Returns
How private equity investors measure returns: money multiple
Training course provider: And what I want to learn about now is measuring returns. So as well as understanding how private equity works – you can see the chart there – as well as understanding some of the issues that are affecting private equity, I just want to talk about private equity: measuring return. And I suspect there’s probably somebody in the room who understands some of this already. David, what’s one way that private equity might measure their returns on our little deal here?
Delegate: Money multiple.
Training course provider: Money multiple. And Matt, can you guess what the money multiple is on this deal?
Delegate: Three.
Training course provider: How did you work that out? He’s a… he’s a genius. An absolute whizz on the maths, this guy.
Delegate: Because it’s the sixty over twenty.
Training course provider: It’s the sixty over the twenty…
Delegate: Yeah.
Training course provider: …so if you like, it’s the equity out over the equity in. And Matt, I know you’re a genius on maths – what’s our money multiple for this deal?
Delegate: Three.
Training course provider: Three times. Absolutely. Genius. Right, and so our money multiple is three times.
Private equity firms want to double or triple their money
Training course provider: And as well as learning about how private equity measure return, I think we’re learning something about their target returns because David/ Matt, you might have heard this – private equity often say that they want to… have you heard this? What have you heard from private equity?
Delegate: That two… money multiple of two plus then the IRR of thirty percent plus.
Training course provider: OK, so… so Matt has heard private equity firms talking about achieving a money multiple of two plus and an IRR of about thirty percent. So what we’ve got here is a private equity firm who’s tripling their money. They’re looking at things from a money multiple basis; they’re looking at equity out over equity in. Of course we’re knowing that’s difficult for them at the moment because it’s hard to sell… hard to sell businesses. All right, so that’s one of the main ways that private equity will measure return; they’re looking at a target money multiple – let’s say, in our example, of three times.
Private equity and the power of leverage: simple exercise
Training course provider: Ollie, I’m sure you will agree with me…
Delegate: Hmm.
Training course provider: ..that we have got some almost expert mathematicians in this room, some almost expert mathematicians. So one of the other things that I’d like you to do with this is I would just like to explore the impact of the power of leverage, all right? Now in our example we’ve got a bank that’s prepared to lend – we know it’s unrealistic in today’s market – we’ve got a bank that’s prepared to lend eighty percent of the original purchase price. I think you guys will be able to work this out.
Delegate: That’s what I’m doing.
Training course provider: Ha-ha-ha-ha-ha! Let’s… let’s work out… all right, so let’s… so here’s the problem, all right; we have got… what we’re going to look at is the power; we’re going to look at the power of leverage. We’re going to look at the power of leverage, and we’re going to understand why banks have been under so much pressure to lend to these kinds of deals. The power of leverage. And in our example what we’ve got is eighty percent debt. We’ve got eighty percent debt, and our… on our deal, sixty over our twenty is a three-times money multiple. All right, now I want you to… just I should’ve… I… hopefully it won’t take you very long; I know I’ve intimidated you by saying that we’re going to do some maths on this course. I want you to imagine – is it possible to imagine this, David? I want you to imagine an Armageddon scenario where private equity would step up to the plate to purchase a business but wouldn’t actually be able to raise any funds from the bank. Complete Armageddon scenario. Can you imagine that scenario? Yeah, you’re laughing. Yeah, because we’ve been in the middle of a credit crunch and it has been very difficult to get bank financing, so maybe our Armageddon scenario’s not too far from the truth: zero percent debt. The other scenario that you can imagine is where things have got ridiculous – completely ridiculous, pre credit crunch – and how much was the bank prepared to lend you on your house, Ollie?
Delegate: Ninety percent.
Training course provider: Let’s just… just… just for argument’s sake, to demonstrate the power of leverage, let’s imagine that we’re at ninety percent debt. So could you run… could you just work some numbers on those two scenarios? Matt’s already relaxed; I think he’s already done it. Work some numbers on those and see if you can work out what is the money multiple. How does… how does the change in leverage affect the money multiple. What is the money multiple? I’ll just give you a few minutes to do that.
The introduction to private equity course continues
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