Private Equity New Investment Process

Street of Walls Private Equity Training

The typical process for evaluating and completing a new private equity investment opportunity has many
different and structured steps that can vary widely by PE firm, and can differ greatly due to specifics of the
target company or the transaction process. The initial investment evaluation can happen very quickly, but the
entire process may take several months or even a year or more. The discovery and assessment of the
opportunity at the beginning of the process is called sourcingin this phase, the firm locates potential targets
and looks at the viability of the investment and the potential returns available. Then, as more information is
gathered, the firm conducts due diligence, creates and develops very detailed financial models, and evaluates
the pros and cons of the opportunity prior to final approval and execution of the transaction.
SOURCING OF AN INVESTMENT OPPORTUNITY
Sourcing for investment opportunities can be difficult and grueling, but it is an essential skill one needs if
aspiring to have a successful career in the PE industry. Depending on the PE firms preference, a deal may be
sourced through a variety of channels: internal analysis, networking, detailed research, and cold-calling
executives at attractive companies, for example. Other sources include meeting with various companies,
company screens through databases for specific criteria, industry conferences, and conversations with industry
consultants and experts. Opportunities sourced through any of these means is referred to as proprietary
sourcingi.e., internally sourced.
Another common way to receive potential investment opportunities is through a financial intermediary, such as
an investment banker. Companies often hire investment banks to sell businesses via Confidential Information
Memorandums (CIMs), which are distributed to potential acquirers, possibly including both financial sponsors
(private equity firms) and strategic buyers. This is typically characterized as a public auction. While searching
for potential opportunities, an associate would need to ensure that the investment opportunity fits into the firms
investment strategy, such as a minimum EBITDA, industry, potential value creation strategy, or a minimum (or
maximum) equity check.
Below we demonstrate the sourcing funnel of potential investment opportunities at an illustrative private equity
firm:

INVESTMENT PROCESS UP TO SIGNING

This section will look at how a typical PE investment process works. Even though the general aspects of the
process are the same across various firms, the details can vary widely depending on how the investment
opportunity was sourced (proprietary sourced vs. public auction) and each firms investment committee

process. The larger the firm, the more formalized the investment committee process will be and the higher the
probability that public auctions will be used. Conversely, growth equity firms tend to work on more proprietarysourced deals where they have less competition and are dealing more directly with management. Growth
equity firms also have less formalized investment committee processes because there are typically fewer
partners in the firm, thereby requiring less work to build consensus among the partners before the investment
can be made.
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Signing a Non-Disclosure Agreement (NDA): In a public auction, investment bankers will often send
out teasers, which are 1-2 page summaries about the company up for sale. If the investment team
finds the teaser interesting, they will negotiate and sign an NDA to receive the companys CIM
prepared by the investment bankers. In a proprietary-sourced opportunity, investment teams will often
sign an NDA directly with the target company in order to receive some confidential information
regarding the company from management.

Initial due diligence & Management Presentation: At this stage, the investment teams will perform
some initial due diligence to better understand the company. This generally includes research on the
industry, talking to advisors about the specific company and the industry, and a building and enhancing
a preliminary financial/LBO model using the managements projections to understand the potential
returns of making the investment. At the same time, the investment team may start reaching out to
investment banks to hear their thoughts on the company and understand how much debt financing
(and what type) would be available for an acquisition of this company. In a public auction, investment
bankers will also offer a select group of potential buyers an opportunity to meet with the management
team (referred to as a Management Presentation). The management team will present an overview
of the company while the deal team is allowed to ask them questions about their business. In order to
prepare for the management presentation, the investment team will create an initial due diligence
question list (similar to questions discussed in the Commercial Due Diligence section).

Deal Alert (first review with Investment Committee): After reviewing the managements presentation
and having initial discussions, the investment team will prepare a brief (2-3 page) investment proposal
and present it to the PE firms Investment Committee. The first Investment Committee meeting can
have a variety of different purposes, depending on the PE firm. The meeting can be a deal update
where no approval is needed, or it can be the beginning of a formal approval process, whereby a deal
team will be given permission to submit a First Round Bid (discussed below) and/or a budget to spend
a specified amount of money (referred to as cost cover) on consultants or other deal-related
expenses. If approved, the investment would proceed into further diligence and discussions with the
target company and its investment bankers.

Non-Binding Letter of Intent (LOI) or First Round Bid: At this point, the investment team may present
the target company with a non-binding LOI for the transaction on certain criteria that have been shared
with the investment team. The offer will detail a proposed purchase price (often a valuation range is
given, rather than a specified amount), a proposed capital structure post-acquisition, key assumptions
made, key due diligence areas, approximate timing needed to submit a binding offer, the PE firms
relevant expertise and experience, and the necessary authorizations & approvals required by the PE
firms Investment Committee in order to complete the transaction. At this point, the target company and
its investment banking advisors will generally choose a few bidders to move on to the next round in the
auction process. The seller will base its decision on key considerations, including total purchase price,
credibility of the offer, the submitting firms experience and value creation strategy, and the submitting
firms compatibility with the current management team.

Further due diligence with management: The target company will begin providing more detailed
confidential information in what is typically referred to as a virtual dataroom to the bidders that proceed
beyond the first round. Some example dataroom files are the corporations organization and legal
entities, board minutes and reports, detailed operations record, owned and leased property
agreements, intellectual property documentation, employee lists and employment agreements,
detailed segment financial information, and historical audited financials. At this point, private equity
firms will begin reviewing all of the relevant dataroom files and start to get more specific, detailed
questions to the management team. Follow-up due diligence calls will be held (through the supervision
of the investment bankers) with specific members of the executive and non-executive management

team. Also, based on the dataroom files, the deal team will start brainstorming the critical issues that
they will often hire third-party consultants to help investigate.
Building an Internal Operating Model: After having detailed conversations with the management team
on all of the main drivers behind the business, the investment team will start building a detailed
operating model for the business based on reasonable forecast assumptions. An operating model is a
very detailed revenue and cost breakdown that is based on specific drivers and assumptions (e.g.
price, volume, raw material costs, number of branches, number of customers, renewal rates, fixed vs.
variable cost structure, etc.). All of these breakdowns combine into one model to describe the expected
financial performance of the company in great detail. This gives the PE investors more detail on the
drivers of potential return for the acquisition.
Preliminary Investment Memorandum: Once the team has completed a more detailed investment
model, and a comprehensive investment thesis (reason for investing) and strategy (plan to carry out
the investment thesis), a Preliminary Investment Memorandum (PIM, typically 30-40 pages) is
compiled to summarize the investment opportunity to the Investment Committee. Sections in the PIM
typically include:

Executive Summary: Details of the proposed transaction, background, and overall deal team
recommendation and investment thesis.
Company Overview: History, description, products & applications, customers, suppliers,
competitors, organizational structure, management team biographies, etc.
Market and Industry Overview: Key market growth rates, trends, etc.
Financial Overview: Historical and projected income statement, balance sheet, and cash flow
statement analysis.
Risks and Key Areas of Due Diligence: Potential risks to the industry/business and key areas
of completed and ongoing due diligence.
Valuation Overview: Comparable company analysis, precedent M&A transactions analysis,
DCF analysis, LBO analysis, etc.
Exit: Initial thoughts on investment exit options and anticipated timing of exit.
Recommendations and Proposed Project Plan: The deal team will recommend proceeding
with their proposed project plan based on a specific valuation range and budget approved by
the Investment Committee. The project plan will include the hiring of third-party consultants to
perform commercial, financial, and legal due diligence, and the team will hold further
discussions with potential debt and mezzanine financing providers. Deal teams will typically
perform only initial legal due diligence at this stage, since it is the costliest, and will typically
hold off on it as long as possible (usually until the final stages of the bidding process).

Final Due Diligence and process up to submit a binding bid: Provided that the PIM has been accepted
by the PE firms Investment Committee, the investment deal team and its consultants will perform any
and all final and confirmatory due diligence in order to provide a Final Binding Bid for the target
company (discussed later). At this stage, the deal team is now working exclusively on this investment
opportunity (other potential investments that the PE professionals on the deal team were working on
will be put aside or farmed out to other PE professionals at the firm) and is having daily interactions
with the sellers investment bankers and management team. The bidder will send specific requests to
the company based on all key outstanding issues. These could include site visit requests, calls with
specific salespeople/non-executive management, or calls with customers and suppliers. In addition,
the deal team will be managing its consultants on other due diligence work streams, including portions
of the commercial, financial, and legal due diligence process (detailed in Areas of Due Diligence). For
example, management consultants (McKinsey, Bain, BCG, etc.) are typically hired to perform
commercial due diligence on the addressable market, trends, and customer relationships. Accountants
(KPMG, PricewaterhouseCoopers, Ernst & Young, Deloitte, etc.), specifically within the Transaction
Services group of the accounting firm, are hired to perform confirmatory financial due diligence to
ensure that all the financial information provided is accurate. M&A lawyers (Wachtell Lipton Rosen &
Katz, Skadden, Sullivan & Cromwell, Simpson Thacher, etc.) are hired to perform legal due diligence
and to handle the initial drafting of acquisition documents. At the same time, the investment deal team
will be negotiating with the financing banks on the debt financing terms. When negotiating, the deal
teams objective is to obtain the best debt financing execution (i.e. choosing the right group of banks)
at the most favorable debt terms. The deal team will also assist the financing banks with their own due
diligence by fielding their specific questions and concerns in order to get them more comfortable with

underwriting their debt commitment. The average time for this entire confirmatory due diligence
process (occurring between the First Round Bid and the Final Binding Bid) is approximately 3 to 6
weeks.
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Update and Final Investment Committee Approval: Depending upon the exact investment process of
the private equity firm, an investment deal team must update the Investment Committee on key deal
issues in a number of potential ways. Once all due diligence items are completed and the investment
team is comfortable moving forward, a Final Investment Memorandum (FIM) is completed. A FIM is
essentially the equivalent of a PIM (which was completed before the First Round Bid) that also
includes further due diligence from the deal team and third-party consultants, and specifically
addresses the key issues introduced by the Investment Committee from the PIM. At this stage, the
deal team will recommend acquiring the target company at a specific valuation, which the Investment
Committee will either reject or approve. It is very common for private equity firms to proceed beyond
the first round without submitting a final binding bid or being restricted to a maximum price by the
Investment Committee (i.e., they will not able to raise their price or indicative valuation range, or may
even fall short of the range specified in the First Round Bid).

10 Final Binding Bid and Signing: If it receives approval, the investment deal team will submit a Final
Round Bid (or Final Binding Bid) for the target company. This final bid is almost always binding (i.e. all
due diligence has been completed) and includes a final purchase price, fully-committed financing
documents from investment banks, and marked-up preliminary merger agreements to be discussed
with the sellers lawyers. The seller and its investment bankers will spend a few days discussing the
various final bids and will choose a winner. They will then work exclusively (and often exhaustingly!)
with that bidder in order to sign the transaction. Once a winner has been chosen, negotiations between
the lawyers of the seller and the lawyers of the buyer will continue to finalize the Merger Agreement
(also referred to as the Purchase Agreement) and other related transaction documents. Several key
points in the Merger Agreement will be negotiated, and the most important of those is the Purchase
Price Consideration (i.e., the definition of what is to be subtracted from the Purchase Price to calculate
the total amount wired to the Sellers stakeholders). Additionally, the Merger Agreement will spell out
logistics of the wire transfers to equity (and other) stakeholders, and how much is to be withheld for
post-transaction adjustments.
INVESTMENT PROCESS FROM SIGNING TO CLOSING
Once a private equity firm has officially signed a deal with the target company, both parties will jointly issue a
press release announcing the transaction. From there, both parties will work toward closing the transaction,
which can take from a few months to a year to complete, depending on the size and complexity of the
transaction. At this point, the sellers investment bankers will become less involved, and the main interactions
will be between the lawyers representing the buyer and seller.
Here are a few examples of items that will need to be finalized before closing:
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Management Equity Roll-Over and Incentive Option Pool: Depending on whether the private equity
firm wants to keep the current management team, it will start negotiating with the executives on their
equity roll-over commitment and their incentive option pool. PE firms will work hard to ensure that the
managements interests are well aligned with theirs. Note that if the deal consists of the acquisition of a
publicly-traded company, the private equity firm is prohibited from having any discussions with the
management team about compensation before the deal is actually signed.

Execute Debt Financing: Once a deal is signed, all parties involved will start working on marketing
materials to present to prospective debt investors. In particular, if the debt markets are active and
financing is available at attractive rates, the financial sponsor will try to finalize the debt financing as
quickly as possible. The financial sponsor will have negotiated specific debt amounts and interest rates
with the financing banks, but the banks will have flex terms negotiated into their commitment letters
which allow them to adjust the debt terms if the financing markets turn sour (i.e., if the proposed
financing terms cease to be viable due to adverse changes in financial market conditions). The
transaction closing and the debt financing execution are coordinated with each other, as the debt is a
vital part of the transaction funding.

Closing Funds Flow: Once all the necessary documentation is completed, the private equity firm must ensure
that everyone is properly paid on time, including selling equityholders, existing debtors, target and acquirer
advisors, and the escrow agent. Since transactions can reach billions of dollars in size, this part of the process
can be very difficult to navigate, given the numerous parties involved, various ownership structures, multiple
funding sources, and complicated funding timelines.