Presentation Aims

Through the presentation, we hope to provide you with:

1) A Definition of Private Equity, along with General Characteristics 2) Mechanics of a Private Equity Deal 3) Risk-Return Profile 4) Comparisons of Private Equity to other Investment Types

Private Equity
Private Equity involves investment firms investing in private companies.

Companies exchange partial company ownership for immediate funds.

General Characteristics
Distinguishing Parameters:

Shares held not publicly traded Illiquid, long term investment

Limited Partnerships with Active Ownership

Magnitude and Scope

MGM Buy Out for

$3 Billion

$211 billion in mergers and acquisitions

Private Equity accounts for 54% of all mergers and acquisitions

The total dollar amount exceeds $5.7 trillion

Player Interaction

Investors

PE Firm / Fund

Private Companies

Investors to PE Firm Interaction

Investment in PE Fund
Banks Insurance Institutional Investors University Endowments Pension Funds (Gov)

PE Firm / Fund

Private Companies

Return on Investment

The Investors
Who invests in PE?
Big groups with a lot of money Examples:
Pension Funds University Endowments Banks Insurance Agencies

How much do these investors put into the fund?

A large sum of money, on the order of millions.

Investing
How then does one invest?
This million dollar investment is placed into a Private Equity Fund, which is managed by a Private Equity Firm

Investors

PE Firm / Fund

The Private Equity Firm will then decide how to manage and allocate the funds for the investors.

PE Firm to Company Interaction

Ownership Management Advising

Banks Josefs Cookies Insurance PE Firm / Fund University Endowments Bluechip Consulting Pension Funds (Gov) Prosthetics by Vivian Private Companies

Increased equity (Return on Equity)

Increasing Equity
Ownership is worth $20,000, Value of company is $100,000 Ownership is worth $120,000, Value of company is $200,000

Enterprise Value

Equity, 120,000

Equity, $20,000

Debt, $80,000

Over time

Debt, 80,000

INVESTMENT

FUTURE

Mechanics of Investment
Equity = Enterprise Value Debt
Increase Value Pay off Debt A Mixture of Both

Firm Specialization
Private Equity Funds invest in a portfolio of 20-25 companies based on their expertise.
Private Equity Firms specialize in:
economic sector target firm size Healthcare, Multimedia, Communications investment styles Small-cap, Mid-Cap, Large-Cap

Overall fund portfolios reflect this preference.

Types of Deals
Expansion Financing
Financing for expanding business operations

Acquisition/Consolidation
Securing absentee-owned or publicly-traded companies

Turnaround Financing
reworking under-managed, distressed companies to restore them to profitability

Leveraged Buy-Outs (LBOs)

restructuring the level of equity versus debt

Use of Leverage
Leveraged Buy-Outs
Private Equity firms help bidders purchase equity shares at a premium this transaction is financed by debt

These are taken out against the current value and expected cash flows of the company.

junk bonds loa n

It also sometimes This mechanism serves allows as a defensive for the maneuver restructuring by of management the debt to that equity thwarts ratio of a hostile company takeovers

Company Incentives
Whats in it for the Companies? 1) exchange ownership (equity) for cash money ($$) 2) use $$ to buy a competitor, grow a business, finance operations, etc. 3) Gain managerial mentorship 4) Equity is not diluted through public offering

Risk/Return

Risk and Return Information on Private Equity Investing

PE Firm Control of Risk

Private Equity firms have some control over risk:
Firms use hedging/portfolio theory to reduce risks Large ownership stakes mean that the PE fund can manipulate each firms management and operations.

Investor Risk/Return
Private Equity Risks and Returns Depend on:
Financial setup employed (i.e. majority/minority positioning) Skill of fund management (blind pool investing) Interest rate trends and other externalities

Other elements that add to risk:

Illiquidity of investment Extent of private information Degree of concentration in a fund portfolio (portfolios are not well diversified

Returns
Private Equity returns are measured as Internal Rates of Return (IRR) IRRs change over the life of a fund
IRRs are usually negative at the beginning of investment IRRs only start becoming positive around the 7th year of investment Due to this characteristic, only the final IRR on a fund is a meaningful measurement

Returns
With Actual Numbers:
The final Internal Rate of Return (IRR) on a mature Private Equity fund averages

~20%*
This represents a 6% return over investing in the S&P500 through the same time period Overall, an investor can anticipate a margin of performance that outperforms the public market this counterbalances the intrinsic shortcomings of the illiquid, blind-pool investing traits of Private Equity
*net of carried interest and management fees therefore this is the actual return to the Limited Partner Source: Ljungqvist and Richardson

Risk Comparison
What does Private Equity investment entail?
High expected returns A long horizon (10+ years!) Higher risk as compared to stocks or bonds Private Equity
less risk more risk

Bond s

Stock s

Venture capital

Overall, the risk of Private Equity investments is higher than that of stocks and bonds, but lower than that of Venture Capital

Relation to Other Assets

Private Equity vs. Stocks

Ownership held by investors of Private Equity is not available to the general public. When compared to stocks, Private Equity has a higher average return coupled with a higher risk. Private Equity fund managers are actively involved in management of companies that they have a stake in this is not true for stocks

Relation to Other Assets

Private Equity vs. Bonds
Firms that issue bonds exchange immediate funds for later payments. Firms that make a Private Equity deal exchange ownership for immediate funds. Bonds are debt financing while Private Equity is equity financing.

Relation to Other Assets

Private Equity vs. Venture Capital
The major difference is in the timing of the investment
Venture involves financing of young, private enterprises Private Equity is the investment in established businesses PE Markets are more stable PE firms interact with seasoned management teams In PE, there is less exposure to technological change and disruption

Interactions
How does Private Equity relate to other Investment Classes?

Venture Capital

Private Equity
Debt (Bonds)

Stocks (public equity)

Why Invest in PE?

Why Private Equity is an attractive investment:
Superior real rate of return*
funds characteristically generate a 56% premium over the expected returns for marketable equities

Less than proportionate risk increase*

The large increase in return is well worth the small increase in risk

Low correlation with public equity or fixedincome returns

PE investment is therefore excellent for portfolio diversification *as compared to public equities

Takeaway Points
1) PE = Private Equity firms investing in Companies 2) Three Players: Institutional Investors, PE Firms, Companies 3) Investment make money by increasing equity over time. 4) Fund Portfolios generate an average IRR of 20%, but incur substantial risk.