Lecture 3

Private Equity

Definition of Private Equity

Private equity consists of investors and funds that make investments directly into private companies, or conduct buyouts of public companies that result in a delisting of public equity. Equity capital that is not quoted on a public exchange. The majority of private equity consists of institutional investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods (up to 12 years).

Examples of private equity

Fundraising sources

Private equity fund valuation

Comparable approach
P/E

DCF model
Forecasting future earnings, cashflows

Option valuation (e.g. deferring the investment)

Private Equity Partnership Structure

The predominant organization form of PE investing is the limited partnership structure. Limited partnership consist of limited partners (LP) and general partners (GP).
The LPs of the partnership are the investors, i.e., the main providers of capital. LPs must not be actively involved in the day-to-day operations of the funds if they are to maintain limited liability status. The GPs of the partnership are responsible for the day to day management of the partnerships investment, as well as general liability for any lawsuit that may be brought against the fund.

Private Equity Partnership Structure cont.

An important element of limited partnerships is that the general partners also commit investment capital to the fund. This ensures that the GP and LP interests are well aligned. Private equity partnerships are typically selfdissolving entities that have a life span of about 10 years.
This limited life span highlights the point that the funds must seek exits of their investments to realize return for their investors.

Private equity structure

The Private Equity Market

Types of private equity

1. Venture capital (VC): an investment to create a new company, or expand a smaller company that has undeveloped or developing revenues 2. Buy-out: acquisition of a significant portion or a majority control in a more mature company. The acquisition normally entails a change of ownership

Types of private equity cont.

3. Growth capital: most often minority investments, in more mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.

Types of private equity cont.

4. Distressed or Special situations: investments in equity or debt securities of a distressed company, or a company where value can be unlocked as a result of a one-time opportunity (e.g., change in government regulations). 5. Mezzanine capital: subordinate debt or preferred equity securities that often represents the most junior portion of a company's capital structure

Features of PE
Substantial entry costs, with most private equity funds requiring significant initial investment, plus further investment for the first few years of the fund. Investments in limited partnership interests are referred to as "illiquid" investments.
Once invested, it is very difficult to gain access to money as it is locked-up in long-term investments which can last for as long as twelve years.

Features of PE cont.
Given the risks associated with private equity investments, an investor can lose all of its investment if the fund invests in failing companies. Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

PE performance

PE performance
Cambridge Associates U.S. Private Equity Index
(period ending 9/30/2006) 35 30 25 20 15 10 5 0
1Yr 2Yr 3Yr 4Yr 5Yr 6Yr 7Yr 8Yr 9Yr 10Yr 11Yr 12Yr 13Yr 14Yr 15Yr 16Yr 17Yr 18Yr 19Yr 20Yr

Liquidity in private equity market

The private equity secondary market refers to buying and selling of preexisting investor commitments to private equity Sellers of private equity investments sell the investments in the fund and also their remaining unfunded commitments to the funds.

Liquidity in private equity market cont.

The private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the majority of private equity investments, there is no listed public market; however, there is a maturing secondary market available for sellers of private equity assets.

Liquidity in private equity market cont.

Secondary transactions can be split into:
1. Sale of Limited Partnership Interests:
This includes the sale of investor's interest in a private equity fund through the transfer of limited partnership interest in the fund. This refers to the sale of portfolios of direct investments in operating companies, rather than limited partnership interests in investment funds.

2. Sale of Direct Interests:

Liquidity in private equity market

Liquidity in private equity market

Secondary

LP

buyer

Insurance company

Pension fund

Large corporate

HNWI

GP

The PE fund

Manager

Portfolio

Company A

Company B

Company C

Company D

Company E

Company D

Venture Capital (VC)

It is the story of the man with the idea and the man with the money

Venture Capital (VC)

Venture capital is a type of PE capital typically provided by professional to new, growth businesses. Venture capital investments are generally made as cash in exchange for shares in the company. A venture capitalist is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often a limited partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky.

Who Invests in Venture Capital?

High net worth individuals with appetite for high risk/reward paradigm Institutions diversifying investment portfolios Insurance companies, pension funds, banks, etc. Funds of funds Governments

VC life cycle
1. Fund raising
From institutional investors, fund of funds, individuals with substantial net worth

2. Investment
involves the provision of capital to business enterprises in the early stages of the development of new products or services.

3. Due diligence
Include financial, legal, labor, tax, environment and market situation of the company

4. Closing the fund: liquidation

IPO, sale of the company, or bankruptcy.

VC life cycle
Idea Conception & Product Development Concept Selling /Pilots Product Acceptance & Market Growth Product gains acceptance across industry segments and geographies Quantum Growth in Revenues High Margins due to competitive edge Competition emerges Revenue growth stabilizes Margins under pressure Need to innovate Technical Obsolescence Maturity

Product Innovation
Innovate to enhance revenues and margins

Revenues / Profits

Product Decline

Team Building Heavy spend on R&D IPR protection

Concept gets accepted in a niche market Nominal revenues kick in from Pilots

Revenues Dwindle rapidly

Margins turn negative On the way to closure

12 to 18 m

12 to 18 m

24 to 36 m

36 to 60 m
Revenues

Time

Profits

VC transactions
1. Start-up phase transactions
Entrepreneur approaches VC firms If VC is convinced, both parties negotiate and structure the transaction

2. Growth stage
Successful company needs more money VC makes the investment because it believes that the value of company will quickly rise

3. Buyout
Changing the ownership of a company

Funding Venture Capital

Venture Capital Money invested to finance a new firm

Funding Venture Capital cont.

Venture Capital Money invested to finance a new firm

Since success of a new firm is highly dependent on the effort of the managers, restrictions are placed on management by the venture capital company and funds are usually dispersed in stages, after a certain level of success is achieved.

Funding Venture Capital cont.

First Stage Market Value Balance Sheet ($mil) Assets Other assets 1.0 Value 2.0 Liabilitie s and Equity Your original equity 1.0 Value 2.0 Cash from new equity 1.0 New equity from venture capital 1.0

Funding Venture Capital cont.

Second Stage Market Value Balance Sheet ($mil) Assets Liabilitie s and Equity Cash from new equity 4.0 New equity from 2nd stage 4.0 Fixed assets 1.0 Equity from1st stage 5.0 Other assets 9.0 Your original equity 5.0 Value 14.0 Value 14.0

Leverage-Buyout (LBO)
An LBO is a strategy involving the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition.
Often, the assets of the company being acquired, in addition to the assets of the acquiring company, are used as collateral for the loans.

Leverage-Buyout (LBO) cont.

The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. In an LBO, there is most often a ratio of 70% debt to 30% equity, although debt can reach as high as 90% to 95% of the target company's total capitalization.

Management-Buy out (MBO)

A special case of such acquisition is a management (MBO), which occurs when a company's managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers' interest in the success of the company.
In most cases, the management will then make the company private.

Management-Buy out (MBO) cont.

MBOs have assumed an important role in corporate restructuring beside M&As. A criticism of MBOs is that they create a conflict of interest, an incentive is created for managers to mismanage a company, thereby depressing its stock price, and profiting by implementing effective management after the successful MBO.