Some people like to do their own research and analysis before investing in a private equity fund. Others prefer to outsource this to professionals such as an independent financial adviser. Whichever camp you’re in, this article will give you a good starting point in understanding some of the most commonly used private equity models.
First off, though, you should have at least a basic understanding of how financial modelling works.
What is financial modelling?
Financial modelling is the process of creating a spreadsheet with a company’s earnings and expenses to assess its financial health and make forecasts about the future, such as estimated cash flows or stock performance. Executives use models to decide whether to acquire or invest in a company or develop new assets.
Types of Private Equity Models
Most private equity firms use leveraged buyout and growth equity models. To understand how these work, you first need to learn about their precursor, the 3-statement model.
These models are commonly known as “budgets” because many companies use them for budgeting purposes. Investment firms and banks also use them to assess companies’ financing requirements.
A 3-statement model has three main components:
- Income statement: This features the company’s revenue, expenses and taxes over a set period, usually several years. An income statement can be used to calculate the after-tax profits or net income.
- Balance sheet: This includes the company’s assets or resources, on the one hand, and its liabilities and equity, on the other. An asset is anything that can provide a future benefit. A liability is anything associated with direct or indirect costs.
- Cash flow statement: The cash flow statement compares a company’s net income to the actual cash it generates. Often, these can be two very different values. For instance, spending on long-term assets such as factory plants doesn’t normally appear on income statements because it could generate value for many years. Instead, this will be recorded as “capital expenditures” on the cash flow statement.
Leveraged buyout (LBO) models
LBO models are a variation on 3-statement models. Despite the similarities, most financial analysts consider them to be separate categories.
What is a leveraged buyout?
When a private equity firm acquires a company with borrowed money, we call this a leveraged buyout. The assets of the acquiring and the acquired company serve as collateral. The private equity firm runs the acquired company for several years, uses the cash flows to repay its debt, and eventually resells it at a higher price.
How does LBO modelling work?
The goal of LBO modelling is to estimate the multiple or annualised return rate that can be earned by investing in a company, keeping a stake for a period of time, and eventually selling it.
For instance, if a private equity firm buys a business for R1 million and runs it for seven years before selling it, could it generate an average annualised return of 30%?
Unlike 3-statement models, LBO modelling doesn’t require full financial statements. The investment returns depend primarily on the company’s cash flow and cash flow growth rate. Likewise, the company’s exit value is typically related to metrics that serve as cash flow proxies, such as earnings before interest, taxes, depreciation and amortisation (EBITDA).
To build an LBO model, a private equity investment firm will start by projecting the company’s revenue, expenses and cash flow. This should give an idea of the business’s free cash flow or the cash generated through core business operations after funding costs, such as interest on debt.
They would then use the proposed purchase price, the cash flows during the holding period, and the company’s estimated exit value to calculate the internal rate of return (IRR), also known as the average annualised return, and the multiple of invested capital (MOIC).
Because we normally need to track debt repayment and other related measures, LBO formulas are more complex than those in 3-statement models.
Growth Equity or Investment Models
In addition to buyouts, there are other private equity types, such as venture capital and growth equity, which don’t necessarily use debt. In that case, the models are simpler than LBO models, as they only require the purchase price, cash flow projections and exit value.
These variations are called “growth equity models” or just “investment models”.
Regardless of the variation, the goal of an equity model is always the same: to estimate plausible ranges for the IRR and MOIC.
Final Thoughts on Private Equity Models
While some private equity models are more popular than others – according to this 2015 Harvard Business School study, the vast majority of firms use IRR- and MOIC-driven models – and you can find various pre-made templates online, there are no one-size-fits-all solutions.
In reality, most private equity firms create custom models in-house to meet their and their clients’ unique needs. The complexity of these models will vary across firms and over time.
The process usually starts with a fairly rudimentary model. If it shows that a potential investment is promising, the firm will carry out much deeper enquiries. It may even hire external consultants. As the diligence process unfolds and the firm develops a better understanding of business drivers, the model becomes increasingly sophisticated.
Another thing to note is that financial models cannot predict the future with a high degree of certainty. Modelling is just a part of the investment process and one of the many factors investors take into account.
For example, if a model indicates that a company is undervalued by 5 to 10%, this would not be particularly helpful because the margin of error is so high. However, if the model tells you that a company is undervalued by 80%, that would be a much more useful and potentially accurate insight.
Make Your First Foray into Private Equity Investing with IFSA
Private equity investing is complicated, and there’s a lot more that goes into it than financial modelling.
The good news is that you don’t have to go it alone. At IFSA, we do all the work for you. Not only do we vet and handpick low-risk and low-volatility investment opportunities, but we also personally sit on the board of directors of the companies we invest in to help maximise your ROI.
To learn more, book a free one-on-one consultation with our financial advisers.
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