach of the banking documentation in more difcult times – all
Year
1 2 3 4 5 6 7 8 9 10
Cash
multiple
2
100% 41% 26% 19% 15% 12% 10%9%8%7%
3
200% 73% 44% 32% 25% 20% 17% 15% 13%12%
4
300% 100% 59% 41% 32% 26% 22% 19% 17% 15%
5
400% 124% 71% 50% 38% 31% 26% 22% 20% 17%
6
500% 145% 82% 57% 43% 35% 29% 25% 22% 20%
7
600% 165% 91% 63% 48% 38% 32% 28% 24% 21%
8
700% 183% 100% 68% 52% 41% 35%30% 26% 23%
9
800% 200% 108% 73% 55% 44% 37%32% 28% 25%
10
900% 216% 115% 78% 58% 47% 39%33% 29% 26%
Figure 1.2 IRR based on date on which exit is achieved
21
Conclusion
such negative cash ows must be taken into account in determining the IRR.
Unfortunately, this is not a detail which the legal practitioner can ignore,
as the IRR is a common measure used in structuring a ratchet arrangement
(which will have to be documented in the articles of association of the Newco
17
bidder).
18
However, whilst this can lead to rather complex drafting, modern
accounting software has made the calculation of the IRR ultimately achieved
more straightforward – provided that actual cash ows paid are accurately
captured in the accounting model during the lifetime of the investment.
4 Conclusion
As we have seen from this brief introduction to the industry, private equity has
matured in the UK over the last sixty years, whilst still adapting to a complex
and ever-changing business and regulatory environment. It has its supporters
and its critics, its champions and its detractors. Its successes at times have
led to an image problem in the minds of many, and it has not always seen the
need to explain its actions to the wider business community or to the public,
or the need to be that concerned with what others think about it. However,
that it has played a very major part in the recent business history of the UK
and many other developed markets, and that it is playing an increasing role in
many emerging economies, is indisputable.
The future is always uncertain. The industry has changed over the years,
and the combined effects of the credit crunch and the increased spotlight in
which private equity must operate will change it further. As long as good busi-
ness opportunities can be put forward that need more money than the owners
(or would-be owners) and debt lenders can provide, and all that they can realis-
tically offer to attract that extra money is a share in the future with great upside
potential but little downside protection, there will be private equity investors
trying to make a turn by bridging that gap. It seems highly likely that private
equity will always have a role to play in any capitalist system where the capital
of some players can combine with the ambitions, potential, ideas and skills of
others to share the resultant success.
We will now begin to examine in more detail how that combination has
been realised in the recent market in the UK. Practice in the future will
change – but the factors that have created the current market will continue to
underpin how practice will develop going forward.
17 The creation of one or more new companies (Newcos) to facilitate buyouts is explained in
chapter 3.
18 See further chapter 3 section 3.2, and chapter 5 section 4.6.
22
2
The deal process and preliminary matters
1 Introduction
In this chapter, we will look in more detail at the deal process and certain
preliminary matters encountered in a typical private equity deal. This will set
the scene for the more detailed analysis of deal structures in chapter 3, and the
discussion of the key transaction areas and documentation that follow in the
later chapters of this book. We also look at the advisers retained by the parties
in a deal, and some of the commercial issues and tensions that can arise in
respect of their terms of engagement. Market practice has developed over time
in this area, and professional and trade bodies have played a role in resolving
some of these aspects – enabling the parties and their advisers to align them-
selves with less friction and delay to the process.
This chapter also considers the early stages in the relationship between the
potential sellers and the potential buyers – what risks each faces as a result of the
deal process, and the protections they may seek to mitigate these risks. Heads
of agreement are used to structure the deal itself (to some extent) and also to set
the expectations of the parties in relation to the deal process, giving the parties
the condence to commit the time and expense needed to reach a nal, binding
contract. In the period leading to the summer of 2007, auction processes became
ever more favourable to sellers, having a signicant impact on deal processes as
sellers looked to exploit the competitive tension that could be created between
competing bidders. Changes in the market since then will undoubtedly lead to a
signicant swinging back of bargaining power towards buyers.
Finally in this chapter, we begin to consider the risks that a private equity
investor may face in acquiring a business, and look at the importance of due
diligence in identifying and addressing these concerns.
2 The deal process: an overview
The deal process for any given buyout will vary according to the circumstances
in which the transaction opportunity has arisen, and the market conditions
prevailing at the time. However, the general nature of the required steps is
23
The deal process: an overview
relatively consistent and it is only the order in which those steps are taken, and
the detail behind those general steps, that will vary. Corporate nance advis-
ers on the transaction will include such steps in a detailed timetable which is
circulated to all of the relevant advisers; in the case of a seller-led auction this
may well be prepared by the seller’s advisers (who will also strictly control
adherence to such timetables by competing bidders by way of comprehensive
process letters). In other cases, the advisers to the private equity house will
take the lead. The steps will include:
preparation/completion of an information memorandum concerning Target’s •
business by the seller’s advisers (save, perhaps, where a deal is originated by
the private equity bidder and progresses on an exclusive basis
1
with no need
for marketing);
preparation/completion of the Business Plan;•
management presentations to interested investors and banks (where there is •
a competitive process);
appointment of advisers;•
selection of a preferred bidder (where relevant) and agreement of heads of •
terms/granting of exclusivity (discussed later in this chapter);
due diligence, which will invariably include nancial, legal, taxation and •
commercial due diligence, and (depending on the house style of the relevant
investors, and the particular requirements of the deal and sector) may also
include insurance, property, environmental, pensions, operational, IT and,
increasingly, management due diligence;
approaches to, and selection of, bank funders, and necessary work for the •
setting of appropriate bank covenants;
legal documentation, including acquisition, equity and debt documents;•
2
and
legal completion (the completion meeting).•
The way in which these consistent steps can be incorporated within very dif-
ferent processes is best illustrated by contrasting a deal originated by a private
equity funder ‘off-market’ with a seller-led auction. Figure 2.1 compares pos-
sible outline timetables for the two processes.
This comparison of admittedly simplistic timetables – the comprehen-
sive timetable issued by the relevant corporate nance adviser will include
detailed steps in relation to each stage of the process – demonstrates a num-
ber of reasons why auctions are generally so unattractive to private equity
buyers (as mentioned in chapter 1). In an auction, a seller usually controls
the information that will be made available to bidders, and the timing of the
release of that information, including the use of vendor due diligence and a
controlled data room.
3
The seller(s) will approach possible bank funders to
1 See further chapter 1, section 2.4.
2 For an overview, see chapter 3, section 4.
3 See further section 4.2 below.
24
The deal process and preliminary matters
secure banking offers, and provide details of those offers to private equity
bidders (a so-called ‘stapled’ debt package), on an understanding that bidders
will be strongly favoured if they can demonstrate deliverability of their nal
offers by agreeing to fund the transaction with one of these preferred lenders.
Draft legal documentation and detailed termsheets setting out the proposed
Week
Originated Deal (Buyer-led)Auction (Seller-led)
1
Initial offer or letter of intent submitted
[Note: Such offer is often facilitated by a
‘headline’ financial due diligence
exercise]
Information Memorandum (IM) issued
2
3
Advisers appointed
Heads of terms agreed and
exclusivity granted
Advisers appointed
Banks approached/selected by seller(s)
Bidders submit initial offers
4
5
6
7
Financial, legal and other due diligence
Banks approached/selected by buyer
Investors may issue equity termsheet
and first draft legal documents
Vendor due diligence released and data
room made available to ‘second round’
bidders with management presentation
Draft SPA and management termsheet
‘Stapled’ bank offers communicated to
bidders
Bidders submit proposed management
terms, and mark up of SPA
8
9
10
11
Legal documentation negotiated and
agreed
Final (confirmatory) due diligence work
Business Plan finalised
Heads of terms agreed, and exclusivity
granted, to preferred bidder
Finalisation of SPA
Equity/bank funding documented
Final (confirmatory) due diligence work
Business Plan finalised
12
Completion Completion
Figure 2.1 Auctions versus originated deals: a comparison
25
The deal process: an overview
terms for management’s equity package will also be issued by the seller before
a single preferred bidder is selected, encouraging buyers to put their best foot
forward in submitting their nal offers. Critically, as highlighted by the bold
text in Figure 2.1, the private equity rm is selected and granted exclusivity
far later in the transaction process (resulting in an increased costs exposure
for bidders), with the seller encouraging the buyer to complete the transac-
tion in a short timescale once that exclusivity has been granted based on the
signicant work and negotiations that have already taken place – whilst the
example above suggests a three-week timetable to completion, in the bullish
buyout market experienced up to the summer of 2007 the periods were often
far shorter. The timing of the granting of exclusivity is key; in many ways, at
that point, the balance of negotiating power switches from the seller(s) to the
buyer (although, as is discussed in section 3.3 below, the granting of exclusivity
does not amount to a legal agreement on the part of the seller(s) to negotiate
should they subsequently become dissatised).
Originally, exclusivity was designed to protect the buyer, who is likely to
invest considerable time and expense (including professional fees) in negotiat-
ing the legal documentation and undertaking substantial due diligence. Private
equity investors are also very keen to ensure that there is an obligation to talk
only to them as early in the process as possible in order to ensure that they are
not being used as a stalking horse, and to minimise their exposure to a situ-
ation where multiple potential bidders are being played off against each other.
The advantages of an originated deal, rather than an auction, in terms of pro-
cess should be obvious in both respects.
Whilst auctions were particularly prominent until the credit crunch had
such a signicant impact on UK transactions, it will be informative to see the
deal process that emerges once transaction activity increases again. Clearly,
the market has become more favourable to buyers, and it is likely that the
desire of bidders for exclusivity at an early stage will become ever more com-
pelling. Private equity rms will place an increased emphasis on origination
(when they are not preoccupied dealing with difculties in their existing port-
folio of investments); however, sellers will still expect a fair price for valuable
businesses, and there is a high level of awareness of how a good corporate
nance adviser and a well-run deal process can be instrumental in securing
this. Low market condence causes an increased risk of buyers walking away,
which a well-run sale process can also help to manage. Therefore, a transac-
tion process which contains elements of both extremes should be expected
in many cases; sellers may well prepare an information memorandum, and
approach a selection of possible bidders from both private equity and trade,
but the target audience will most likely be selected after considerable thought,
and be smaller in number. Similarly, banks may well still be approached by
the sellers, but this may be to ensure that a business is actually ‘bankable’ in
a difcult climate (to ensure an approach to private equity bidders is credible),
rather than an attempt to present a specic debt package as ‘stapled’ to the sale
26
The deal process and preliminary matters
process in itself. Most importantly, sellers are more likely to be sympathetic to
arguments that exclusivity should be granted before any detailed legal or other
advisory work is undertaken.
It should also be clear that a buyout is a signicant project. Lawyers and
other advisers must manage complex issues relating not only to the Target
business and acquisition terms, but also to securing the necessary debt and
equity funding. Project management is key and, provided it is structured sens-
ibly, a comprehensive timetable should assist with this. Completion meetings
are often particularly fraught, in many cases simply because the parties and
their lawyers have convened the meeting prematurely. The legal adviser must
work closely with the corporate nance adviser throughout the process both
to keep the project on track and to manage their mutual client’s expectations.
It is often worthwhile scheduling a ‘dummy run’, lawyers-only, completion
meeting a day or so ahead of the suggested completion date, which will help
identify and iron out the issues or identify and allocate tasks which otherwise
might arise at the last moment, to everybody’s frustration.
Much of the legal adviser’s time will be spent drafting and negotiating the
key legal documentation towards the end of the transaction process. However,
there are various preliminary matters where a legal adviser will often be asked
to provide input by a client (whether a seller, private equity rm or manage-
ment team), or by a client’s corporate nance adviser. Indeed, such prelimin-
ary input can be particularly helpful in ensuring that the more substantial legal
process that follows later runs more smoothly.
3 Preliminary matters
3.1 Engaging advisers
At an early stage in the process, the private equity investor will usually engage
a number of key advisers. Not all advisers will be engaged at the same time,
and not all advice is needed in the early stages – generally, as the negotiation
advances and the transaction becomes more certain, the private equity investor
will look to appoint additional advisers and to extend the role of those already
appointed. The range of advisers needed for a transaction will vary depend-
ing upon the nature and extent of the business, the jurisdictions in which it
operates and, later in the process, on the particular issues or concerns that are
identied by due diligence.
The two key advisers will, generally speaking, be the accounting advis-
ers (who may undertake accounting due diligence, corporate nance advisory
work and tax due diligence), and the legal advisers who will undertake the
legal due diligence and negotiate the acquisition, equity and banking docu-
ments as part of the overall client team. Sometimes, either or both of these
rms will have been instrumental in originating the deal, and accordingly may
already have secured a role in the transaction.