FNCE 751
L EC T U R E 1 6 : O VERVIEW O F PR IVAT E EQ U IT Y
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
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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 realize
profits 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 to
fund the purchase price
PE firm injects equity into a new shell company which borrows debt and
simultaneously acquires the target
PE firm contributes capital, operating and financial expertise, strategic
insight, contacts and management talent operations and deliver results
Management ownership increases, creating higher incentives to improve Debt is repaid by the operating cash flows or by the sale of non-core
assets of the acquired business pay down the mortgage debt
LBO is similar to buying and renting out a house - the rent cash flows to
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LBO Fund
An LBO Fund is 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/Manager and the
investors 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) are
Limited 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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Structuring a Private Equity Fund
so e be s
PE Principals
Members
GP $10M
Management Company
General Partner
20% Carried Interest Share in 80% of profits proportionate to GPs 1% capital contribution
LPs
2% Management Fee GP $10M U.S. Individuals U.S. Corporations TEOs Non-U.S. Persons
PE Fund $1 billion
LPs $990M
Portfolio Company #1
Portfolio Company #2
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General Partners Key Activities
Selecting investments
o o
Obtaining access to high quality deal flow Sorting and evaluating large amount of information Designing transactions Providing strategic, operational and financial assistance to portfolio companies IPO, Sale or Recapitalization
Structuring investments
o
Monitoring investments
o
Exiting investments
o
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Sources of Funds
Equity
o o o o
New equity injection from LBO sponsor Potential equity contribution from existing management Potential continuing equity investment by existing shareholders (rollover) Equity from a strategic partner Bank debt (senior debt) High yield debt (subordinated debt) Can be structured to be more debt-like or more equity-like depending on the situation
Debt
o o
Mezzanine securities
o
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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 loans
Revolvers allow multiple drawings for working capital and general corporate needs o Term loans funded at closing
o
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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
FORMAL REVIEW
Professionals review every opportunity Qualitative/quantitative screens Meetings to discuss all active deals
1500
INITIAL DUE DILIGENCE & INITIAL OFFER
300
Explore all aspects of commercial due diligence Develop detailed financial case Highlight and research strengths/weaknesses Assess competitive edge in the process and/or postdeal and identify Partner(s)
50 1308 20
EXTENSIVE DUE DILIGENCE
Conduct thorough commercial and financial due diligence and evaluate management team Introduce the opportunity to financing sources Draft Investment Committee Memorandum Design launch plan
5-10
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Sample Target Company
Sales EBITDA % of Sales
$100MM $20MM 20%
Purchase Price Multiple of EBITDA
$100MM 5x
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Financing
New Senior Debt= $50MM
Total Cash $100 MM
New Mezzanine= $20MM
New Equity= $30MM
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Transaction Overview
Total Sources Of Cash $100mm
New Banks Loans New Senior Debt= $50MM New Mezzanine= $20MM New Equity= $ 30 MM Expenses= $5MM
Total Uses Of Cash $100mm
Repay Old Debt $15 MM
Repayment
Old Banks
Mezzanine Fund
Acq. Of Old Equity = $80 MM
Purchase Of Stock
Shareholders
LBO Shop Equity
Payments
Advisors LBO Shop
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Adding Value
Time of Purchase Sales EBITDA Enterprise Value $100MM $20MM $100MM
Five Years Later $150MM $30MM $150MM
Five Years Later
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Returns
Five Year CAGR 8.4 %
Use excess cash to reduce debt Total Value = $100MM
Total Value = $150MM
Senior Debt= $20MM Mezzanine= $20MM
New Senior Debt= $50MM New Mezzanine= $20MM New Equity= $30MM
Equity= $110MM
22 %
Growing profitability and lowering debt increases equity value
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3. Value Creation
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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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THE MODEL
FINANCIAL OPERATIONAL MULTIPLES INSTITUTIONAL FACTORS
SOURCE
Underlevered
Growth equity Divestitures Loss-making firms
Undervalued
I-banks Informal networks Local Intermediaries
STRUCTURE
Leverage
Control Growth Equity more passive
Price
DELIVER
Avoid short-term Executive Talent Industry/Regional temptations expertise Monitor/Advise Monitor/Advise
Passive
EXIT
IPO/Sale/Recap
IPO/Sale/Recap
IPO/Sale
Recap-Banks Sale-M&As IPO-Active Equity Markets
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FINANCIAL
INSTITUTIONAL FACTORS
SOURCE
Underlevered
STRUCTURE
Leverage
DELIVER
Avoid short-term temptations Monitor/Advise
I-banks Informal networks Local Intermediaries Private Banks Mezz. Funds High Yield Hedge Funds Covenants Disclosure Legal Framework Recap-Banks Sale-M&As IPO-Active Equity Markets
EXIT
IPO/Sale/Recap
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OPERATIONAL
INSTITUTIONAL FACTORS
SOURCE
Growth equity Divestitures Loss-making firms
STRUCTURE
Control Growth Equity more passive Executive Talent Industry/Regional expertise Monitor/Advise
I-banks Informal networks Local Intermediaries Trust Bankruptcy Laws Labor Market Disclosure
DELIVER
EXIT
IPO/Sale/Recap
Recap-Banks Sale-M&As IPO-Active Equity Markets
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MULTIPLES
INSTITUTIONAL FACTORS
SOURCE
Undervalued
STRUCTURE
Price
DELIVER
Passive
I-banks Informal networks Local Intermediaries Institutional Trading Bidding Competition Disclosure
EXIT
IPO/Sale
Recap-Banks Sale-M&As IPO-Active Equity Markets
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5. Trends
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Private Equity Is a Cyclical Business
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Global Deal Activity
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Europe: South vs. North
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Asia-Pacific: Down
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Exits: North America up
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Exits: Sponsor-to-Sponsor up
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GP Expectations
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LP Expectations: Emerging Markets
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Size of Deal
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Capital Raised
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Sources of Capital
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Capital: Dry Powder
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Default by Portfolio Companies
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6. Performance of Private Equity Funds
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Top Quartile vs. Average
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Buyout Funds vs. Public Markets
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Performance of PE Funds
Kaplan & Schoar
Large heterogeneity across funds LBO fund returns net of fees are lower than S&P500 on an equal
weighted basis, but higher on a value weighted basis.
GPs returns are persistent. Fund flows are positively related to past performance
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Performance of PE Funds
Metrick and Yasuda
Two thirds of expected revenue comes from fixed revenue components. There is striking difference between buyout funds and venture capital
funds o Update: Venture capital continues to underperform
BO funds earn higher revenue per partner
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Performance of PE Funds
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 funds
that performs better than average
Fee bill is more than 25% of the value invested (6% per year) and two
thirds of the fees come from management fees.
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Performance of PE Funds
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% in terms of alpha.
There is a large discrepancy across funds. There is a strong persistence
of performance and it dominates all other fund characteristics.
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