Blackstone Raise Large (blind) Pools of Equity Capital from Fund Investors - Accounting and Finance Assignment Help

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Valuation Models: Basic Background

In many private equity deals, the acquirer uses primarily debt to finance an acquisition. One obvious source of value is the interest tax shields arising from the deductibility of interest. Other sources include the attenuation of certain agency costs and the concentration and control of the equity — and, hence, the enterprise — in a few active hands.

In a typical arrangement, private equity sponsors such as Blackstone raise large (blind) pools of equity capital from fund investors, which enables them to search for companies to acquire. To fund a specific acquisition, the sponsors contribute some equity and then raise debt capital, sometimes as much as four (or more) times the amount of equity contributed. In principle, the debt is reduced quickly post-acquisition, and sometimes (but rarely) eliminated completely within five years after a transaction. This, of course, depends on many variables. Perhaps the most important variable is the price paid for the company as a multiple of its Free Cash Flow (FCF). More often than not, private equity firms use EBITDA as a less-than-perfect proxy for a firm’s cash flow, and “multiples of EBITDA” are perhaps the most widely used measures of price paid. Of course, if a company is acquired for a low EBITDA multiple, the debt is likely to be paid off far more quickly than if a high EBITDA multiple were paid. Naturally, the actual pay-down period depends greatly on a number of factors, including how attractively priced the deal was and how successful the company is post-LBO. Funds to retire debt typically come from the target company’s operations but may also come from asset sales. LBO debt contracts generally contain a “cash sweep” provision, which stipulates that all excess cash must be used to pay down debt.  Equity holders typically do not receive any cash payments until a normal capital structure is attained, or until the business is sold or refinanced.

There are, of course, many atypical arrangements. The most notable is when the LBO sponsor initiates what have become known as “leveraged dividend recapitalization transactions,“ wherein the portfolio company may increase its borrowings and use the proceeds of the incremental debt to pay a one-time dividend to its shareholders, well ahead of paying down its debt. Absent such dividend recaps, the debt contract typically prohibits or greatly limits dividend payments, such that each year the equity account of the company increases by the amount of the company’s net income. The senior debt is typically paid first, but the junior creditors generally receive a higher interest rate.

Immediately upon completing the acquisition, the PE firm often changes the operating company’s incentive programs to motivate managers and employees to implement targeted operating improvements. Under the new incentive programs, the management team typically receives a larger-than-pre-LBO share of the proceeds in the event of a company sale. This is just one of the ways private equity firms align their interests with those of their operating management teams. The board of the operating company is also usually replaced by a board consisting primarily of the PE firm’s representatives, who have a large stake in the acquired firm’s wealth creation. The PE firm’s representatives then take an active role in managing the strategy and operations of the acquired firm in order to maximize cash flow. If all goes well, they resell the company in three to five years for a substantial gain. The investors in the PE fund, the general partners of the PE firm, and the management team all share the proceeds. This “cashing out” of the partners can occur via a public sale of equity (IPO); a private sale of equity; or a new LBO led by a different private equity firm (known as a “sponsor-to-sponsor transaction.”)

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