Trouble in Private Equity Paradise: Who Benefits When a Portfolio Company Invests?

Abstract: Problems arise when a private equity owned portfolio company wants to make an additional investment in assets and the private equity company has to make an investment decision based on capital budgeting models presented by the management of the portfolio company. Since a private equity firm evaluates their holdings using LBO valuation models with the resulting IRR and their portfolio company evaluates investments using various budgeting methods, the purpose of this Master’s Thesis is to analyze whether such an additional investment could in some cases be value improving for only one of the parties, and if that is the case, when that is most likely to occur. To answer the thesis question asked, an analytical approach comparing the outcomes of different investments on capital budgeting models and the LBO valuation model is used. Several investments were tested, and the analysis showed that there is a risk of a discrepancy between value improvement for a private equity firm and value improvement for their holding, the portfolio company. In the cases where the investments generate earnings late and when investments are made closer to the exit time, the different interests are more likely. Underinvestment is the most likely consequence and a negative change in the exit multiple used in the LBO model could alter that effect even further.