Overview of Private Equity - PowerPoint Presentation

1. Overview of Private Equity

2. Private EquityPrivate equity can be broadly defined to include the following different forms of investment:Leveraged Buyout: Leveraged buyout (LBO) refers to a control purchase of all or most of a company or a business unit by using equity from a small group of investors in combination with a significant amount of debt (the targets of LBOs are typically mature companies that generate strong operating cash flow)Growth Capital: Growth capital typically refers to minority equity investments in mature companies that need capital to expand or restructure operations, finance an acquisition, or enter a new market, without a change of control of the companyMezzanine Capital: Mezzanine capital refers to an investment in subordinated debt or preferred stock of a company, and not taking control of the company (often these securities have attached warrants or conversion rights into common stock) Venture Capital: Venture capital refers to minority equity investments in less mature, higher-risk, non-public companies to fund the launch, early development, or expansion of a business

3. Private Equity Although private equity can be considered to include all four of these investment activities, it is common for private equity to be the principal descriptor for LBO transactions Venture capital, growth capital, and mezzanine capital are each considered a separate investment strategy, although some large private equity firms participate in all four investment areasInvestment firms that engage in LBO transactions are called private equity firms, buyout firms, or financial sponsorsThe term financial sponsor comes from the role a private equity firm has as the “sponsor,” or provider of the equity component in an LBO, as well as the orchestrator of all aspects of the LBO transaction, including negotiating the purchase price and securing debt financing to complete the purchasePrivate equity firms are considered “financial buyers” because they don’t bring synergies to an acquisition, as opposed to “strategic buyers,” who are generally competitors of a target company and will benefit from synergies when they acquire or merge with the target

4. Characteristics of a TransactionKey characteristics of a private equity (LBO) transaction include:In a private equity transaction, a company or a business unit is acquired by a private equity investment fund that has secured debt and equity funding from institutional investors such as pension funds, insurance companies, endowments, fund of funds, sovereign wealth funds, hedge funds and banks, or from high net worth individuals (the equity investment portion of an acquisition has historically represented 30% to 50% of the purchase price, with the balance of the acquisition cost coming from debt financing)High debt levels utilized to fund the transaction increase the return on equity for the private equity buyer, with debt categorized as senior debt that is provided by banks and usually secured by the assets of the target company and subordinated debt that is usually unsecured and raised through issuance of high yield bonds

5. Characteristics of a TransactionIf the target company is a public company (as opposed to a private company or a division of a public company), the buyout results in the target company “going private,” with the expectation that this newly private company will be resold in the future (typically three to seven years) through an IPO or private M&A sale to another company (or to another private equity firm)Most private equity firms’ targeted internal rate of return (IRR) during the holding period for their investment has historically been above 20%, but actual IRR depends on the amount of leverage, the ability of the target’s cash flow to pay down some of the debt, dividend payouts and the eventual exit strategyThe “general partners” of the private equity fund commit 3%-5% of the equity capital to the transaction alongside “limited partners” who provide more than 90% of the equity funding In addition, management of the target company usually also contributes a small amount of equity capital to the transaction

6. Target CompaniesFor an LBO transaction to be successful, the target company must generate a significant amount of cash flow to pay high debt interest and principal payments and, sometimes, pay dividends to the private equity owners Without this ability, the investors will not achieve acceptable returns, and the eventual exit strategy may be impairedTo achieve strong cash flow, management of the target company must be able to reduce costs while growing the company’s revenueThe best potential target companies generally have the following characteristics:Motivated and competent management: management must be willing and able to operate a highly leveraged company that has little margin for error, and if existing management is not capable of doing this, new management must be brought in (some private equity firms have a cadre of operating executives that they bring in to either take over or supplement management activities in order to create value and grow the company)

7. Target Companies Robust and stable cash flow: private equity funds look for robust and stable cash flow to pay interest that is due on large amounts of debt and to pay down debt over timeThe fund initially forecasts cash flow that incorporates cost savings and operational initiatives designed to increase cash flow post-acquisitionThis forecast includes the risk-adjusted maximum amount of debt that can be brought into the capital structure, which leads to the determination of the amount of equity that must be invested, and the corresponding potential return based on the equity investment The greater the projected cash flow, the greater the amount of debt that can be utilized, creating a smaller equity investment The lower the equity investment, the greater the potential return

8. Target Companies Leverageable balance sheet: if a company already has significant leverage and if their debt is not structured efficiently (e.g., not callable, carries high interest payment obligations and other unfavorable characteristics), the company may not be a good target An ideal target company has low leverage, an efficient debt structure, and assets that can be used as collateral for loans Low capital expenditures: since capital expenditures use up cash flow available for debt service and dividends, ideal target companies have found a balance between making capital expenditures that provide good long-term returns on investment and preserving cash to pay interest and principal payments on debt and potential dividendsQuality assets: a good target company has strong brands and quality assets that may have been poorly managed or has unrealized growth potential Generally speaking, service-based companies are less ideal targets compared to companies that have significant high-quality tangible assets because a service company’s value is significantly linked to employees and intangible assets, such as intellectual property and goodwill, and is operated with a minimal amount of hard assets such as inventories, machinery, and buildingsThis type of company sometimes can’t provide adequate collateral value for loans

9. Target CompaniesAsset sales and cost-cutting: a target company may have assets that are not used in the production of cash flowFor example, the company might have too many corporate jets or unproductive real estate used for entertainment or other less productive uses A private equity firm focuses on any assets that don’t facilitate growth in cash flow, and sales of these assets are initiated to create cash to pay down acquisition debt The ability to cut costs is also important to create incremental value, and sometimes this leads to a reduction in personnel or in entertainment and travel budgetsHowever, for certain target companies, the principal focus is on facilitating growth, with cost-cutting as an important second priority

10. ParticipantsThe key participants in a private equity transaction include the following: Private Equity Firms: also called LBO firms, buyout firms, financial buyers, or financial sponsorsSelects the LBO target (often with the assistance of an investment bank)Negotiates the acquisition price Secures senior and subordinated debt financingCompletes the acquisition through a closing event Operates the acquired company through either existing management or new management and oversees the activities and decision-making of senior managementMakes all major strategic and financial decisionsDetermines when and how to sell the company

11. Participants Investment BanksIntroduce potential acquisition targets to private equity firmsConduct auctions that sell targets to private equity firmsHelp negotiate the acquisition priceProvide loans and/or underwrite high-yield bond offeringsUnderwrite debt or provide loans that fund the distribution of a large dividend to the private equity ownerArrange exit transactions through either an M&A-related sale or an IPOInvestorsSign investment contracts that lock up their money for as long as 10-12 years Commit to providing capital over time rather than in a single amount upfront ManagementCoinvest with the private equity fund Lawyers, accountants, tax experts, consultants, and other professionals Advise in the full array of private equity activities

12. Structure of a Private Equity Fund Private equity firms are usually organized as management partnerships or limited liability partnerships that act as holding companies for several private equity funds run by general partnersAt the largest private equity firms, there may be 20 to 40 general partners These general partners invest in the fund and also raise money from institutional investors and high-net-worth individuals, who become limited partners in the fund Private equity firms receive cash from several sources They receive an annual management fee from limited partners that generally equals about 2% of the fund’s assets under management They also receive a portion of the profits generated by the fund, which is called “carry” or “carried interest”The carry is typically approximately 20% of profits, which provides a strong incentive for the private equity firms to create value for the fund The balance of profits is paid out to limited partners

13. Structure of a Private Equity Fund The companies that the fund invests in (called “portfolio companies”) sometimes pay transaction fees to the fund in relation to various services rendered, such as investment banking and consulting services, which are typically calculated as a percentage of the value of the transaction, and sometimes, “monitoring fees”Partnership agreements between the general partners and limited partners are signed at the inception of each fund, and these agreements define the expected payments to general partnersThe management fee resembles up-front fees paid to mutual funds and hedge funds that are based on AUM (higher than fees paid to mutual funds and about the same level paid to hedge funds) The carry has no analogue among most mutual funds but is similar to the performance fee received by hedge funds (although hedge fund managers receive performance fees annually based on the value of assets under management, whereas private equity fund general partners only receive carry when their investment is monetized, which often is after a 3-7 year holding period

14. Structure of a Private Equity FundSuccessful private equity firms stay in business by raising a new fund every two to four yearsEach fund is expected to be fully invested within five years and is designed to realize an exit within three to seven years of the original investmentLimited partners make an upfront commitment to provide capital over, typically, a five-year period, and they write checks only when the GP has found a company to buyThis means that a limited partner might pay about 20% of their capital commitment each year over a five-year period of timeThe limited partner pays a management fee on the full amount of their commitment each year, even though not all funds are invested

15. Capitalization

16. Capitalization

17. Assets Under Management

18. Assets Under Management

19. Bridge LoansA bridge loan is an interim debt financing for a private equity fund to facilitate an acquisition until permanent debt financing can be obtainedBridge loans are typically more expensive than permanent financing to compensate for the additional risk of the loan The bridge loan commitment won’t be drawn down unless permanent debt funding is not availableInvestment banks generally provide bridge loans to private equity firms when they are certain that other permanent debt funding can be sourced, like syndicating a term bank credit facility or successfully placing a high-yield bond offering in the capital markets

20. Equity BridgesA target company requires private equity funds to provide an equity commitment letter prior to signing a purchase agreement If the fund is unable to cover the entire equity commitment at that time, they could ask banks that are receiving fees from advising on the acquisitions to provide an equity bridge to the private equity firm to cover the gap The expectation is that the bridge is a short-term commitment and will be rapidly sold down to permanent equity sources The equity bridge provider usually has the right to collect a pro-rata portion of any breakup fee that might be paid by the target if the deal is terminated but may resist payment of any reverse breakup fee if the private equity firm walks away from the deal

21. Covenant-Lite LoanCovenant-Lite loans do not include the traditional financial triggers that allow banks to shut off credit and force loans to become due and payable Covenant-lite loans come in many forms, including the elimination of covenants that require a borrower to maintain certain financial ratios, leaving lenders to rely only on covenants that restrict a company from “incurring” or actively engaging in certain actions This type of loan reduces the likelihood of a loan default but, at the same time, delays the ability of banks to intervene based on early warning signs of a problemPrivate equity firms are able to access these loans during periods of greater market financial stability but less so when credit markets are more problematic

22. A Payment-in-Kind or “PIK toggle” feature in high-yield bonds and leveraged loans provides a borrower with a choice regarding how to pay accrued interest for each interest period: Pay interest completely in cash Pay interest completely “in kind” by adding it to the principal amount (or by issuing new debt having a principal amount equal to the interest amount due) Pay half of the interest in cash and half in kind Covenant-lite loans and PIK toggle features allow private equity firms to secure more favorable debt transactions in support of their acquisition activity Payment-in-Kind Toggle

23. When the size of a potential acquisition by a private equity firm exceeds around 10%-15% of the capital in a fund sponsored by the firm, the possibility of a “club transaction” is considered In a club deal, two to five different private equity firms coordinate to coinvest in a target company Club transactions are beneficial because they:Spread economic riskShare expertisePool relationships with financing sourcesReduce costs per firmReduce competition Club Transaction and Stub Equity

24. “Stub equity” refers to the practice of letting public shareholders of a target continue to own a non-controlling portion of the equity in a company that is purchased by private equity funds Stub equity allows these shareholders to participate in valuation growth alongside the private equity funds Usually, stub equity is limited to no more than 30% of post-acquisition equity and, if it is a U.S. transaction, is Securities and Exchange Commission (SEC) registered, but it won’t be listed on an exchange Club Transaction and Stub Equity

25. Teaming Up With ManagementPrivate equity firms typically make arrangements with management of a target company regarding terms of employment with the surviving company, post-closing option grants, and rollover equity (the amount of stock that management must purchase to create economic exposure to the transaction) prior to executing definitive agreements with the target When the target is a U.S. public company, these arrangements with management are problematic because of securities law regulations that govern such arrangements, especially if management rolls over a large amount of equity For example, the first question is whether a special committee of the board of the target company is needed to oversee agreements with management The firm must be careful that the transaction does not lose the benefit of the presumption of fair dealingIn a transaction where a private equity fund teams up with a “controlling” shareholder to take a public company private, the actions of the target’s board become subject to the “entire fairness” test, a standard of review that is more exacting than the traditional business judgment rule

26. Private equity firms will turn to private investment in public equity (PIPE) investments when the leveraged loan and high-yield markets are not healthy or control investing opportunities are limited These are minority investments in 5%-30% of the stock of a publicly traded company, and investments are made without using debt financing A PIPE investment allows private equity firms to influence (rather than control) senior management in their decision-making, and the investment is designed to help management make good long-term decisions based on the injection of long-term patient capital Examples of PIPE investments include:Blackstone’s acquisition of a 4.5% equity stake in Deutsche Telekom for $3.3 billion KKR’s purchase of a $700 million convertible bond from Sun Microsystems $1 billion investment by General Atlantic in Bolsa de Mercadorias & Futuros as part of an IPO offeringPrivate Investment in Public Equity

27. Leveraged RecapitalizationA leveraged recapitalization of a private equity fund portfolio company involves the issuance of debt by the company sometime after the acquisition is completed, with the proceeds of the debt transaction used to fund a large cash dividend to the private equity ownerThis action increases risks for the portfolio company by adding debt but enhances the returns for the private equity fund Although the provider of the debt in a leveraged recapitalization is undertaking considerable risk, they are generally paid for this incremental risk through high interest payments and feesHowever, the new debt can cause the value of outstanding debt to decline as the company’s risk profile increasesEmployees and communities can also be harmed if the increased leverage results in the destabilization of the company because of inability to meet interest and principal payments (employees can lose their jobs, and communities can lose their tax base if the company is dissolved through a bankruptcy process)

28. Secondary Market A secondary market has developed to facilitate the sale of limited partnership interests in private equity funds In addition, individuals and institutional investors are also sellers of limited partnership interests in private equity fundsSecondary market sales fall into one of two categories: the seller transfers a limited partnership interest in an existing partnership that continues its existence undisturbed by the transfer, or the seller transfers a portfolio of private equity investments in operating companies Sellers of private equity investments sell both their investments in a fund and also their remaining unfunded commitments to the fundBuyers of secondary interests include large pooled investment funds and institutional investors, including hedge funds

29. Fund of FundsA private equity fund of funds consolidates investments from many individual and institutional investors to make investments in a number of different private equity fundsThis enables investors to access certain private equity fund managers that they otherwise may not be able to invest with, diversifies their private equity investment portfolio, and augments their due diligence process in an effort to invest in high-quality funds that have a high probability of achieving their investment objectives Private equity fund of funds represents a declining portion of capital in the private equity market

30. Private Equity Deal Size

31. Private Equity Deal Size

32. Private Equity Deal Flow

33. Private Equity Deal Flow

34. Private Equity Deal Sector Composition

35. Minority Buyout Participation

36. Private Equity Valuation Multiples

37. Private Equity Exit Activity

38. Private Equity Holding Periods

39. Private Equity Fundraising