Private Equity

Private equity spans a start-up raising its first round to a mature company bought with five times its EBITDA in debt. This module follows companies through their life cycle and the strategies that finance each stage, contrasts how venture capital, growth equity and buyouts take risk and earn returns, values investments with the methods suited to each stage (the venture capital method, comparables and LBO analysis) and assesses what private equity really contributes to a strategic asset allocation once smoothing, leverage and illiquidity are taken into account.

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What you will learn

1. Describe private equity strategies across the company life cycle, from seed and early-stage venture capital through growth equity to buyouts, and the instruments and deal types used at each stage.

VC is staged by milestones (seed, early, late) and uses convertible preferred shares with liquidation preferences and control rights.
Each new round dilutes earlier holders; ownership after several rounds = initial stake x product of (1 - dilution) in each round.
Growth equity takes minority stakes in profitable or near-profitable, fast-growing companies with little leverage.
Buyouts take control of mature, cash-generative companies using debt: LBOs, MBOs and MBIs, take-privates, carve-outs and secondary buyouts.
The source of return shifts from rare outsized winners in VC to operations and leverage in buyouts.

2. Contrast venture capital, growth equity and buyout investments in terms of control, leverage, risk, sources of return and deal terms, including liquidation preferences.

VC: minority, no leverage, business risk, power-law returns and the widest manager dispersion.
Growth equity: minority stakes in growing, profitable companies with little leverage and moderate dispersion.
Buyouts: control and leverage; returns from EBITDA growth, deleveraging and multiples, with leverage magnifying risk.
Non-participating preferred receives max(preference, as-converted value); participating preferred receives the preference plus its share of the remainder.
Headline VC valuations price protected preferred shares and overstate the value of common equity.

3. Value private equity investments using methods and inputs suited to the stage of the company, including the venture capital method, comparables, discounted cash flow and LBO analysis.

VC method: post-money = exit value / (1 + r)^T; ownership = investment / post-money; pre-money = post-money - investment.
Adjust for future dilution by dividing required final ownership by the retention ratio.
VC target rates (30% to 70%) reflect failure risk, illiquidity and optimistic projections; scenario weighting is an alternative.
Growth companies: comparables, recent rounds (adjusted for preferences) and DCF where feasible.
LBO analysis: maximum entry EV = (exit equity discounted at the target IRR) + entry debt.

4. Evaluate the risk and return of private equity within a strategic asset allocation, including smoothing, leverage, the J-curve, manager dispersion and vintage-year diversification.

Model private equity as leveraged, illiquid equity; unsmoothed betas are typically above 1.
True volatility is roughly reported volatility x sqrt((1 + rho) / (1 - rho)).
The J-curve depresses returns in a program's early years.
Manager dispersion and vintage-year timing are major risks; diversify across vintages and managers.
Size the allocation using unsmoothed risk, realistic manager-selection assumptions, liquidity needs and governance capacity.

Module at a glance

Strategies follow the life cycle: seed and early VC, late-stage VC, growth equity, then buyouts (LBOs, MBOs, take-privates, carve-outs, secondary buyouts).
Dilution is multiplicative; each round shrinks the stake that remains after earlier rounds.
VC is minority, unlevered and power-law; buyouts are control and leverage; growth equity sits in between.
Liquidation preferences protect VC investors in weak exits and make headline valuations overstate common-share value.
VC method: discount the exit value at the target return to get post-money, divide required ownership by the retention ratio, subtract the investment for pre-money.
LBO analysis gives the maximum price: discount exit equity at the target IRR and add the entry debt.
Treat private equity as leveraged, illiquid equity: unsmooth volatility, expect a J-curve, and diversify across vintages and managers.

This free module has 4 lessons, 16 practice questions with full explanations and 1 essay case with a model answer.

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