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What are the sources of return on investments for Private Equity companies?
Private Equity companies typically make returns through four strategies:
3. Operational improvements and
Let’s work with a case study to understand this better.
Assume a PE fund, (let’s call it City Ventures) just purchased a silicon chip company (Valley Inc.) for £100m. Given the strong cash flow of the business, banks were willing to lend City Ventures £80m to fund the deal. City poured in the rest of the £20m in the form of an equity investment.
Valley Inc. was producing £20m of free cash flow (FCF) at the time of the purchase, meaning that City Ventures purchased it at 5x it’s free cash flow.
After five years of holding the company and improving its profitability to £35m, City Ventures was able to sell the company at 8x FCF at £270. Let’s assume that the FCF generated by Valley Inc. allowed it to repay 80% of its debt in addition to servicing the interest expense. The total debt outstanding at exit was £16m (£80m *20%).
At exit City Ventures gets £254m (£270m exit value - £16m debt outstanding). Over a five-year period, this equates to a 12.7x return or a mind-boggling IRR of 66%.
The swanking return was generated by three sources: 1. Increase in profitability (£35m from £20m) 2. Higher exit multiple (8x) versus the entry multiple (5x) and 3) Paying back debt (£16m of debt at exit versus £80m at entry)
Additionally, PE companies may also indulge in buying similar companies and merging the two companies. This allows investee companies to become larger players in the industry, also allowing for synergies.
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