Module II: Private Equity Financing

1. Module II: Private Equity Financing Week 4 –February 2, 2006

2. Objectives of this Lecture • Contrast venture capital, hedge funds, and other sources of private equity • Discuss the role of venture capitalists in providing capital to new firms and to companies attempting to go private • Understand why leveraged buyouts are profitable and how LBOs are done • Analyze the impact of LBOs

3. Private Equity • Managed pools of capital not subject to SEC review or regulation • Major types are venture capital, hedge funds, and other limited partnerships • Most funds are managed by specialized experts who are general partners • Funds are raised in “rounds” and have specified goals and time limits • Efforts to regulate hedge funds by SEC

4. Venture Capital • Venture capital is a global phenomenon although it is largest in the United States • Venture capitalists invest in firms started by entrepreneurs • They are a temporary source of financing with a limited time horizon • They provide entrepreneurs with more than money • Management advice and strategic planning • Personnel services • Additional financing

5. Venture Capital • Venture capital is early stage financing of new and young firms looking to grow quickly • Venture capitalists are an important source of funds for these firms • Venture capital is also critical when a company goes private.

6. Types of Venture Capitalists • Venture capitalists supply capital; there are several types: • High Net Worth Individuals (“Angels”) and Families • Private Partnerships and Corporations • Arthur Rock & Co. • Large Industrial or Financial Corporations • Example: Citicorp Venture Capital

7. Venture Capital Financing Stages • Several distinct stages • Seed money: to “prove” the product or concept • Start-up: Funds for marketing and product development for new firms • First-Round Financing: Supplements to start-up funds to begin sales and manufacturing

8. Venture Capital Financing Stages • Second-Round Financing: Funds earmarked for working capital beyond first-stage financing • Mezzanine Financing: Financing for a profitable firm contemplating expansion • Bridge Financing: Funds for firms likely to go public within a year.

9. Venture Capital • In IPO situations, venture capitalists often require rates of return of 25-50% on an annualized basis • To achieve this with loans, they usually demand and get warrants (“equity kickers”) that effectively give them an equity stake as well.

10. Example • In 1999, EDT Inc. decides to go private. • It obtains a loan of $30 million from a venture capitalist in the form of a zero coupon bond with maturity 2006 and face value $50 million. • In addition, the VC demands warrants that can be exercised in 2006. Using the Black-Scholes formula, these warrants are valued at $11 million currently. • Determine the VC’s rate of return

11. Computation Notice that we use the PV of warrants in year 0

12. Issues in LBOs • Why do LBOs occur? • How are such deals structured? • How can venture capitalists obtain their required rates of return? What is the source of value? • Do LBOs represent an expropriation of shareholder wealth by management? Do they hurt minority shareholders?

13. Hedge Funds • Name comes from “short-long” strategies and use of hedging strategies • Subject of intense interest globally and in U.S. because of failure of LTCM • Hedge funds are evolving • Multiple strategies • Active role in management • Assuming credit risk and others in hedged portfolios

14. Types of LBOs • Going Private: This occurs if the entire public stock interest of the firm is bought by management exclusively; this is sometimes known as a management buyout • LBO: Ownership in the subsequent private firm is shared by management and third-party investors and some (often large) financing in the form of debt

15. Anatomy of Going Private • Merger: Management forms a shell that merges with the original firm, paying with cash or securities; requires shareholder approval. • Asset Sales: Similar in that a vote is required, and assets are purchased by a shell corporation owned by management

16. Anatomy of Going Private • Tender Offer: No vote required, and minority shareholders are not required to involuntarily surrender their shares • Reverse Stock-Split: requires holders of fractional shares to sell their ownership back to the firm -- rare

17. Anatomy of an LBO • Leveraged buyouts involve purchase of the entire public stock interest of the firm • Typically, the transaction is heavily debt financed; additional sources of funds are often found in the cash reserves of the firm itself

18. Financing an LBO • LBOs are often financed with several layers of non-equity financing such as senior debt, subordinated debt, convertible debt, and preferred stock. • Mezzanine level financing refers to the securities between senior debt and common stock, e.g., subordinated and convertible debt

19. Senior Debt Subordinate Debt Strip Financing Convertible Debt Preferred Stock Common Stock Financing an LBO Mezzanine Financing

20. Financing an LBO • Strip financing is common in LBOs • This requires that a buyer purchasing, say, 12% of any mezzanine level security must also purchase 12% of all mezzanine level securities and some equity

21. Financing an LBO • Strip Financing has two advantages • As each level of financing senior to equity goes into default, the strip holder automatically gets new rights to intercede in the organization. • Eliminates conflicts between senior and junior claim holders

22. Sources of Financing • Senior Debt: Usually banks • Equity: Venture capitalists (up to 80%) and management; venture capitalists usually get warrants attached to bonds • Mezzanine: Third-party financiers, holding strips and maybe equity as well

23. LBO Targets • Firms with large cash flows • Firms in less risky industries with stable profits • Firms with unutilized debt capacity • Example • O. M. Scott

24. Gains from LBOs • Reduced regulatory and listing costs: • Exchange registration and listing costs and shareholder servicing costs are eliminated • If costs are, say, $200,000 annually, the present value at 10% is $2 million, which may be significant for small firms • For large firms, these gains may be insignificant.

25. Gains from LBOs • Reduction in agency costs: • LBOs align the interests of management and shareholders, increasing management performance • Management has strong incentives to cut costs given the high ratio of interest expense to cash flow -- this may lead to “downsizing” that hurts other stakeholders

26. Gains from LBOs • Increased monitoring: • High debt provides strong incentives for outside auditing by the lenders and venture capitalists • The conflicts between stockholders and bondholders may be reduced; strip financing allows quick replacement of management

27. Free Cash Flow Argument • When the firm’s actual growth rate is less than its sustainable growth rate, cash accumulates within the corporation: • Although this belongs to shareholders, it is controlled by management • Jensen observes that managers may waste shareholder wealth • High debt places limits on such managerial “excess”

28. The Trigger Strategy Red arrows mark the amount of firm value that can be lost without triggering bond-holder action Retained Earnings Equity Paid In Debt High Debt Normal

29. The Trade-Off • The costs of financial distress may be reduced as reorganization is triggered earlier. • But the commitment of free cash flow to service debt reduces management discretion.

30. Evaluation • The free cash flow argument will work for companies that derive value from assets in place rather than discretionary investment • For companies with high R&D costs and high capital expenditures, you may cut muscle with the fat.

31. Example of O.M. Scott • O.M. Scott was a division of ITT; in 1986, there was a divisional LBO • Venture capitalists were Clayton and Dublier, with 70% of equity • Post-buyout leverage was 90%

32. O.M. Scott • Operating performance increased in 1986-1988 • EBIT rose 56% (Baker and Wruck) • Organizational changes focused on incentives • Bonuses for top managers increased dramatically • There was increased monitoring because of covenants

33. Empirical Evidence • LBOs can be very profitable for the new owners • Kohlberg, Kravis, Roberts & Co. (KKR) earned an average annualized return over 60% on its equity in highly levered transactions • DeAngelo, DeAngelo, and Rice report that buyout specialist Carl Ferenbach has a required rate of return of 50% on its equity investment

34. Empirical Evidence • LBO’s involve a potential conflict of interest • Managers are insiders and may make deals at the expense of minority shareholders • Managers may also have better information than the shareholders; • Managers often have majority voting rights

35. Empirical Evidence • One way to assess the relative importance of the positive and negative effects is to look at the share price reaction when an LBO is announced • Focus on abnormal (excess) returns

36. Empirical Evidence • There are positive excess returns following LBO/private announcements • DeAngelo, DeAngelo, and Rice find a two-day excess return of 22% following the initial announcement of an LBO. • Accounting for leakage in the 40 trading days before the announcement, the cumulative excess return is 30%.

37. Empirical Evidence • However, these returns are below the 56% average premium offered in LBO transactions • The difference is explained by the high percentage of offers (23%) withdrawn following announcement

38. Problems • The problem is that we cannot separate the effect of good insider information from the other benefits such as the reduction in agency costs • Accordingly, research has focused on whether minority shareholders win or lose

39. Minority Shareholders • For offers that are subsequently withdrawn, prices Spring by 9% • Clearly, even minority shareholders benefit from LBOs • The division of the gains is still an open question

40. Alternatives to LBOs • Cost-cutting associated with LBOs often gives them a bad name • One option is a voluntary restructuring • Donaldson discusses the case of General Mills

41. Restructuring and General Mills • In the 1980s, the company was over-diversified and lacked focus • They decided to concentrate on core areas • Change in incentive compensation to focus on ROE

42. Results • In 1980, General Mills had a ROE of 16.7% • By 1989, ROE had risen to 56.6% • Positive stock Market response

43. Caveats • Debt also increased: The leverage ratio rose from 27% to 74% • Orderly implementation “LBO-like” • But, did it take too long?

44. Conclusions • Highly levered transactions are a source of value; restructurings may do the same • Although they can be highly profitable, the evidence is difficult to interpret • There is no evidence that minority shareholders are hurt as a result of LBOs - the same cannot be said of other stakeholders

45. Next Week – February 9 • Review RWJ, Chapter 22 to 24 • Read Term Sheet Negotiations for Trendsetter Inc. case and begin to think about the issues