The Fundamentals of Funds: Modeling Private Equity Funds

A private equity fund model is an indispensable tool for fund managers, providing insights into investment opportunities and helping drive a fund’s success. We’ll walk through the types of private equity models.

 

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Understanding Private Equity Funds

Private equity (PE) funds are specialized investment vehicles designed to pool money from high-net-worth individuals and institutional investors. The combined capital is then put towards investments typically inaccessible to the public markets. The fund can pursue opportunities such as acquiring a stake in a private company, orchestrating a turnaround, or propelling growth in a startup. A PE fund often has an investment time horizon of four to seven years.

The key players in private equity funds are the investors, the fund manager, and the portfolio companies. The investors contribute capital, attracted by the promise of returns exceeding traditional offerings. The fund manager drives the investment process, raising money and seeking investments aligning with the fund’s overall strategy. Finally, there are the portfolio businesses. These companies harness the capital influx to fuel growth or fund an operational overhaul.

Types of Private Equity Funds

There are two types of PE funds: leveraged buyout (LBO) and venture capital (VC). Each fund type is unique based on its business cycle stage.

Leveraged buyout (LBO) funds use significant debt levels to finance the acquisition of a late-stage business. Companies that are targets for LBO funds are mature with an established track record. Because the company has stable cash flows, it can service higher debt levels, a necessity for LBO funds as they rely heavily on leverage to provide investors with enhanced returns.

Venture capital (VC) funds provide equity to high-growth potential startups. PE funds are often critical to the success of these new companies as they are not eligible for traditional loans and other debt financing. Instead, the business’s growth relied on outside investments for its capital requirements.

What is Private Equity Fund Modeling?

Financial modeling impacts decision-making in private equity by illuminating the path from investment to exit. Private equity modeling has many practical applications. PE companies and VC firms use these models to assess a business’s viability, helping them identify the key risks of a potential investment. They also can evaluate the impact of different management decisions and estimate potential returns for investors. The purpose of PE models extends beyond the initial cash outlay and covers the post-investment period. Modeling can help monitor a continually evolving business and provide insight into possible exit strategies. 

The PE modeling process also asks “what if.” What if. It may seem simple, but it is difficult for a business to answer in practice. Financial modeling can help test a hypothesis without realizing any financial repercussions. For example, a financial forecast can help a PE firm answer, “What if we take over the business and streamline operations?”

How to Model Private Equity Funds

The LBO modeling steps start with constructing a three-statement financial forecast for the target company. By building a financial model, you can estimate the value of the business with its current ownership structure before the buyout happens.

Next, adjust for the buyout. This means you will incorporate the new financing structure, including the impact of debt on the company’s cash flow due to the resulting interest payments and debt servicing costs. At this stage, create a debt schedule outlining the amount and maturity dates associated with all outstanding loans and debts.

Finally, calculate the PE fund’s expected internal rate of return (IRR) for the LBO deal so the fund manager can determine if the target company is an appropriate investment for the fund.

Key Components of a Private Equity Fund Model

No two investment strategies in private equity are identical. No two models are identical. Each time you build a financial model for a private equity fund, it will reflect the nuances of its specific investments. With this in mind, there are several components to consider for your private equity fund model, though you can tailor the model to the fund.

Revenue projections: A PE fund model forecasts a portfolio company’s revenue streams to determine the potential for investor return. Conduct thorough market research to understand the competitive landscape and industry trends for more accurate revenue calculations. You can also consider the target business’s operational efficiencies and gauge the impact of future strategic initiatives.

Cash flow considerations: PE funds need to consider the capital commitment from investors and the portfolio companies’ needs. By tracking the timing and amounts of cash coming into and out of the fund, the model helps ensure liquidity is available to seize investment opportunities without overextending its commitments.

Debt schedules and interest expenses: Private equity funds with LBO objectives often rely on significant leverage. The PE fund model must accurately track the debt repayment and the associated interest expenses. The model should also consider the impact of changing interest rates on the fund’s ability to meet these payments. As you build a PE fund model, debt is a crucial consideration as it outlines the impact financing has on cash flow and the total investment return.

Scenario analysis: As with many financial forecasts, PE fund models can test how different circumstances could impact a company and the fund’s bottom line. When modeling private equity funds, consider providing a best and worst case in addition to the base case. This prepares the business and its investors for all possible outcomes.

Sensitivity analysis: PE funds can benefit from gauging the potential effect of a change in a specific variable. For example, if interest rates fluctuate, a private equity model could test how an investment’s net income would change. This is crucial information for modeling LBO deals, as leverage plays a major role in the investment. When interest rates rise, servicing the debt becomes more expensive, making it more difficult for the business to cover its borrowing costs. This, in turn, will decrease the investment’s profitability. Sensitivity analysis can measure the specific impact this could have on the rate of return for investors.

Debt Ratios for PE Fund Models

For private equity funds, managing debt ratios is particularly important. With debt being the primary source of financing for an LBO fund, it is critical to ensure the fund can cover the borrowing costs while using leverage to achieve the highest possible returns for its investors.

When you create a financial model for LBO funds, consider analyzing the following debt metrics:

  •  Debt-to-equity ratio
  •  Debt-to-EBITDA ratio
  •  Fixed charge coverage ratio
  •  Debt service ratio
  •  Interest coverage ratio

Exit Strategies in PE Modeling

Though investment strategies in private equity funds differ greatly, it is essential to consider a company’s exit strategy and its time horizon. Exit strategies help forecast when and how the PE fund will divest its ownership in a business.

Common exit strategies for private equity include initial public offerings (IPO), merging with another business, strategically selling the company, or a management buyout. A PE fund may also choose to maintain a reduced stake in the business for a partial exit only.

You can use an exit multiple or discount rate to incorporate the exit strategy when financial modeling for PE funds.

Exit multiple: A PE fund model may incorporate a multiple applied to a specific metric. You can estimate the potential exit price for a business using the calculated metric from the model in combination with a multiple from comparable company analysis or precedent transactions.

Consider, for example, the EBITDA (earnings before interest, taxes, depreciation, and amortization) metric, representing a company’s profitability from core operations. You can estimate a company’s potential sale price using its calculated EBITDA and the EBITDA multiple for comparable companies.

Discount rate: You can also find the value of a business by applying a discount rate or perpetual growth rate. The rate should reflect the company’s long-term risk profile. To determine the valuation, apply the discount rate to future estimated cash flows. This method calculates an investment’s present value, influencing the PE fund’s valuation and timing of company exit decisions. 

Best Practices in Private Equity Modeling

A forecast is simply a prediction of the future. Unfortunately, there is no way to predict what will happen with 100% certainty; however, there are ways to improve a financial model.

Are you wondering how to make a PE financial model more accurate? Consider the following.

  • Incorporate conservative assumptions to prevent an unrealistic view of the portfolio company. Conservative inputs allow for more flexibility as market conditions shift and help to manage investor expectations.
  • Engage in continuous dialogue with portfolio companies for real-time insights into the business and shifting market conditions.
  • Build dynamic formulas into the model, ensuring quick and seamless updating. Consider using Trace Precedents and Trade Dependents in Excel to identify cells that might not be appropriately linked.
  • Utilize technology to reduce human error and mistakes due to incomplete or inaccurate data. Technology can reduce manual input errors, but it also helps ensure data remains current. Automation practices can prevent your model from relying on stale-dated information.

Conclusion

Private equity fund models are indispensable tools, providing valuable insights into potential target companies. PE models aid fund managers in answering essential investment questions. “What if” questions. They help trace cash flows, decipher the impact of debt, and identify possible exit strategies and associated business risks. When modeling for private equity funds, following best practices can equate to a more accurate model and help deliver enhanced returns for investors. 

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