Private Equity Valuation

Section: Private Equity Valuation Estimated study time: 60 minutes Content: Private equity (PE) investing encompasses venture capital (early-stage companies), growth equity (established but pre-IPO companies), and leveraged buyouts (LBOs) of mature companies. At CFA Level 2, PE valuation focuses on the unique analytical frameworks for each stage, the mechanics of LBO modeling, the structure of PE fund economics, and the performance metrics used to evaluate PE fund returns. Unlike public market valuation, PE valuations rely on periodic appraisals rather than continuous market prices, creating issues of stale valuations, smoothed returns, and illiquidity premiums. Leveraged buyout (LBO) analysis is the most heavily tested PE valuation method at Level 2. In an LBO, a PE firm acquires a company using a combination of equity (typically 30-40%) and debt (60-70%). The debt is serviced from the target company's operating cash flows. Returns to the PE equity investors come from: (1) EBITDA growth (improving operating performance), (2) multiple expansion (selling at a higher EV/EBITDA than the purchase multiple), and (3) debt paydown (as the LBO debt is repaid using cash flows, the equity's claim on the enterprise value increases). The return decomposition framework isolates each driver: PE Fund IRR = contribution from EBITDA growth + contribution from multiple expansion + contribution from leverage. LBO analysis determines the maximum price a PE firm can pay for a target while still achieving its target IRR (typically 20-25% over a 5-year hold). LBO value creation: The enterprise value at entry = EBITDA_entry * EV/EBITDA_entry. Equity invested = EV - Debt_entry. At exit (year 5): EV_exit = EBITDA_exit * EV/EBITDA_exit. Equity value at exit = EV_exit - Debt_exit (remaining after paydown). IRR is the discount rate equating…