According to private equity industry analyst Prequin, North American private equity firms are currently sitting on around $1 trillion ‘dry powder’ in addition to approximately $3 trillion in AUM.
Onlookers differ as to what this means for the mid-term consequences for private equity, but there is almost no argument on one point:
Private industry deals are sure to flow in the next 2-3 years.
DealRoom works with dozens of private equity firms on every stage of their deal process, from origination right through to due diligence and post-deal issues. This has given us a unique perspective on current movements in the industry as well as some more general insights.
In this article, we share some of those more general insights, aiming to give the reader a better understanding of what’s involved in a typical private equity deal.
While the initial evaluation of investment opportunities may seem to happen quickly, the materialization of private equity deals could take a few months or even a year.
The private equity due diligence process is a lengthy sequence of steps that involves a lot of research and information gathering, analytics, discussions, and assessments. (Check out our private equity due diligence playbook)
Institutional and accredited investors dedicate large sums of money for private equity investments. Holding periods of such funds are often long because investments require time to turnaround and exit.
However, private equity can be highly beneficial for many companies such as startups. It offers them advantageous alternative liquidity options when compared to conventional financing options.
How does private equity work?
The typical private equity process is usually some variant of the following:
- The private equity fund creates a strategy, usually based on a set of characteristics around the companies it will search out. These might include location, company size, financial position, industry vertical, or competitive advantage. The strategy would also include the size of the typical investment, the minimum investment by each limited partner (investor), their expected payback, and the payback period. This is put in documentation to pitch the fund to investors.
- The private equity fund uses this documentation to raise funds to invest, usually conducting some form of roadshow (referred to in private equity as ‘capital calls’) for the fund with pension funds, family offices, insurance firms, hedge funds, and even other private equity funds.
- The private equity firm manager and the team dedicated to the fund in question will begin searching for companies that fit the criteria for the fund’s strategy. The process of finding a single company can take months, with most private equity companies making contact with one company in forty or fifty potential targets.
- When a deal is agreed to acquire a minority or majority share in a private company, the private equity company begins implementing its strategy. This often involves cutting costs, or redirecting the company on a new strategy that they believe will generate enhanced growth. They will very often bring in more experienced managers than the newly acquired company has in place, ensuring that every part of the company’s operations are maximized in a bid to reach their target returns.
- The strategy will usually outline an exit plan for each acquisition, at which point the private equity fund will seek out buyers for their investment. A typical exit would occur after at least five years, by which point, cash flows have risen by a multiple of 2 to 3 times where they were at the time of the initial transaction, thanks to operational and market changes.
What are the phases of a private equity deal? (Process in details)
1. ‘Sourcing’ and ‘Teasers’
The beginning of the private equity deal structure is called ‘deal sourcing.’ Sourcing involves discovering and assessing an investment opportunity.
PE deals are sourced through various methods such as equity research, internal analysis, networking, cold-calling executives of target companies, business meetings, screening for certain criteria, conferences and conversations involving industry experts, and more.
A teaser is a one to a two-page summary sent by a financial intermediary about a company up for sale or private equity investment opportunity.
It does not mention the name of the seller, but only a brief description of the business, its products and services, and key financials. Companies often hire investment banks to confidentially attract private equity firms and strategic buyers.
Investment banks can provide software solutions like investment banking data rooms for conducting a deal there.
How to Have the Best Strategies for Advantageous Deal Sourcing
2. Signing a Non-Disclosure Agreement (NDA)
If a private equity firm is interested in the prospects from a ‘teaser,’ they will move forward by signing a Non-Disclosure Agreement (NDA).
Upon signing the NDA, the financial intermediary will provide the PE firm with a Confidential Information Memorandum (CIM). A CIM includes an investment thesis, financials, projections, and capital structure.
If an investment opportunity is sourced, the NDA is signed directly with the target company.
Consequently, the management of the target company will then provide confidential information regarding their business. In this stage of the private equity deal flow, the PE firm is granted with enough information to decide whether it will explore the investment opportunity any further.
3. Initial Due Diligence
In this phase of the private equity process, initial due diligence is conducted to form a better understanding of the target company.
It includes research and information gathering about the company and its industry.
Another huge piece of due diligence is estimating the return of investment according to the projections provided by the company’s management.
They may also get in touch with the investment bank to learn about the company from their perspective and potential debt financing options that are available for the acquisition.
Usually for these kind of work companies utlyze data rooms or special PE due diligence software like DealRoom which combines both functionalities for smooth diligence process. Here you can see the diligence requests examples:
4. Investment Proposal
After initial due diligence, the investment team prepares an investment proposal and presents it to their investment committee. The purpose of the first investment committee meeting often changes from one PE firm to another.
It can be a simple deal update or the initiation of a formal approval process. In the latter, the investment team is given the Green light to spend a certain amount of money on consultancy and other relevant expenses.
During this step as well, they may even submit a First Round Bid, which we will discuss next.
5. The First Round Bid or Non-Binding Letter of Intent (LOI)
During this stage of the private equity deal process, the investment team will provide the target company with a non-binding letter of intent (LOI) for the transaction.
This is the under specific criteria provided to them by the target company’s management. Often, a valuation range is mentioned rather than a specific amount. The target company and its advisors will then choose a few bids and move on to the next round in the auction process.
Some key points that are taken into consideration here include:
- Purchase price (or range)
- Post-acquisition capital structure
- Time needed to provide a binding offer
- PE firm’s experience and expertise
- Value creation strategy
- Credibility of the offer
- Compatibility with the submitting firm’s management team
6. Further Due Diligence
The private equity due diligence framework gets back to work again.
Here, the sellers provide more confidential information.
Many companies utilize virtual data rooms (VDRs) or DealRoom with built-in data room to collaborate, assign tasks, and exchange information.
This information includes but is not limited to:
- The company’s legal and organizational entities
- Operations records
- Board reports including meeting minutes
- Property agreements
- Documentation related to intellectual properties
- Financial information including audited and unaudited financials
- Employee details
- Employee agreements
The PE investment team conducts due diligence by reviewing the files in the data room.
They will have follow-up calls with the management of the target company for further assessments and clarifications.
On top of that, they will also brainstorm critical post-acquisition issues that the acquiring firm may face short- and long-term.
7. Creating an Internal Operating Model
An operating model is a highly detailed revenue and cost breakdown.
It takes key drivers of the target business and assumptions into consideration. Key drivers may vary greatly from deal to deal. Some common ones include:
- Raw material costs
- Number of customers
- Renewal rates
- Fixed vs. variable cost structure
Investors utilize this model to estimate the financial performance of the target firm. This gives the PE firm’s decision-makers a clearer picture of the major factors that drive return for the acquisition.
8. Preliminary Investment Memorandum (PIM)
The Preliminary Investment Memorandum (PIM) is a 30 to 40-page document that summarizes the investment opportunity to the PE firm’s investment committee.
The Preliminary Investment Memorandum usually consists of the following sections:
- Executive Summary -- important details such as the transaction, background, deal team recommendations, and the investment thesis.
- Company Overview -- the target firm’s description, products and services, history, suppliers, competitors, customers, organizational structure, and biographies of the key management, and more.
- Market & Industry Overviews -- market growth rates and trends.
- Financial Overview -- past and projected income statements, balance sheets, and analytics of cash flow.
- Valuation Overview -- analytics about the company, M&A transactions, LBO, DCF, etc.
- Risks & Key Areas -- probable risks to the industry and business that were identified by due diligence.
- Exit Details -- options when it comes to an investment exit and its timing.
- Proposed Project Plan -- recommendations to the committee on how to proceed with the project based on a valuation range and a budget approved by the investment committee.
Deal teams usually perform only the initial due diligence up to this stage due to high costs. Further legal due diligence is carried out later in the private equity due diligence framework.
9. Final Due Diligence
Once the investment committee approves the PIM, the PE deal team will then perform all the remaining and final due diligence. The investment team will dedicate their time only for the particular project at this stage.
Other PE projects will be either sidelined or delegated to other professionals within the firm.
In this stage of the private equity investment process flow chart, the deal team typically interacts with the investment bank and the management of the target company on a daily basis.
They will send requests to the target company to address any outstanding issues such as visit requests, calls with sales personnel, non-executive management, customers, and suppliers.
During this time, the investment team will manage the consultants on various streams of the due diligence process such as financial, commercial, and legal.
Furthermore, they will start negotiating with the banks about debt financing options, aiming to secure the best debt terms with a group of banks.
It usually takes between three to six weeks for the due diligence process in private equity from the First Round Bid to the Final Binding Bid.
10. Final Investment Committee Approval
Once all the steps in the private equity due diligence process are completed and the investment team is comfortable moving forward with the deal, a Final Investment Memorandum (FIM) is created.
The FIM addresses the further due diligence carried out by the deal team and its consultants from the time of creating the PIM, especially highlighting any key issues pointed out by the investment committee.
Furthermore, the deal team will recommend a specific valuation to acquire the target company. The valuation will be either approved or rejected by the investment committee.
11. Final Binding Bid
If the FIM is approved by the investment committee, the deal team will proceed by sending a Final Binding Bid (or a Final Round Bid) to the target company.
This bid includes a final buying price, financing documents from investment banks, and preliminary merger agreements. The preliminary merger agreements will be discussed later with the seller’s lawyers.
The seller and their advisors will then spend at least a few days considering the bids they receive and ultimately choose a winning bid.
12. Signing the Deal
Once the seller along with its investment bankers and advisors pick a winning bid, they will work exclusively with that preferred party to sign transaction documents and contracts.
A Purchase Agreement (or Merger Agreement) and other documents will be created after negotiations between the lawyers of the buyer and seller.
The private equity investment cycle
The private equity investment cycle refers to the period in which the private equity fund manages the company. A typical holding period is three to five years, with the long-term average holding period for private equity funds being around four years.
However, the ‘harvest period’ - that is, the time at which the companies in the fund are divested and funds returned to investors - may be extended beyond five years if the conditions to sell are not suitable (or the business is performing so well that the private equity fund decides to continue to benefit from its cash flows).
How private equity deals are funded
Private equity deals can be funded by almost every conceivable combination of private capital. As mentioned at the outset, the ultimate source of the funds could be anything from a university endowment fund to a rich aunt with an appetite for high returns on her investment.
Ultimately, all of this cash makes its way into the private equity fund, which is then used to pay for the investments. A key point to note here is that the limited partners - the endowment fund, the rich aunt, and others - hand control of the investments over to the general partners, the private equity manager.
Thus, his or her reputation depends on how well they manage the funds invested.
Examples of private equity deals
There is an extraordinary number of private equity deals being closed on a daily basis, particularly when deals in venture capital, growth capital, distressed assets, and the rest are taken into account.
For this reason, we decided it would be worthwhile to look at examples of two different kinds of private equity deals - a leveraged buyout and a venture capital deal - to understand the dynamics of private equity from a couple of different standpoints.
The leveraged buyout example: Blackstone acquires Hilton Hotels for $26 billion, 2007
If anyone ever doubted the blurred lines between M&A and private equity, it is worth noting that Blackstone started life as an M&A advisory firm in 1985, using its advisory fees to move into private equity.
In 2007, Blackstone used a leveraged buyout to purchase Hilton Hotels. Blackstone leveraged almost 80% of the total amount, ($20 billion), to take control of the famous hotel chain. It reduced operational inefficiencies at Hilton, sold underperforming assets, and reinvested in good locations.
When it sold the asset in 2018, it did so at a profit of around $14 billion. And all by initially just using $5.6 billion of its own equity.
Venture capital example: SoftBank acquires 34% Alibaba for $20 million, 2000
In the venture capital branch of private equity, investors are looking for young, sometimes non-profitable companies with massive potential.
The acquisitions are almost never for anything other than a share of the company, on the basis that the equity investment in those fast-growing companies will lead to holding a share in a much larger, profitable company a few years down the road.
That was the bet that Softbank took with a young Chinese e-commerce store called Alibaba in 2000. When Alibaba listed launched its IPO nearly twenty years later, it achieved a valuation of $231 billion - making Softbank’s share worth a cool $60 billion.
The process from evaluation to completion of a new private equity investment venture can be lengthy and exhausting.
While the steps carried out in the private equity due diligence process may vary from one private equity firm to another, most key steps mentioned above remain the same. This is due to their importance in ensuring a prosperous and successful private equity investment.
What is private equity deal flow? PE deal flow is the quantity and quality of investment opportunities and the process by which firms source, evaluate, and win investment deals. Good deal flow is a key indicator of a successful fund, and it's how PE firms develop and maintain their pipelines.What is private equity answer? ›
Private equity firms buy companies and overhaul them to earn a profit when the business is sold again. Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt.What is deal by deal private equity? ›
In a deal-by-deal fund, a dedicated vehicle will be created for purposes of making an investment in a single target oppor- tunity (or single portfolio of target opportunities).What are the stages of private equity? ›
According to Blackstone's Private Wealth Solutions group, the life cycle of PE funds is typically 7 to 10 years, and is generally broken down into three stages: the fundraising period, the investment period, and the harvest period.What is private equity in simple terms? ›
Private equity, in a nutshell, is the investment of equity capital in private companies. In a typical private equity deal, an investor buys a stake in a private company with the hope of ultimately realising an increase in the value of that stake.What is deal structuring? ›
Deal Structuring allows the buyer of a business to shape the deal to their advantage. It can result in a large transfer of value from the seller to the buyer at the closing. M&A negotiations are tense and usually involve back and forth around the price.How long does a private equity deal take? ›
Typically takes about 3-6 months. Initial investor commitments are made and the fund launches. Initial “calls” are often not full the full amount committed. Also called “first closing.”How do you evaluate a private equity deal? ›
The three measures of private equity performance you need to know are internal rate of return (IRR), multiple of invested capital (MOIC), and public market equivalent (PME). It's important to learn and use all three metrics in tandem because they account for the others' blind spots.What is private equity with example? ›
Private equity is the category of capital investments made into private companies. These companies aren't listed on a public exchange, such as the New York Stock Exchange. As such, investing in them is considered an alternative.What do you say in a private equity interview? ›
- Describe the industry and the company's business model.
- Discuss the revenue, EBITDA, or earnings of the business.
- Talk about the valuation that the company sold for (EV/EBITDA, or other) ...
- Outline the strategic rationale for the transaction.
To go back to first principles, equity is a stake of a company's value. Public equity is a share in a company that is publicly traded on a stock exchange. Private equity is a stake in any company that is not publicly traded.How does deal by deal carry work? ›
Deal-by-deal or “American” carry provisions allow the general partners (GP) to earn carried interest on each deal as it is exited, even if the fund as a whole has not returned sufficient capital to limited partners for them to break even.What is deal by deal basis? ›
Deal-by-deal structures tend to charge a lower fee, based on the deal value (say, 1% per annum), and only once the investment has been acquired. No abort costs: unlike with a traditional fund, any costs from an aborted investment opportunity are borne by investment manager, not the investors.What is deal by deal waterfall? ›
Under the deal by deal model, returns are generally calculated for each investment, and the manager receives its carried interest as proŽts are realized on the particular investment.
Cerberus is an industry pioneer of Operational Private Equity, an approach where investment professionals and operating executives work in close partnership throughout the lifecycle of an investment to improve business performance and drive long-term value creation.What is the private equity business model? ›
Private equity firms raise money from institutional investors (e.g. pension funds, insurance companies, sovereign wealth funds and family offices) for the purpose of investing in private businesses, growing them and selling them years later, generating better returns for investors than they can reliably get from public ...What is private equity round? ›
Private Equity: A private equity round is led by a private equity firm or a hedge fund and is a late stage round. It is a less risky investment because the company is more firmly established, and the rounds are typically upwards of $50M.What happens when company is bought by private equity? ›
When a private-equity firm (PE) acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.Why is private equity Interesting? ›
Private equity investors work with portfolio companies over the long-run, often 5-8 years. Hedge funds investments can be as short as a few weeks. So private equity teaches you the art of long-term view. Private equity also gives you the ability to work closely with the company over an extended period of time.What do private equity investors look for? ›
Their mission is to invest in companies (with a majority or minority stake), create value during a period of approximately four or five years and then sell their share with the greatest capital gain possible. Therefore, they look for businesses that show clear growth potential in sales and profits over the next years.
There are three well-known methods of M&A deal structuring: asset acquisition, stock purchase, and merger, each with its own merits and potential drawbacks for both parties in the proposed deal. A proper deal structure will lead to a successful merger or acquisition deal.Why is deal structuring important? ›
Structuring deals properly means that both parties understand the outcome of the merger or acquisition, reducing the chances of the negotiations falling through.What is deal structuring in sales? ›
Deal structure clearly defines what will occur during and after the sale of your business. You have put years of hard work into building your company. The deal structure outlines how the merger or acquisition will occur, how much cash you can expect to receive as a result, and when you will receive those funds.What is due diligence in private equity? ›
In the private financial markets, private equity due diligence describes a potential investor's process for assessing the desirability, value, financial viability and potential of an investment fund before they commit capital.What is it called when a private equity fund ends? ›
Harvesting. Once the Investment period has expired, the fund will be finished with making initial investments, and will focus on helping the portfolio companies grow and succeed and on exiting its investments.What is a good IRR for private equity? ›
Depending on the fund size and investment strategy, a private equity firm may seek to exit its investments in 3-5 years in order to generate a multiple on invested capital of 2.0-4.0x and an internal rate of return (IRR) of around 20-30%.What makes a private equity firm successful? ›
Whether it's a prospective investment or an existing portfolio company, PE firms should consider the hallmarks of both sales excellence and sales obsolescence. Successful sales organizations are customer-oriented, highly productive, revenue- and profit-centric and excellent at both execution and implementation.How is private equity risk measured? ›
Investors should consider all material risks, including general market risk and specific risk exposure. The most widely used methodologies to measure the risk of private equity investments are based on the assessment of the volatility of net asset values (NAVs) and that of cash flows.Who funds private equity? ›
Who can invest? A private equity fund is typically open only to accredited investors and qualified clients. Accredited investors and qualified clients include institutional investors, such as insurance companies, university endowments and pension funds, and high income and net worth individuals.What is the largest private equity firm? ›
1. Thoma Bravo. Thoma Bravo is a leading software investment firm with over $114 billion in assets under management as of March 31, 2022.
Private equity firms invest the money they collect on behalf of the fund's investors, usually by taking controlling stakes in companies. The private equity firm then works with company executives to make the businesses — called portfolio companies — more valuable so they can sell them later at a profit.How can I impress in private equity interview? ›
Good answers suggest to the interviewer what you can bring to the company. Check out recent deals, target companies, and say something that shows a genuine interest in the company you want to work for. “Summarize your experience in the context of their firm – why are you going to be useful to them?” advises McManus.How do you stand out in a private equity interview? ›
Being able to articulate a well thought out reason why you want to come join our fund specifically goes a long way toward standing out. It shows strong preparation, an ability to think high level, and a keen interest to be in a specific place.Are PE interviews hard? ›
Private equity interviews can be challenging, but for most candidates, winning interviews is much tougher than succeeding in those interviews. You do not need to be a math genius or a gifted speaker; you just need to understand the recruiting process and basic arithmetic.Is private equity better than public equity? ›
According to a 2021 McKinsey report, private equity has outperformed public equity consistently in the last two decades. Over a 10-year period, private equity generated annualized returns of 14.3%, while the S&P 500 — a reasonable benchmark for the public market — returned 13.8%.What is the size of the private equity market? ›
Although the private equity market saw its size triple from $2 trillion to over $6 trillion in the past decade, it still makes up “only a small fraction of total global equity markets,” according to the BlackRock report.How does private equity improve companies? ›
By partnering with private equity, you can get access to more components for your overall growth strategy. Private equity investors bring process improvement, margin enhancement and margin improvement expertise.What does a 20% carry mean? ›
With a 20% carried interest provision, general partners earn 20 cents for every dollar of return to limited partners in the fund.What is waterfall method in private equity? ›
A distribution waterfall is a way to allocate investment returns or capital gains among participants of a group or pooled investment. Commonly associated with private equity funds, the distribution waterfall defines the pecking order in which distributions are allocated to limited and general partners.What is a carry vehicle in private equity? ›
The carry vehicle acquires an interest in the fund at the start of the fund's life; typically, in funds structured as limited partnerships, by becoming a limited partner.
Giveback means obligations to return distributions to satisfy certain fund-related obligations and liabilities pursuant to section 9.2 of SP VII Partnership Agreement.What is a hurdle rate in finance? ›
A hurdle rate is the minimum rate of return required on a project or investment. Hurdle rates give companies insight into whether they should pursue a specific project. Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower risk.What is catch up clause? ›
Finally, the catch-up clause is a legal provision meant to compensate the General Partner (GP) based on an investment's total return, not just the return in excess of the pre-established hurdle.What is an 80/20 catch up? ›
In a preferred return with GP catchup, once the preferred return hurdle is met, the GP receives all or most of the future profits until the GP catches up to its 20% carry amount, and after that the profits are split 80% to the LPs and 20% to the GP (for its normal carry).What is the hurdle rate in private equity? ›
The minimum return to investors to be achieved before a carry is permitted. A hurdle rate of 10% means that the private equity fund needs to achieve a return of at least 10% per annum before the profits are shared according to the carried interest arrangement.What is a 50/50 catch up private equity? ›
Another option that many funds feature is a catch-up provision. Such a provision allows a sponsor to split cash flows 50/50 (or at some other accelerated rate) over the preferred return until they have received 20% of all profits, after which the economics return to the 80/20 split.What is deal flow management? ›
Deal flow management software equips teams with tools to fast track deals, manage their pipeline, and keep decision makers informed. Every aspect of the deal, from diligence to integration, can be managed with the software.What is the deal process in investment banking? ›
•Gather Financial & Legal Due Diligence Material. •Analyze Structural Considerations, Including Tax & Accounting Issues. •Review Tactical & Strategic Considerations. •Analyze Structural & Timing Considerations. • Create deal Collateral including Information Memorandum, Financial Model and Teaser.What dealflow means? ›
Deal flow refers to the rate at which business proposals and investment pitches are being received by venture capitalists, angel investors and private equity investors. Rather than a rigid quantitative measure, the rate of deal flow is somewhat qualitative.How do private equity firms find deals? ›
- Investment banks / M&A intermediaries.
- Referral sources (attorneys, accountants, etc.)
- Other private equity firms.
- Management team sponsors.
A “good” deal flow is defined as one that generates the amount of revenue, or equity-generating opportunities, required to keep a company performing at its highest capacity.What is deal analysis? ›
Deal analysis is the process by which you determine how much you can pay for a house in order to cover all the expenses of fixing it up and selling it. You want to make sure you can still make a profit after all that's done – after all, that's the point of flipping houses.What is a term sheet in business? ›
A term sheet is a nonbinding agreement outlining the basic terms and conditions under which an investment will be made. Term sheets are most often associated with start-ups. Entrepreneurs find that this document is crucial to attracting investors, such as venture capitalists (VC) with capital to fund enterprises.What are the steps in the acquisition process? ›
- Decision to acquire companies as inorganic growth.
- Criteria for acquiring a company.
- Company search and selection.
- Due Diligence.
- Contract of acquisition.
Once your financials are cleaned up, you and your banker will create a Confidential Information Presentation (CIP). Your CIP will be a ~30-page deck laying out key business metrics and explanations for buyers to evaluate your business at a high level.What is M&A deal execution? ›
The phrase mergers and acquisitions (M&A) refers to the consolidation of multiple business entities and assets through a series of financial transactions. The merger and acquisition process includes all the steps involved in merging or acquiring a company, from start to finish.What is considered good deal flow? ›
An organization's deal flow is considered “good” if it results in enough revenue- or equity-generating opportunities to keep the organization functioning at peak capacity.What is deal type? ›
A term used in the smartx ecosystem and a key element of a demand business rule (DBR), the deal type sets out which auction mechanism will be used to decide the final price paid for programmatic ad inventory. There are a number of deal types – first-price auction, second-price auction, direct deal, etc.What is a deal finance? ›
An entity that stands ready and willing to buy a security for its own account (at its bid price) or sell from its own account (at its ask price). Individual or firm acting as a principal in a securities transaction.How long does a private equity deal take? ›
Typically takes about 3-6 months. Initial investor commitments are made and the fund launches. Initial “calls” are often not full the full amount committed. Also called “first closing.”
- Source referrals from other investors. ...
- Get referrals from portfolio companies. ...
- Seek referrals from service providers. ...
- Network your way to high-quality deal flow. ...
- Increase your online engagement.
Private equity is the category of capital investments made into private companies. These companies aren't listed on a public exchange, such as the New York Stock Exchange. As such, investing in them is considered an alternative.