Private equity theory and practice for finance

Private Equity: Theory and Practice for Finance

Students Prepared by [Your Name], Finance Lecturer

May 20, 2025, 02:58 PM +07

1 The Private Equity Market 1

1.1 What is Private Equity? 1

1.2 Difference with Venture Capital and Growth Capital 1

1.3 What Do Private Equity Fund Managers Do? 1

1.4 What is a Private Equity Fund? 2

1.5 The Objectives of Private Equity Investments 2

1.6 Are There Theoretical Ideas Behind the Private Equity Model? 2

1.7 Private Equity Funds: What Are the Risks Involved? 2

1.8 Carried Interest 3

1.9 What is Leverage and Its Role Within Private Equity? 3

1.10 Private Equity and Market Risk 3

1.11 How Does Private Equity Control Their Investments? 3

1.12 The History of Private Equity 4

1.13 Total PE History Explained from 19601970 Until Now 4

1.14 How Big is the PE Market? 4

2 Private Equity in Practice 4

2.1 Leverage Calculations 4

2.2 Equity Returns Based on Leverage 5

2.3 Calculations in Excel 5

3 Case Studies in Private Equity 6

3.1 KKRs RJR Nabisco Buyout (1989) 6

3.2 Blackstones Hilton Hotels (2007) 6

4 Exercises for Students 6

5 References 7

6 Appendix: Glossary 7

Private Equity Lecture Notes Page 1

1 The Private Equity Market

1.1 What is Private Equity?

Private equity (PE) involves investment funds acquiring equity stakes in private compa-nies to enhance their value and sell for profit Unlike public markets, PE investments are illiquid, often spanning 37 years, and require active management For instance, in 2018, TPG Capital acquired a majority stake in J.Crew for $3 billion, later restructuring its operations and selling assets to recover value despite challenges

PE firms typically target mature firms with stable cash flows or underperformers needing turnaround This process involves appointing new management, optimizing op-erations, and leveraging debt, distinguishing PE from passive public investments

1.2 Difference with Venture Capital and Growth Capital

PE differs from VC and growth capital in focus:

• Private Equity: Targets mature firms, using leverage (e.g., 70% debt) for control.

Example: KKRs 2016 buyout of H.J Heinz for $28 billion

• Venture Capital: Funds startups with high growth potential, like Andreessen

Horowitzs $50 million investment in Lyft in 2013, taking minority stakes without debt

• Growth Capital: Supports expansion in established firms, such as Silver Lakes

$1 billion investment in Dell in 2018 for market growth, with minimal leverage

PE focuses on later-stage optimization, VC on early innovation, and growth capital on scaling

1.3 What Do Private Equity Fund Managers Do?

PE fund managers (GPs) handle:

• Deal Sourcing: Identifying targets via networks, e.g., a $10 million EBITDA firm

overlooked by competitors

• Due Diligence: Analyzing $5 million liabilities and market risks over 8 weeks.

• Deal Structuring: Blending 60% debt at 5% interest with 40% equity.

• Value Creation: Cutting costs by 10% or adding a $2 million revenue stream.

• Exit Execution: Exiting via IPO, like Carlyles 2012 IPO of Booz Allen Hamilton,

yielding $2 billion

GPs also manage LP communications and may replace executives to align with their strategy

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1.4 What is a Private Equity Fund?

A PE fund is a limited partnership:

• Limited Partners (LPs): Investors like pension funds (e.g., Ontario Teachers

Pension Plan with $500 million) provide capital with limited control

• General Partners (GPs): The PE firm (e.g., Blackstone) manages, charging 2%

fees and 20% carried interest

Funds last 10 years, with 5 years for investments (e.g., $400 million in 10 firms) and 5 years for exits, aiming to exceed an 8% hurdle rate

1.5 The Objectives of Private Equity Investments

PE aims to:

• Generate Returns: Target 1520% IRR, e.g., $40 million to $100 million in 5

years

• Improve Firms: Boost EBITDA from $5 million to $8 million via efficiency.

• Profit Exit: Sell at 3x multiple, like $50 million to $150 million.

• Align Interests: Use carried interest to motivate GPs.

These goals balance risk (e.g., layoffs) and growth (e.g., acquisitions)

1.6 Are There Theoretical Ideas Behind the Private Equity Model?

PE rests on:

• Agency Theory: Aligns managers with owners via 5% equity stakes.

• Modigliani-Miller: Leverage adds value with tax shields (e.g., $1 million interest

saves $300,000 at 30%)

• Market Inefficiency: Buys firms at 5x EBITDA vs 8x peers.

• Resource-Based View: Adds value via supply chain savings.

These theories support PEs outperformance but highlight leverage risks

1.7 Private Equity Funds: What Are the Risks Involved?

Risks include:

• Illiquidity: 510 year lockup, e.g., $20 million LP capital.

• Leverage Risk: 70% debt risks default, as in 2008.

• Operational Risk: Failed turnarounds, like overestimating growth.

• Market Risk: 20% valuation drop lowers 8x to 6x EBITDA.

• Regulatory Risk: Tax law changes cut returns by 5%.

Private Equity Lecture Notes Page 3

1.8 Carried Interest

Carried interest is the 20

• Hurdle: 8% over 5 years = $46.9 million

• Profit: $40 million

• Carried: 20% of $40 million = $8 million

• LP Return: $132 million

Taxed as capital gains (20%), its debated for favoring GPs

1.9 What is Leverage and Its Role Within Private Equity?

Leverage uses 6070% debt (e.g., $70 million of $100 million):

• Amplifies Returns: 108.33% ROE vs 50% without (see Section 2.2).

• Tax Benefits: $3.5 million interest saves $1.05 million.

• Discipline: Enforces cash flow focus.

Risks include default, as seen in Chryslers 2008 failure

1.10 Private Equity and Market Risk

PE faces:

• Economic Cycles: 2008 dropped valuations 30%.

• Interest Rate Risk: 2% hike adds $1.4 million on $70 million.

• Valuation Risk: 6x vs 8x EBITDA cuts $20 million.

Mitigation includes sector diversification and exit timing

1.11 How Does Private Equity Control Their Investments?

PE controls via:

• Majority Ownership: 51%+ stakes.

• Board Seats: Oversight with veto power.

• Incentives: 5% equity for managers.

• Oversight: Cost cuts or growth plans.

• Covenants: Debt-to-EBITDA below 4x.

This ensures strategic alignment

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1.12 The History of Private Equity

PE evolved:

• 1940s1950s: ARDCs 1946 founding.

• 1960s1970s: KKRs 1976 Houdaille buyout.

• 1980s: RJR Nabiscos $31.4 billion deal.

• 1990s: Global growth by Carlyle.

• 2000s: TXUs $45 billion deal, 2008 crisis.

• 2010s2025: Tech focus, $6 trillion AUM.

1.13 Total PE History Explained from 19601970 Until Now

• 1960s1970s: Houdaille used 50% debt.

• 1980s: RJR Nabisco leveraged junk bonds.

• 1990s: Carlyle expanded globally.

• 2000s: TXU peaked, 2008 hit hard.

• 2010s: AUM to $4.5 trillion.

• 20202025: Healthcare focus, $6 trillion AUM.

1.14 How Big is the PE Market?

As of May 2025:

• AUM: $6 trillion (Preqin).

• Dry Powder: $2 trillion.

• Regions: North America (50%), Europe (25%).

• Growth: 10% CAGR since 2010.

2 Private Equity in Practice

2.1 Leverage Calculations

Example:

• Purchase: $100 million

• Debt: 70% = $70 million

• Equity: 30% = $30 million

• Ratio: $70m/$30m = 2.33

• Capital: 70%

Private Equity Lecture Notes Page 5

2.2 Equity Returns Based on Leverage

With 5% interest:

• Exit: $150 million

• Interest: $17.5 million

• Debt at Exit: $87.5 million

• Equity Value: $62.5 million

• ROE: 108.33%

• Annualized: 15.81%

Without leverage: 50% ROE

2.3 Calculations in Excel

Leveraged Buyout (LBO) Calculation

Inputs

A1: Purchase

Price

B1:

A2: Debt

A3: Equity

A4: Exit

Value

B4:

A5: Interest

A6: Holding

Calculations

A8: Equity B8: $30,000,000 =B1*B3

A9: Total

Interest Paid B9: $17,500,000 =B7*B5*B6

A10: Debt at

Exit

B10:

A11: Equity

Value at Exit

B11:

Returns

A12: Return

on Equity

(ROE)

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Annualized

ROE

(1/B6)) −

1

Instructions for Students:

• Setup: Create this table in Excel starting at A1.

• Formulas: Use column D formulas to compute column B values.

• Formatting:

– Header: Merge A1:D1, enter "Leveraged Buyout (LBO) Calculation", bold,

font size 14, fill dark blue (RGB: 31, 78, 121), white text

– Subheaders: Bold A1, A7, A12; fill light blue (RGB: 91, 155, 213).

– Currency: Format B1, B4, B7-B11 as currency ($) with 0 decimals.

– Percentage: Format B2, B3, B5, B12, B13 as percentage with 2 decimals – Borders: Apply "All Borders" to the table.

– Shading: Alternate rows with light gray (RGB: 221, 221, 221) using

Condi-tional Formatting with =MOD(ROW(),2)=0

– Alignment: Center B and D, left-align A.

3 Case Studies in Private Equity

3.1 KKRs RJR Nabisco Buyout (1989)

KKRs $31.4 billion deal used $25 billion in debt via junk bonds High interest and a declining tobacco market posed risks, but asset sales yielded a profit This highlights leverages double-edged nature

3.2 Blackstones Hilton Hotels (2007)

Blackstones $26 billion acquisition with $20 billion debt faced the 2008 crisis Restruc-turing and a 2013 IPO earned $14 billion, showing PEs operational strength

4 Exercises for Students

1 Calculate ROE for a $200 million deal (60% debt) exiting at $300 million over 5 years at 4% interest

2 Analyze a 2% rate increases impact on a $500 million deal (70% debt)

3 Research TPGs J.Crew deal; evaluate its turnaround strategy

4 Compute ROE for a $150 million deal (70% debt) with exits at $200m, $250m,

Private Equity Lecture Notes Page 7

5 References

• Kaplan, S N., & Strömberg, P (2009) Journal of Economic Perspectives.

• Preqin (2025) Global Private Equity Report

• Lerner, J., & Schoar, A (2005) Journal of Finance.

6 Appendix: Glossary

• LBO: Acquisition with significant debt.

• Dry Powder: Uninvested capital.

• Hurdle Rate: Minimum return for carried interest.

• EBITDA: Earnings before interest, taxes, etc.

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