Introduction to Private Equity

September 2009

Slides 1 – 6 inserted by Professor Blemaster

1

Private Equity Generic LBO Candidates

2

Private Equity Generic LBO Capital Structure

3

Private Equity What Does PE Offer?For investors, superior returns, at least for the top quartile players

– The diversification of another asset class

A better governance model– Stable shareholder– Direct involvement with the business via the board and control of CEO

selection– Proactive intervention frequent – i.e. replacing the CEO

A longer time frame not quarters but not forever – Buy, improve, sell

Superior compensation – more and better designed– Better alignment– Attract the best talent

More efficient capital structures – i.e. more debt– Debts helps returns and acts as a governance item

Higher expectations, a sense of urgency

4

Private Equity

Ability to support global infrastructure– Requires over $20bn under management– Allows firm to move with opportunities over time

Ability to organize around sector groups– Requires substantial size to support 10-15 sector groups– Allows firm to follow sector cycles

Portfolio power– Creates investment insight (easier to understand a retailer if you

already own 5 of them)– Economic cycles, both positive and negative, can be identified

from portfolio data– Large base to encourage investment banking-created

opportunities– Ability to attract senior advisors to sit on significant boards

Ability to support a functional operating group– Requires 30-40 portfolio companies– Must be large enough to offer Ops team a career path

Strategic relationships with major capital partners

Competitive Advantages of a Leading Buyout FirmCompetitive Advantages of a Leading Buyout Firm

Big Time PE Firm Advantages

5

Private Equity Structural Issues

Remember whose money it is!

The risks are largely limited to the special purpose borrowing entity

The PE firm and its partners are not primarily the ones at risk

The limited partners investors i.e. the institutional investors and the lenders have 95% of the risk more or less

For example, Blackstone is not liable for the debt of any specific buyout deal

The risks to the PE firm are more reputational and related to their ability to raise future funds

6

Private EquityThis presentation is provided for informational purposes and reference only. The contents hereof should not be construed as investment, legal, tax or other advice. This presentation may not be used or relied upon in evaluating the merits of any investment. No representation or warranty, express or implied, is made as to the accuracy or completeness of the information contained herein.

By acceptance hereof, you agree that you will keep confidential all information contained in this presentation and will only use it for informational purposes.

Disclaimer

7

Private Equity Agenda

I. Nuts and Bolts of Private Equity

II. Overview of TPG

III. Case Studies

IV. Discussion

8

Private Equity

Buy operating businesses

Usually obtain control or significant influence

Pension funds

Life insurance companies

Financial institutions

High net worth individuals/families

Active members of board of directors

Help in development of strategy

Provide direct assistance in certain areas (M&A; corporate finance)

Hold period typically 3-7 years

Capital markets

Strategic sales

Private Equity Investors

4. Sell Invest-ments

1. Raise Capital

2. InvestCapital

3. Manage Investments

What Do Private Equity Investors Do?

PE CyclePE CycleRaise MoneyRaise MoneyBuyBuyTransformTransformSellSell

9

Private Equity Deal Flow and Fundraising

GLOBAL PE VOLUME($ Billions)

BUYOUT FUNDRAISING($ Billions)

Recent deal flow and fundraising environment for buyouts near trough levels

$52 $64$109 $100 $81 $106 $132

$230$336

$760$818

$240$32$23

$66

$33

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1H09

$67$44

$88

$53 $43$28

$64

$238

$292

$205

$159

$36$44$23

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1H09

Source: Morgan Stanley, SDC, Thompson Source: Buyouts.

10

Private Equity

Why the Explosion and Decline in Private Equity?

11

Private Equity Growth of Private Equity

More Big Deals

Strategic Acquirer Behavior

Big Companies were Cheaper

More Public to Privates

Lower Cost of Debt Capital

Entry into New Geographies

12

Private Equity Largest LBOs of All Time

TOP 10 GLOBAL LBOS OF ALL TIME ($ Billions)

$43.8$38.9

$32.7 $31.1$27.4 $25.7

$21.6$17.6 $17.4

$15.0

TXU Equity

Office

HCA RJR

Nabisco

Harrah's Clear

Channel

Kinder

Morgan

Freescale Albertson's Hertz

9 of the 10 largest LBOs of all time have occurred since 2005

Source: Mergermarket and SDC

13

Private Equity Strategic Competition

Strategic competition increasing

PRIVATE EQUITY MARKET SHARE OF M&A(% Market Share)

2.9% 3.4% 3.6%2.8%

3.6% 3.2%

5.3%

10.1%10.7%

13.5% 13.0%

22.7%

19.0%

8.9%

2.9%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

YT

D 2

009

Source: Morgan Stanley

14

Private Equity

0x

25x

50x

75x

100x

125x

150x

175x

P/E

Mul

tiple

March 2000March 2000

Source: ISI Group

Forward PE of the 50 Largest (Market Cap)

Large cap stocks earned premium valuations in 2000…

Private Equity Market OverviewLarge Cap Valuations

15

Private Equity

... but looked relatively cheap in 2006

0x

25x

50x

75x

100x

125x

150x

175x

P/E

Mul

tiple

September 2006September 2006

Forward PE of the 50 Largest (Market Cap)

Source: FactSet

Private Equity Market OverviewLarge Cap Valuations

16

Private Equity Public-to-Privates

US PUBLIC–TO–PRIVATE TRANSACTIONSVolume ($ Billions)

$3.7 $0.6 $0.5 $6.4 $4.2 $4.9 $9.4 $6.8 $14.8 $13.2$3.8 $5.2 $3.4 $10.4

$0.20

$33.6$55.7

$304.8

$278.7

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 YTD

2009

Dramatic decline in public-to private volume over the last year

Source: SDC, Morgan Stanley, S&P

17

Private Equity

High Yield Pricing

6%

9%

12%

15%

18%

21%

.

The market has experienced a dramatic recovery since early 2009

1997 1998 1999 2000 2001 2002 2003 2004 20051996

HY

Inde

x

Era #2“the 12% Era”

Era #1“the 10% Era”

Source: JPMorgan

2006

Private Equity Market Overview

Era #4Era #4““the 11% Erathe 11% Era””??

Era #3“the 8% Era”

2007 2008 2009

18

Private Equity

Significant increase in WACC…

25%35% 40%

2002 2005 2009

Total Debt Equity

WACC =12.4%

Representative Cost of Capital for a Large Transaction(1)

Average Cost of Debt = 8.7%

(1) Large transactions typically reflect below-market average equity contributionSource: TPG Estimates

Bank Debt

High Yield

Bank Debt

High Yield

25% Hurdle

Private Equity Market OverviewIncrease in PE Cost of Capital

Average Cost of Debt = 7.3%

25% Hurdle

WACC = 9.8%

25% Hurdle

High Yield

Bank Debt

WACC = 14.7%

Average Cost of Debt = 7.8%

19

Private Equity

…but lower valuation multiples may allow Private Equity buyers to pay a lower purchase price and earn the same returns

$850

$995

$770

17% premium

Illustrative Deal at 2002 WACC (12.4%)

Lower Multiples Enable Lower Price for Same Returns(1)

(1) Illustrative case assumes 15% EBITDA CAGR, and capital structure per previous slideSource: TPG Estimates

Illustrative Deal at 2005 WACC (9.8%)

Private Equity Market OverviewIncrease in PE Cost of Capital

Illustrative Deal at 2009 WACC (14.7%)

23% discount

20

Private Equity

9586

63

34346

72

175 6

5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 14%+

164313 5

6376 76

21

60

8 3

<=5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 14%+

Shift of Cost of Capital

The buyout opportunity set has markedly declined, but historic M&A cycle suggests it will return

WACCS FOR NON-FINANCIAL S&P 500 COMPANIES – 2007Number of Companies

74%“WACC Eligible”

PE WACC: 8.3%

Source: Bloomberg, McKinsey analysis

<3%“WACC Eligible”

Normalized PE WACC: ~14%

Public After Tax WACC

Public After Tax WACC

WACCS FOR NON-FINANCIAL S&P 500 COMPANIES – 2008Number of Companies

21

Private Equity Asian PE Market is Coming of Age

SPONSOR-LED M&A VOLUME($ Billions)

PRIVATE EQUITY DEAL VALUE AS % OF GDP(2008)

Accelerating growth through 2007

Source: Dealogic

…but still in early stages of development

Source: Dealogic

$4

$9$11

$18

$39 $40

$25

$3

2001 2002 2003 2004 2005 2006 2007 2008

0.4%

0.2%

North America Asia

GDP: U.S. $17 Trillion U.S. $13 TrillionPE Deal Value: U.S. $70 Billion U.S. $25 Billion

2x

22

Private Equity Growth of Private Equity

Big Deals

Strategic Activity

Big Companies PE Multiples

Public to Privates

Cost of Debt Capital

New Geographies

–

Currently

23

Private Equity

(100)

(50)

0

50

100

150%

(60%) (40%) (20%) (0%) 20% 40% 60%

What Explains Rise and Fall of Deal Volumes?

Inside diligence by PE firms drives deal volume growth when work reveals potential performance ahead of expectations

Correlation: 0.82

EarningsActual Earnings Growth Lower than Expectations

Actual Earnings Growth Higher than Expectations

Incr

easi

ngD

ecre

asin

g

Q4 2008

Q2 2005Deals

Get Done

Deals Don’t Happen

PE Deal Volume Growth

It’s All About Expectations

24

Private Equity

Total = $44 Billion

LPs

HedgeFunds

Lead Sponsors Other PE

Banks

Strategic / Other

Note: Selected companies as of May 2007

Supply – Shadow Participants Exit

Non-traditional participants, who contributed ~50% of the equity during peak PE deal flow, have already largely exited

BREAKDOWN OF EQUITY SYNDICATIONSELLDOWN IN LARGE ’05 – ‘07 TRANSACTIONS

4%7%

9%

10%

22%

48%

25

Private Equity

I. HealthcareII. Software

The Next Opportunities

Baby with the Bath Water

Profit-Cycle Opportunities

IV. RetailV. Inventory destockingVI. “Sweat the assets”VII. Capitalizing on latent demand

Macro TrendsVIII. China StimulusIX. U.S. StimulusX. Inflation

III. Chapter 11 is our friend

Restructuring

26

Private Equity

CoreCompetencies:

Return

1985

Ability to do the deal

Three bankersand a Rolodex

Wave 1 Wave 2Ability to find and spot

the value

InvestmentJudgment

Wave 3Ability to improve

the value

OperatingValue Add

Wave 4Ability to build and

sustain a firm

FirmBuilding

1995 2005 2007

Art of the DealArt of the Deal Sector ExpertiseSector Expertise Active Transformation Active Transformation of Companiesof Companies

Replicable, Replicable, Sustainable ModelSustainable Model

FirmPrivate Equity Firm Building

27

Private Equity

“Buy” decision

Public MarketPublic Market

“Sell” decision

Private Equity OverviewRelative Tool Kits: Public vs. Private Investors

28

Private Equity

“Buy” decision

“Sell” decision

Private EquityPrivate Equity

“Buy” decision

The “Deal”

– Purchase negotiations

– Structure

Financial leverage

– New debt

– Restructuring

Management control

– Incentives

– New Management

– Cost cutting

Strategic direction

– Business model changes

– Growth

“Sell” decision

– Public or private

Public MarketPublic Market

Private Equity OverviewRelative Tool Kits: Public vs. Private Investors

29

Private EquityPrivate Equity Required Skill Set

InvestmentInvestmentJudgmentJudgment

Industry knowledge

Themes

Top-down/bottom-up

Deal SkillsDeal Skills

Financing

Negotiation

PortfolioPortfolioManagementManagement

Value-added

Strategic direction

Turnarounds

Build all skill sets to optimize performance

Private Equity Overview

30

Private EquityPrivate Equity Return Drivers

Revenue growthMargin improvement

Buy cheapImprove strategic positioning

Leverage important, but riskyRequires focus on cash generation capability (working capital, capex, etc.)

Earnings/EBITDA GrowthEarnings/EBITDA Growth

Multiple ArbitrageMultiple Arbitrage

Debt PaydownDebt Paydown

or

or

One is probably okay, two is great, three is a home run

Private Equity Overview

31

Private Equity

Sales

EBITDA

margin

TEV Multiple

Leverage Multiple

Total Enterprise Value

less: Net Debt

Equity Value

$1,000

200

20%

5.0x

3.0x

$1,000

600

$400

At Investment

10% CAGR

10% CAGR

No Expansion

No Debt Paydown

Change During5 Year Hold Period

$1,611

322

20%

5.0x

1.9x

$1,611

600

$1,011

At Exit

IRR = 20%

Private Equity OverviewPrivate Equity Return Drivers

32

Private Equity

$1,000

200

20%

8.0x

3.0x

$1,600

600

$1,000

No Growth

No Growth

3.0x Multiple Expansion

No Debt Paydown

Sales

EBITDA

margin

TEV Multiple

Leverage Multiple

Total Enterprise Value

less: Net Debt

Equity Value

$1,000

200

20%

5.0x

3.0x

$1,000

600

$400

At InvestmentChange During

5 Year Hold Period At Exit

IRR = 20%

Private Equity OverviewPrivate Equity Return Drivers - Multiple Arbitrage

33

Private EquityPrivate Equity Return Drivers - Debt Paydown

$1,000

200

20%

5.0x

0.2x

$1,000

41

$959

No Growth

No Growth

No Expansion

Debt Paydown fromCash Flow

Sales

EBITDA

margin

TEV Multiple

Leverage Multiple

Total Enterprise Value

less: Net Debt

Equity Value

$1,000

200

20%

5.0x

3.0x

$1,000

600

$400

At InvestmentChange During

5 Year Hold Period At Exit

IRR = 19%

Private Equity Overview

34

Private EquityPrivate Equity Return Drivers - the “Trifecta”

$1,611

322

20%

8.0x

nm

$2,577

(206)

$2,783

10% CAGR

10% CAGR

3.0x Multiple Expansion

Debt Paydown fromCash Flow

Sales

EBITDA

margin

TEV Multiple

Leverage Multiple

Total Enterprise Value

less: Net Debt

Equity Value

$1,000

200

20%

5.0x

3.0x

$1,000

600

$400

At InvestmentChange During

5 Year Hold Period At Exit

IRR = 47%

Private Equity Overview

35

Private Equity

Management Fees

– 1-2% per year of committed capital

– Ratchets down after investment period

Transaction Fees

– Ability to charge varies with deal

– GP usually allowed to keep 20-50% with balance going to LPs

Carried Interest

– 15-30% of profit subject to 8-20% LP hurdle rate

– Based on total fund performance

– Funds typically target 20-30% IRR’s

General Partners Compensation