Lecture 16 Fall 2013

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FNCE 751

LECTURE 16 : OVERVIEW OF PRIVATE EQUITY

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Acknowledgements

Materials in this presentation are kindly provided by Edward J. Mathias of

Carlyle, Vinay Nair of Ada investments, Mehmet Budak, WG95, Bruce I.Ettelson of Kirkland & Ellis LLP and Bain and Company

PE performance section relies on papers by Kaplan & Schoar, Metrick &Yasuda and Phalippou & Gottschalg.

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1. Introduction

FINANCE DEPARTMENT 3

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What is Private Equity?

Investment strategy that involves the purchase of equity or equity linked

securities in a company

Investment is made through a negotiated process

By sophisticated investors with financial and operating expertise

The goal is to acquire undervalued or promising assets and realizeprofits in 3-5 years after the acquisition

Information asymmetry and inefficiencies are important factors

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Private Equity Investment Strategies

Leveraged Buyouts (LBO)

Venture Capital (early vs. late stage)

Special Situations (i.e. distressed)

Mezzanine

Secondary Purchases

Fund of Funds

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What is an LBO?

Acquisition of a company where a PE firm uses cash equity and debt tofund the purchase price

PE firm injects equity into a new shell company which borrows debt andsimultaneously acquires the target

PE firm contributes capital, operating and financial expertise, strategicinsight, contacts and management talent

Management ownership increases, creating higher incentives to improveoperations and deliver results

Debt is repaid by the operating cash flows or by the sale of non-coreassets of the acquired business

LBO is similar to buying and renting out a house - the rent cash flows to

pay down the mortgage debt


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LBO Fund

An LBO Fundis a pool of raised capital committed by investors to be

invested over the course of a number of years

The operator of the fund is the General Partner/Managerand theinvestors in the fund are Limited Partner

The Limited Partners are only required to invest capital once an

investment occurs

Superior returns are expected by:operational improvements for growth,

purchase/exit multiple expansion

use of leverage (target returns in the 20% - 30% range)

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Good LBO Candidates

History of (or potential to have) consistent profitability

Predictable cash flows to service debt

Availability of (or potential to produce) excess cash

Easily separable assets or businesses

Strong management team

Strong brands and market position

Industry with barriers to entry

Little danger from disruptive changes (technology, regulatory, etc.)

Visible/feasible exit strategy (IPO or M&A)


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How are PE Funds Structured?

Private limited partnerships

Individual managers are the General Partner (GP)

Providers of capital (pensions, insurance companies, wealthy people) areLimited Partners (LPs)

Partnerships have 10-year life with +1+1 extension

4-6 year investment period

1-2% annual management fee

Profits split 80-20, after reaching hurdle return level for LPs

LPs need to fund within 2-3 weeks of capital call

Penalties for failure to fund by LPs

IRRs depend on when money is transferred by LPs

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Structur ing a Private Equity Fund

GeneralPartner

PE Princ ipals

GP $10M

GP $10M

PEFund

$1 billion

PortfolioCompany

#1

PortfolioCompany

#2

2% ManagementFee

LPs $990M

20% Carried Interest Share in 80% of profits proportionate to GPs 1% capital

contributionManagement

Company

LPs U.S. Indivi duals U.S. Corporations TEOs Non-U.S. Persons

Members

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General Partner s Key Activit ies

Selecting investments

o Obtaining access to high quality deal flowo Sorting and evaluating large amount of information

Structuring investments

o Designing transactions

Monitoring investmentso Providing strategic, operational and financial assistance to portfolio

companies

Exiting investments

o IPO, Sale or Recapitalization

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Sources of Funds

Equityo New equity injection from LBO sponsor

o Potential equity contribution from existing management

o Potential continuing equity investment by existing shareholders(rollover)

o Equity from a strategic partner

Debto Bank debt (senior debt)

o High yield debt (subordinated debt)

Mezzanine securities

o Can be structured to be more debt-like or more equity-likedepending on the situation


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Bank Debt

Senior secured (most senior debt)

Matures before other debt classes, amortizing

Typically callable/prepayable at par

Quarterly interest payments

Do not need public disclosures

Structured at the operating company level

Underwritten via syndication

Diligence, commitment, launch, syndicate, fund

Revolving Credit Facilities vs. Term loanso Revolvers allow multiple drawings for working capital and general corporate

needs

o Term loans funded at closing


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High Yield Bond Debt

Usually subordinated and/or unsecured

Interest rate is fixed, maturity of 8-10 years

Greater leverage capacity

Bullet maturity after full bank debt amortization

Usually not callable at par in early years, typically 1-5 years

Structured at the operating company level

Publicly quoted security

Public filing requirements Diligence, document, road-show, price and fund


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Mezzanine Debt

Subordinated to bank debt and high yield bonds

Flexible, typically floating interest rate Non-amortizing, bullet maturity typically after 10 years

Cash & PIK coupon payment further enhanced with equity warrants

PIK component can eat into equity

Often structured at the holding company level


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2. The Anatomy of a Deal


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The Anatomy of a Deal

1308

1500

FORMAL REVIEW

EXTENSIVE DUE DILIGENCE

INITIAL DUE DILIGENCE& INITIAL OFFER

Professionals review every opportunity

Qualitative/quantitative screens

Meetings to discuss all active deals

Explore all aspects of commercial due diligence

Develop detailed financial case

Highlight and research strengths/weaknessesAssess competi tive edge in the process and/or post-

deal and ident ify Partner(s)

Conduct thorough commercial and financialdue dil igence and evaluate managementteam

Introduce the opportunit y to financingsources

Draft Investment Committee Memorandum

Design launch plan

300

50

20

5-10


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Sample Target Company

Sales $100MM

EBITDA $20MM

% of Sales 20%

Purchase Price $100MM

Multiple of EBITDA 5x


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Total Cash$100 MM

New Equity=$30MM

New SeniorDebt=$50MM

NewMezzanine=

$20MM

Financing


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TransactionOverview

LBO

Shop

Equity

NewSeniorDebt=$50MM

NewMezzanine=

$20MM

New

Equity=

$ 30 MM

Total Sources

Of Cash$100mm

Repay OldDebt

$15 MM

Expenses=

$5MM

Total Uses

Of Cash$100mm

OldBanks

Shareholders

Advisors

LBO Shop

Loans

Repayment

Purchase

OfStock

Payments

Mezzanine

Fund

NewBanks

Acq.Of Old

Equity =$80 MM


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Five Years

Later

Time of Purchase Five Years Later

Sales $100MM $150MM

EBITDA $20MM $30MM

Enterprise Value $100MM $150MM

Adding Value


R t

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Total Value =

$100MM

Total Value =

$150MMUse excess cash

to reduce debt

Growing profitability andlowering debt increasesequity value

Five Year

CAGR

8.4 %

22 %

New Equity=$30MM

New SeniorDebt=$50MM

NewMezzanine=

$20MM Equity=$110MM

Senior Debt=$20MM

Mezzanine=$20MM

Returns


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3. Value Creation


H D PE Fi C t V l ?

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How Do PE Firms Create Value?

Minimize purchase price

Maximize leverage

Minimize liabilities purchased

Manage transaction costs

Improve business operations Maximize tax efficiency

Financial management

Optimize exit

Details next lecture


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4. Private Equity Framework


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Recap-BanksSale-M&AsIPO-ActiveEquity Markets

IPO/SaleIPO/Sale/RecapIPO/Sale/RecapEXIT

PassiveExecut ive TalentIndustry/RegionalexpertiseMonitor/Advise

Avoid shor t-termtemptationsMonitor/Advise

DELIVER

PriceControl

Growth Equitymore passive

LeverageSTRUCTURE

I-banksInformalnetworksLocalIntermediaries

UndervaluedGrowth equityDivestituresLoss-making firms

UnderleveredSOURCE

INSTITUTIONALFACTORS

MULTIPLESOPERATIONALFINANCIAL

THE MODEL


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IPO/Sale/RecapEXIT

CovenantsDisclosureLegalFramework

Avoid shor t-termtemptationsMonitor/Advise

DELIVER

Private Banks

Mezz. FundsHigh YieldHedge Funds

LeverageSTRUCTURE


UnderleveredSOURCE


FINANCIAL


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IPO/Sale/RecapEXIT

Labor MarketDisclosure

Execut ive TalentIndustry/RegionalexpertiseMonitor/Advise

DELIVER

Trust

BankruptcyLaws

Control

Growth Equitymore passive

STRUCTURE


Growth equityDivestituresLoss-making firms

SOURCE


OPERATIONAL


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IPO/SaleEXIT

DisclosurePassiveDELIVER

Institutional

TradingBiddingCompetition

PriceSTRUCTURE


UndervaluedSOURCE


MULTIPLES


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5. Trends


Private Equity Is a Cycl ical Bus iness

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Private Equity Is a Cycl ical Bus iness

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Europe: South vs Nor th

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Europe: South vs. Nor th


Asia Pacif ic: Down

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Asia-Pacif ic: Down


Exits: North America up

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Exits: North America up


Exits : Sponsor to Sponsor up

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Exits : Sponsor-to-Sponsor up


GP Expectations

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GP Expectations


LP Expectations: Emerging Markets

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LP Expectations: Emerging Markets


Size of Deal

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Size of Deal


Capital Raised

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Capital Raised


Sources of Capi tal

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Sources o f Capi tal


Capital: Dry Powder

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Capital: Dry Powder


Default by Portfol io Companies

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Default by Portfol io Companies


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6. Performance of Private Equity Funds


Top Quart ile vs Average

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Top Quart ile vs. Average


Buyout Funds vs Publ ic Markets

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Buyout Funds vs. Publ ic Markets


Performance of PE Funds

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Kaplan & Schoar

Large heterogeneity across funds

LBO fund returns net of fees are lower than S&P500 on an equalweighted basis, but higher on a value weighted basis.

GPs returns are persistent.

Fund flows are positively related to past performance



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Metrick and Yasuda

Two thirds of expected revenue comes from fixed revenue components.

There is striking difference between buyout funds and venture capitalfunds

o Update: Venture capital continues to underperform

BO funds earn higher revenue per partner



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Phalippou and Gottschalg

Average net of fees fund performance of 3% below that of S&P500

Once adjusted for risk, i.e., leverage, underperformance is 6%.

Standard aggregation choices bias performance estimates upward.

Commonly used dataset for private equity performance contains fundsthat performs better than average

Fee bill is more than 25% of the value invested (6% per year) and twothirds of the fees come from management fees.



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Moving from 2% to 2.5% management fee translates into a 1.3%

decrease in alpha and that reducing the fee to 1% is only worth 0.6% interms of alpha.

There is a large discrepancy across funds. There is a strong persistenceof performance and it dominates all other fund characteristics.


Documents

Lecture 16 Fall 2013