Module 2, Lesson 2.1 Introduction to LBO and VC Investments

This lesson explores leveraged buyouts (LBOs) and venture capital (VC) in more detail, and introduces the LBO model and the VC method.

Our two main categories of private equity investments, buyout and VC funds, dominate in terms of number of funds and invested amounts. Whereas a VC firm may have a specialized industry focus—seeking the next rising star in technology or life sciences—LBO firms generally invest in a portfolio of companies with more predictable cash flow. VC firms seek revenue growth from new enterprises and technology; LBO firms focus more on EBIT or EBITDA growth by established companies. Valuation is thus fundamentally different, and Exhibit 1 presents certain key distinctions.

**Exhibit 1: Pros and Cons of Common PE Strategies**
LBO Investments	VC Investments
Steady and predictable cash flows	Low cash flow predictability; cash flow projections may not be realistic
Excellent market position (can be a niche player)	Lack of market history; new market and possibly an unproven future market (early stage venture)
Significant asset base (may serve as a basis for collateralized lending)	Weak asset base
Strong and experienced management team	Newly formed management team with strong individual track record as entrepreneurs
Extensive use of leverage consisting of a large proportion of senior debt and a significant layer of junior and/or mezzanine debt	Primarily equity funded; the use of leverage is rare and very limited
Risk is measurable; investments are in mature businesses with long operating histories	The assessment of risk is difficult because of new technologies, new markets, and a lack of operating history
Predictable exit (trade sale, initial public offering (IPO), secondary buyout)	Exits are difficult to anticipate (sale to strategic/financial buyer, IPO, secondary venture sale)
Established products	Technological breakthrough but the route to market is yet unproven
Potential for restructuring and cost reduction	Significant cash burn rate required to ensure company development and commercial viability
Low working capital requirement	Expanding capital requirement if in the growth phase
LBO firms typically conduct full-blown due diligence before investing in the target firm (financial, strategic, commercial, legal, tax, environmental)	VC firms tend to conduct technology and commercial due diligence before investing; financial due diligence is limited as portfolio companies have no or very little operating history
Buyout firms monitor cash flow management and strategic and business planning	VC firms monitor the achievement of milestones defined in the business plan
Investment portfolio returns are generally characterized by a lower variance across returns from underlying investments; bankruptcies are rare	Investment portfolio returns are generally characterized by very high returns from a limited number of highly successful investments and a significant number of write-offs from poor-performing investments or failures
Large LBO firms are generally significant players in the capital markets	VC firms tend to be much less active in the capital markets
Most transactions are auctions involving multiple potential acquirers	Many transactions are “proprietary,” arising from relationships between venture capitalists and entrepreneurs
High-performing LBO firms tend to have a better ability to secure larger pools of financing given their track record	VC firms tend to be less scalable relative to LBO firms; the increase in size of subsequent funds tends to be less significant
Variable revenue to the general partner (GP) at buyout firms generally comes in the form of carried interest (participation in profits), transaction fees, and monitoring fees	Carried interest is generally the main source of variable revenue to the general partner at VC firms; transaction and monitoring fees are rare in practice

^{Source: CFA Institute}

Objectives

By the end of this module, you will be able to:

Compare and contrast LBO and VC investments, and interpret LBO model and VC method outputs.