What’s A Private Equity Deal
Recent private equity deals, and the focus on private equity investments amidst stock market volatility, are clear indications that the appeal of private equity will rise in the coming years. Private equity (PE) firms follow various steps to evaluate investment opportunities before completing them. These structured steps can often vary from one another depending on the target company as well as the nature of the transaction.
Private equity deals occur when an investment deal takes place with capital that is not listed on a public exchange. Typically, private equity funds or investors invest in undervalued private entities and revamp them prior to becoming public companies.
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.
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.
What are the Phases of a Private Equity Deal
Here is a structure of a private equity deal:
- ‘Sourcing’ and ‘Teasers’
- Signing a Non-Disclosure Agreement (NDA)
- Initial Due Diligence
- Investment Proposal
- The First Round Bid or Non-Binding Letter of Intent (LOI)
- Further Due Diligence
- Creating an Internal Operating Model
- Preliminary Investment Memorandum (PIM)
- Final Due Diligence
- Final Investment Committee Approval
- Final Binding Bid
- Signing the Deal
‘Sourcing’ and ‘Teasers’
The beginning of the private equity deal structure is called ‘sourcing.’ Sourcing involves discovering and assessing an investment opportunity. PE deals are sourced through various methods such as 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.
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.
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.
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.
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
Further Due Diligence
The private equity due diligence framework gets back to work again. Here, the sellers provide more confidential 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.
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.
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.
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.
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.
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.
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 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.