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Introduction to Private Equity

Scott Stallings, Senior Associate Director MBA Career Management


August 2006

MBA Career

Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

MBA Career

Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton

MBA Career

Introduction to private equity

Who can argue with a new model of enterprise that aligns the interest of owners and managers, improves efficiency and productivity, and unlocks hundreds of billions of dollars of shareholder value. Michael Jensen, Harvard Business School

MBA Career

Introduction to private equity

Source: EVCA

MBA Career

Introduction to private equity


There are a number of incorrect misconceptions about private equity (organized investments in non-listed equity)
Due to the limited information and transparency in the private equity world, there are

a number of incorrect misconceptions and rumours about the industry: It is all about buying at low multiples and selling at high multiples Value creation comes from aggressive over-leveraging In private equity-owned companies, R&D costs are slashed and people loose their jobs The only winners from the private equity industry are the greedy private equity managers - all other stake-holders are losers

MBA Career

Introduction to private equity

MBA Career

Introduction to private equity


On the contrary, there are number of evidences that all these misconceptions are incorrect In fact, private equity is today an important and valuable part of the global economy, benefiting industries in development/transition, owners of businesses, employees, investors and the economy as a whole. Private equity investors are prepared to take risks where there exists a potential to create value!

Hence, private equity is today an important function in the global economy providing liquidity and ensuring accelerated industrial development and change.

MBA Career

Introduction to private equity

"Ange l"

"Ve nture Ca pita l" 2nd & 3rd Round 1-3 years

"Grow th" Em e rging Grow th 3-10 years

"Buyouts" Leve ra ge d Buyouts 10-50 years Me zza nine De bt 10-50 years

"Distre ssed Inve sting" Distre sse d Equity 10-50 years

"He dge Funds"

See d Age of Com pany Sta ge of Com pany Public or Priva te? Equity Re quirem ent Re turn Expe cta tions

1st Round

Distre ssed Hedge Funds De bt 10-50 years 5+ years

0 years

0-1 year

Idea

Prototype

2nd or 3rd 1st generation generation product product Private Private or Public $5-20m

Established, Established, slow growth slow growth Private or Public $10 - 250m Private or Public $10 - 250m

Stressed Private or Public $10 - 250m

Stressed Private or Public $10 - 250m

Public

Private

Private

Public

$0.2-0.5m

$1-2m

$2-5m

N/A

70%+

50-70%

50-60%

40-50%

25-40%

20-30%

30-50%

30-40%

20%

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Introduction to private equity


There are two principal parts of private equity venture capital (unproven startups) and buy-outs (mature/proven businesses)
Buy-outs Cash flows +
Mature companies and industries (proven) Proven technology and industries Low or declining margins, scope for increased

efficiency
Outdated/ill-suited ownership structure Need for industrial change and consolidation Experienced management Tax shields from interest costs and leverage on

Venture Capital
New companies and industries

equity invested by using debt

(unproven)
Technology/industry bets New business models with potentially

Low operational risk, low/moderate growth,

positive cash flows

high margins

High operational risk, high growth,

Cash flows -

negative cash flows

+Organic growth rate -

+Time/Maturity -

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Introduction to private equity

(7) Liquidate / Sell Portfolio Companies (1) Raise Capital

(6) Nurture Portfolio Companies

(2) Evaluate Market Segments

(5) Negotiate and Structure Investments (3) Generate Deal Flow

(4) Select Investment Candidates


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Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

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Fund structure and organization #1 General Partner (GP) raises a fund of illiquid capital $500M to be spent over seven years #2 Investors (Limited Partners / LPs) often sophisticated institutions (pensions / insurance / finance) or wealthy families #3 GP utilizes unique knowledge / relationships / strategy to invest in companies / securities #4 GP guarantees a minimum return to LPs after which GP splits profits with LP (often 20% / 80%)

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Fund structure and organization


GP person / group with proven track record to attract investors GP writes fund documents explaining investment strategy, how much they wish to raise, who else is on the team GP meets with LPs or increasingly with LPs advisors LPs commit specific dollars for specified period Fund Economics: 2% and 8% and 20% / 80% split 2% of fund size as annual management fee ($500M fund has $10M / year to pay employees, rent offices, travel, etc.) 8% annual return hurdle on money drawn for investments 20% / 80% split on profits above 8% return This 20% is known as carried interest

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Fund structure and organization

Source: EVCA

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Fund structure and organization

Source: EVCA

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Fund structure and organization

Source: EVCA

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Fund structure and organization

Source: EVCA

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Fund structure and organization

Source: Venture Economics / Datastream

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Fund structure and organization

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Fund structure and organization

Source: EVCA

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Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

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The history of buy-out funds


Serving a fundamental need and niche, buy-out players are an institutionalized evolvement with several predecessors Value ensurers Ensuring no-value arbitrage opportunities in the public and private equity markets. Cleaners/fixers Fixing up underperforming companies. Preparers Preparing companies for being listed on a stock exchange or other types of institutional ownership. Developers and risk takers Actively driving undeveloped potential without the short-sighted mind-set of the stock market (quarterly capitalism). Liquidity enhancers Ensuring liquidity in times of poor liquidity and in succession situations, and other complicated ownership structures etc.
1900 1950 2000

There is a fundamental need for a type of owner that is always flexible, liquid, and hands-on

1850

Wealthy families Merchant banks Investment companies/conglomerates Buy-out firms

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The history of buy-out funds


Why have the buy-out players been so successful as a concept? Where did the predecessors fall short?
Capital base

Why have the buy-out players been successful? Funded by a number institutions/ investors for 10-year periods the buyout players are always liquid and not affected by individual economic circumstances Buy-out players are temporary owners focused solely on their strategy of implementing their value-enhancing strategies there are no side agendas Buy-out players have explicit competences in their focus areas of change management, sector expertise, financial engineering etc Buy-out players are professionally structured to act as a temporary owner: 10 year funds Clear governance models GP/LP Clear split of value creation

Liquidity affected by individual/ corporate/stock market cycles and fortunes

Approach

Temporary holdings are non-core. No clear exit strategies can lead to a very large portfolio and lack of focus Usually, their competences are centred around other issues than being a professional temporary owner No uniform structures exists

Expertise

Set-up and structure

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The history of buy-out funds


Conclusions on the background of the buy-out funds
Role and purpose

Act as a professional temporary owner take a business from one level to the next Develop businesses Create value and make money for the investors There is a need for flexibility and liquidity in the market place for corporate ownership A company can always be taken to the next level! Institutional investors do not have the organisations, know-how or experience to make these investments themselves there is hence a need for buy-out management companies Being private is advantageous in many ways no politics, no distractions, no short-sightedness, only focus on long-term value creation Broad ownership and buy-in of strategies = motivated staff and management Aggressive, continuous focus on all value creation strategies: Strategic re-positioning New growth venues markets, products Sustainable improvements to costs and margins Low hanging fruits on costs Efficiency improvements Leverage - tax efficient, leverage on equity invested Flexibility on exit MBA Career 25

Why needed?

Why does it work so well?

Development of the buy-out business models


The buy-out business model has evolved significantly the last three decades
1960s and 1970s Phase I Value Arbitrage
Market Conditions Inefficient market place Few buyers several companies for sale Limited availability of loan capital Focus of transactions Break-up of conglomerates Asset disposals Value arbitrage

1970s and 1980s Phase II Financial Engineering


Market Conditions Semi-efficient market place Several MBO firms competing Abundance of capital both equity and debt

1990s and 2000 Phase III Industrial/Accelerating Development


Market Conditions Efficient market place Many MBO firms competing Plenty of financing and financial engineering available Focus of transactions Companies with development potential Create value by building businesses Competitive advantage Industrial competence Willingness to invest in the future Experience of driving change

Focus of transactions Old economy industries Cost-cutting strategies Financial engineering

Competitive advantage M&A transaction competence needed Ability to maximize leverage

Competitive advantage Restructure balance sheet Manage cash flows

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Development of the buy-out business models


What is corporate value and value creation? Enterprise value
Description

Net debt

Equity value

Perceived value of all cash flows from the Company to debt and equity holders. Hence, deducting the future value of all operational costs and tax.

Net present value of net debt undertakings (interest bearing debtcash). Usually = book value of debt.

All remaining value after deducting net debt.

Equity_valueExit
Factors affecting valuation of the equity

DCF value, or = [EBITDA +1 * multiple] - net _ debtExit Exit

Top-line growth

Company and industry Margins profile EBITDA, EBIT, etc

Release of cash flows

Without a doubt, top-line growth and margin improvements are the most important value drivers
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Private equity continues to mature internationally


Most international private equity, while well-established, is still relatively small compared to more mature markets
Maturity and sizes of different private equity markets
USA, 4,9% ~28 years

Drivers of the growth of private equity in international regions Continuous corporate restructurings Private company ownership succession issues Large public equity market with some inefficient pricing of smaller/odd shares Significant share of mid-sized companies with ambitions and potential for geographical expansion Privatization

Private equity ownershi p as % of GDP

UK, 2,9% ~20 years

Nordic region, 1,4% ~12 years Germany, 0,4% ~7 years China, < 0,1% ~4 years Years of professional and sophisticated buy-out market

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Private equity corporate governance model


Clear division of labor

Management

Manage day-to-day operations Report to the Board

Board of Directors

Appoint and evaluate key managers and supplement managers when needed Define and monitor strategic plans Share and expand network

Private Equity Firm

Oversee strategic development and evaluate new initiatives Appoint and evaluate the Board and evaluate performance of Company Appoint new Board members if necessary Constant focus on impact on exit and ensuring maximum value Initiate and lead the exit process Assisting management in financing processes and M&A work

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Simple LBO Example

LBOs are just like buying a house


Minimal down payment (20%) Significant leverage / debt (80%) Cash flow (your wages / company earnings) must meet debt payments Asset (house / company) should increase in value during holding period (home improvements / company is more profitable) Minimal initial investment yields significant gain

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Simple LBO Example (contd)


Buy a house / company for $100 Minimal down payment ($20) Significant leverage / debt ($80) Cash flow (your wages / company earnings) must meet debt payments Over three years mortgage / debt payments reduce principal to $75 Over 3 years value of the house / company rises to $125 Sell company for $125 Subtract $75 of debt $50 profit on $20 investment in three years 8% annual hurdle on $20 is $25 at end of year three when I sell $50 profit - $25 to LPs = $25 left to split 20% to GP ($5) and 80% to LPs ($20)

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Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

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Overview of venture capital

Source: Macquarie

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Overview of venture capital: 5 Year Summary


1999-2000 investment frenzy in all market segments IPO expectations and new business models based on Internet and Y2K impact 2001-2003 The hangover and clean-up/downsizing of many portfolio company investments Negative 1st quartile returns Late 2003-4 Continued clean-up: The walking wounded survive The beginning of new company investing Fresh fundraising attempted on a broader scale 2005 Increasing liquidity with selected IPOs and M&A activity Stable investment activity Capital overhang period ended 2006 Forward Venture returns regain top place in IRRs but with significant variability among managers 1st quartile returns significantly positive and less correlated with public markets Reduced start-up and early stage investment capital
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Overview of venture capital


History of value creation after initial investment in early-stage venture investing

10x

1985-1997

2003-2010

Company Value

1997-2003

5x

1x

10

11

12

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Commitments to U.S. VC funds


Fundraising is stabilizing
Total Commitments to VC Funds ($ Billions) $100
$82.8

$80
$58.8

$60

$50.5

$40
$26.9 $17.1 $12.7 $2.8 $6.7 $5.4 $7.0 $13.1 $9.2 $17.8 $18.8

$20

$0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: VentureSource/Venture One * Annualized 3Q 2005

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U.S. venture capital investment activity


Investment is stabilizing
$100
$94.6

Venture Capital Invested ($ Billions)

$80

$60
$49.5 $36.2

$40

$22.0

$20
$4.2 $6.4 $9.2

$17.9 $13.1

$19.1

$21.3

$20.2

$0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005*

Source: NVCA / Venture Economics * Annualized 3Q 2005

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Valuation movement
Recent Increase in Private Company Valuations
$30

$25 Median Pre-$ Valuation ($ Millions)

$20

$15

$10

$5

$0 3Q99 1Q00 3Q00 1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 3Q05

Source: VentureOne

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Older companies going public - years to IPO increases


Time from Initial Equity Funding to IPO In 2005, the average IPO is for a five and a half-year-old company
6 5 4 Years 3 2 1 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
5.7 5.7 5.7

4.5 3.5 3.6 3.2 2.8 2.8 3.1

Source: VentureOne

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Liquidity: IPO vs. M&A exits


Venture-backed IPOs vs. M&A Transactions
700

= Venture-backed M&A
600

= Venture-backed IPOs

500

Number of Transactions

400

300

200

100

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: National Venture Capital Association

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Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

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Deal process/role of an associate


Investment Model
Identify sectors with the following characteristics Large, high-growth market opportunity Competition is made up of many small companies with no dominant market-share leader Undergoing a fundamental shift in the business as a result of economic or technological change Identify initial company upon which to grow the business Focus on companies that have meaningful revenues Identify the company best positioned to exploit the market opportunity Select a management team capable of carrying out an aggressive growth plan Accelerate the companys growth through acquisition and consolidation of smaller-sized companies

With the goal of building a $750 million market capitalization company

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Deal process/role of an associate


Multiple Points of Contact

Auditors Auditors

Attorneys Attorneys

Search Firms Search Firms

Portfolio Company

Employees Employees

Customers Customers Directors Directors


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Investors Investors

43

Deal process/role of an associate

q q q q q q q q q q q q

Source deals and initially screen opportunities Meet with management team of potential investment Partner meeting and further screening Due diligence begins Prepare formal Investment Memorandum Partners meeting and investment decision Term Sheet submission Legal negotiations Co-investor syndicate selection Due diligence checklist completed Investment closing Active investment management

Week 1

Months 2-4

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Deal process/role of an associate

Source: BVCA

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Typical Due Diligence Checklist


1. Basic Information from Company a. PowerPoint deck b. Business Plan c. Detailed revenue plan with backup assumptions 2. Ownership Structure a. Detailed Capitalization Table b. Will option pool need to be increased? 3. Market Opportunity a. Research analyst reports - size, growth, dynamics of the space b. Bottom-up analysis the size of the market 4. Competition a. Competitive Matrix including: i. Funding ii. Last Round Valuation iii. Revenues iv. Business Model v. Value inflection points 5. Public Comparables a. Business Model b. How they compare to the company being considered c. Revenue Model d. Market Cap/Revenues e. Time to IPO 6. Customer Interviews a. Relationship with the company b. Assessment of the company - Strengths and Weaknesses c. Perceived value proposition d. Project/proposed relationship details e. Comparison of alternatives - Strengths and Weaknesses f. What might be the potential revenues the company could generate? g. Who else might be interested in the company for their product/service? h. How does the technology/service fit in with other technologies/services in place at the customer i. Other potential applications/avenues for the product/service j. Hurdles to success - potential obstacles for the company to be successful

7. Analyst Interviews a. Assessment of the company - Strenghts and Weaknesses b. Market opportunity c. Competetive landscape d. Hurdles to success e. Exit opportunities - who might acquire the company 8. Management a. Detailed resumes for each member of management team b. Management interviews - determine prio experience, track record c. Open positions that need to be filled i. When will they be filled ii. Who are the candidates, type of candidates d. References i. From the management team ii. Other references from past co-workers at other companies 9. Previous Round a. Term Sheet b. Due Diligence c. Conversation with previous round investors i. From last round to this round ii. Future value inflection points 10. Sales Assessment a. Review of current accounts i. Nature of relationship, stage - e.g. pilot, beta, etc. ii. Revenue potential b. Current pipeline c. Backlog 11. Technical Assessment (if applicable) a. Determine appropriate person to do technical assessment b. Key questions i. Does it work as advertised? ii. Will it scale? iii. What are the alternative technologies iv. How much of a lead, if any, does the company have? 12. Legal Due Diligence 13. Company Specific Due Diligence

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Deal process/role of an associate

Source: EVCA

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Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

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The hiring process What PE firms are looking for?


Analytics/problem solving ability Case Method General business situations Answer-driven diligence vs. output-driven Judgment Desire/Energy/Drive Willingness to work hard Thoughtful about career goals Very high achiever Track record of success Fit

Team Player Maturity Integrity Curiosity and initiative Leadership

Commercial Instinct Business judgment


Able to discern what is likely and what is possible Operating pragmatism

Composure
Able to interact as peer with senior professionals

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Private Equity/Venture Capital/LBO Full-Time Offers Extended to Wharton Students in 2005-2006


Abraaj Capital Limited Advantage Partners Inc. AIG Highstar Akkadian Private Ventures American Capital American Securities Capital Partners Apax Partners, Inc. Arlington Capital Partners Bain Capital, LLC Blackstone Group LP, The Bridgepoint Capital Brockway Moran & Partners, Inc. C.V. Starr Camden Partners Holdings, LLC Carlyle Group, The Caxton Associates, LLC Centerbridge Capital Partners Cherokee Investment Partners, LLC Churchill Capital Circle Capital Ventures Citigroup Asian Principal Investment CMS Companies Crestview Partners Darby Overseas Investments, Ltd. Dubilier & Co. Emerging Markets Partnership Equity International Fidelity Capital First Round Capital FriedbergMilstein, LLC GE Capital Corporation Goldman Sachs & Company Great Hill Partners Greenwich Energy Investments, LLC GSC Partners HIG Capital International Finance Corporation Ironwood Equity Fund LP JLL Partners Lake Capital Landmark Partners LEM Mezzanine, Inc. LightSpeed Venture Partners Lionstone Group Macquarie Holdings (USA) Inc Metalmark Capital MKS Partners Morgan Stanley Alternative Investments Onex Corporation Partners Group Paul Capital Partners Quad-C Management, Inc. Quadrangle Group LLC Riverside Company Riverstone Holdings LLC Sankaty Advisors Soros Fund Management LLC Sterling Venture Partners The Carlyle Group The Riverside Company Time Warner Inc. Thomas H. Lee Partners, L.P. Torch Enterprises Trivest Partners, L.P. Unison Capital Veronis Suhler Stevenson Partners LLC Vestar Capital Partners Warburg Pincus LLC WL Ross & Co. LLC

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Private Equity/Venture Capital/LBO Internship Offers Extended to Wharton Students in 2006


AEA Investors AIF Capital Allianz Capital Partners AMC Delancey Group, Inc. American Capital Apax Partners, Inc. BC Partners Bentley Forbes Buchanan Street Partners, Inc. Burrill & Company Carlyle Group, The Citigroup Alternative Investments Group Clearview Capital, LLC Clearwater Capital Partners Commons Capital ContiInvestments Credit Suisse Deutsche Bank Real Estate Opportunity Fund DFJ Dragonfund DN Capital Entrepreneur Partners, L.P. Falfurrias Capital Partners Fidelity Ventures Flywheel Ventures Fortress Investment Group LLC Forum Gruppe GE Asia Pacific Technology Fund Golden Gate Logistic Graham Partners, Inc. Hamilton Lane Advisors Inc Hupomone Capital Partners IDG Ventures ING Clarion Real Estate Insight Equity Internet Capital Group J.F. Lehman & Company JP Morgan Bay Area Equity Fund Kayne Anderson Private Investors Keystone Property Group Lehman Brothers Holdings Inc. Liberty Associated Partners Lightyear Capital Linden LLC Loita Capital Partners International MidMarket Capital Advisors, LLC Milestone Partners Millennium Technology Ventures Morgan Stanley New Boston Fund NJTC Venture Fund Olympus Partners PA Early Stage Pacific Corporate Group LLC Palladium Equity Partners, LLC Paul Capital Partners Petrus Partners Ltd. Permira Advisors L.L.C. Quaker BioVentures RAF Industries, Inc. Relativity Fund Russian Technologies S.R. One Limited Sandbox Industries, LLC Sankaty Advisors Sequoia Capital Silver Point Capital Soros Private Equity Partners Sterling Venture Partners SunTx Capital Partners SV life sciences TAMC Texas Pacific Group Veronis Suhler Stevenson Partners LLC

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Offer and Acceptance Stats for Full-time and Summer Jobs

The class of 2006 received 74 full-time offers in private equity. 46 of these offers were accepted. The class of 2007 received 75 summer internship offers. 57 of these offers were accepted.

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PE Recruiting Landscape for 2005* (Update)

Firms that came on campus to recruit: 17 Firms that did a resume drop through CareerPath: 18 Firms that posted to the MBA Job Board: 69 Firms that bought the resume book: 32

*this list is mutually exclusive, so each company is only counted in one category Total PE firms recruiting at Wharton: 136

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PE Hiring Funnel
There was a backup in the market
2000-2001 analysts / associates stopped leaving for b-school 2002-2003 MBA graduates took any P/E job
Now looking to upgrade - limiting opportunities for current MBAs

2004 2006 opportunities up but so are the number of qualified candidates

The P/E Funnel: student with prior PE experience job search


150+ letters / calls 20 legitimate opportunities / interviews 10 second rounds 1 job

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Role of the Private Equity Club

Educates members on private equity industry; assists members in their job search Works closely with MBA Career Management Club events with companies (main form of company contact with students after EISs) are sometimes scheduled through the Private Equity Club Club receives weekly emails from MBACM with updated information on EISs, job postings and major recruiting updates/changes

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Background of Candidates with PE Offers

11% 2% 25% PE VC IB Consult. Entr. HF O ther

13%

6% 13%

30%

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Reasons to Consider a Career in Private Equity

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Reasons to Consider a Career in Private Equity


Develop wide range of skills (finance, strategy, board governance, etc.) Team and project management Interact with senior management Deal directly with CEO/CFO and senior management Transactions undertaken are often high profile, company altering events Work with highly talented peers Learn from those around you Able to take on responsibility early Steep learning curve Industry expertise or breadth of knowledge across industries Can specialize in an industry (e.g., Technology, Healthcare, etc.) or take a generalist approach depending on the firm Deal flow Long-term growth in industry expected to continue and to evolve Breadth of different types of transactions and experiences

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Guidelines For Private Equity Job Search


Think Big but be realistic and have a back-up plan Find a passion and focus: if your direction and approach isnt working then find another Network your way into the information flow: find constituencies who share goals and values Make lists, work the lists; dont underestimate the need to do your homework Seek out mentors who can offer strategic advice and act as a sounding board to provide reason Listen and hear what others are really saying 21 Nos then move on Assess and re-assess your skills and identity Be careful what you wish for, it may come true
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What should I be doing over the next few weeks?

Self-Reflecting on Potential Career Directions


Is private equity right for me? Am I right for private equity?

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MBA job opportunities skill-set scorecard


Entrepreneurship Capital Markets Strategy Consulting Corporate Finance Hedge Funds General Mgmt Investment Mgmt Private Equity Venture Capital Finance Accting Raw Genius Industry Knowledge Judgment Leadership Pedigree; Education Team Player

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Agenda

Introduction to private equity Fund structure and organization Overview of leverage buyouts Overview of venture capital Deal process/role of an associate Recruiting at Wharton Questions and Answers

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