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Private equity valuation

In this chapter: LBO valuation framework · Venture capital method · IRR and multiple of money (MoM) · J-curve effect · Carried interest waterfall

~3 min readLayer 4 · Professional CertificationsFree

Private equity returns include leverage, operational improvements, and multiple expansion. CFA L2 tests LBO valuation, exit-IRR analysis, and waterfall mechanics.

Foundation

**LBO basics**: PE firm acquires company using high leverage (60-80% debt). Post-acquisition: improve operations, repay debt, exit at higher EBITDA + multiple. Return drivers: 1. **EBITDA growth**: operational improvements. 2. **Multiple expansion**: exit multiple > entry multiple (rare, market-dependent). 3. **Debt paydown**: free cash flow used to delever — equity grows mechanically. 4. **Time arbitrage**: 4-7 year hold, then exit via IPO, secondary, strategic sale. **Venture capital method**: - Pre-money valuation = post-money – investment. - Required return high (20-50%+) reflects risk + illiquidity. - Step-up rounds: each round dilutes earlier investors but at higher valuation.

Deep Dive

**Carried interest (carry) waterfall**: Typical structure (2 and 20): - 2% management fee on committed capital. - 20% performance fee (carry) above hurdle rate (usually 8% IRR). - Catch-up: GP catches up after LPs receive hurdle. - Clawback: if early winners followed by losers, GP returns excess carry at end. **IRR vs MoM (multiple of money)**: - MoM = total exit value / total invested. - IRR = annualised return. - Quick exit boost IRR (high) but MoM low. Long hold may have lower IRR but bigger MoM. **J-curve**: PE fund returns negative early (fees + initial markdowns) then turn positive as portfolio companies mature/exit. Typical: net IRR negative for 2-3 years, then climbs to vintage benchmark.

Advanced

L2 trap: confusing fund-level vs deal-level returns. - Deal-level IRR: gross of fund fees. - Fund-level IRR: net to LP, after 2-and-20. - Difference can be 3-5%+ annual. Time-weighted vs money-weighted returns: PE uses money-weighted (IRR) because GP controls timing of capital calls and distributions. Public-market equivalent (PME) compares PE IRR to S&P 500 equivalent capital flow. Indian PE: maturity is 8-10 years (longer than US 5-7). Exit options narrower — IPO market less developed; strategic exits to MNCs common. IRR benchmarks: top quartile ~20-25%, median ~12-15%.

Regulatory references
  • SEBI AIF Regulations 2012
  • CFA Institute Alts curriculum
Common mistakes & pitfalls
  • Confusing gross-of-fees with net-of-fees IRR.
  • Comparing PE IRR to public-market arithmetic returns (use PME).
  • Ignoring J-curve effect — early negative returns are normal.

Frequently asked

Why are PE returns hard to compare to public equity?
IRR vs TWR difference, smoothed reported NAVs, illiquidity premium baked in. Use PME for honest comparison.
What is a "good" PE IRR?
Top quartile US buyout: 20%+ net IRR. India top quartile: similar in USD, higher in INR. Median often 8-12%.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
LBO equity returns from EBITDA growth + debt paydown + ___:
  1. (a)Tax shield
  2. (b)Multiple expansion
  3. (c)Dividend reinvestment
  4. (d)Currency hedging
Correct: (b) Multiple expansion
Three pillars of LBO returns: EBITDA growth, debt paydown, multiple expansion (or compression).
Q 2
"2 and 20" structure means:
  1. (a)2% carry, 20% mgmt fee
  2. (b)2% mgmt fee, 20% carry above hurdle
  3. (c)2-year fund, 20% return
  4. (d)Both fees 20%
Correct: (b) 2% mgmt fee, 20% carry above hurdle
2% annual management fee + 20% performance carry above hurdle rate.
Q 3
J-curve means PE fund returns are:
  1. (a)Always positive
  2. (b)Negative early, positive later
  3. (c)Zero
  4. (d)Linear
Correct: (b) Negative early, positive later
Negative early due to fees + writedowns; positive later as exits realise.
Q 4
PME compares PE returns to:
  1. (a)Treasury bills
  2. (b)Equivalent public-market timing
  3. (c)Gold
  4. (d)Other PE funds
Correct: (b) Equivalent public-market timing
PME = public-market equivalent: simulates same cash-flow timing in S&P 500 to benchmark fairly.
Q 5
In LBO, debt paydown drives equity returns because:
  1. (a)Interest is tax-deductible
  2. (b)Free cash flow reduces debt → equity grows mechanically
  3. (c)Banks pay PE firms
  4. (d)No effect
Correct: (b) Free cash flow reduces debt → equity grows mechanically
EV stays roughly constant (or grows); debt shrinks → equity = EV - debt grows.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.