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Private Equity • Private equity can be broadly defined to include the following different forms of investment: • Leveraged Buyout: Leveraged buyout (LBO) refers to the 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 company • Mezzanine Capital: Mezzanine capital refers to an investment in subordinated debt or preferred stock of a company, without taking voting control of the company. Often these securities have attached warrants or conversion rights into common stock • Venture Capital: Venture capital refers to equity investments in less mature non-public companies to fund the launch, early development or expansion of a business
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 activity • 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 areas • Investment firms that engage in LBO activity are called private equity firms, buyout firms or financial sponsors • The 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 purchase • Private 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
Private Equity • Leveraged Buyouts • The purchased company's balance sheet is leveraged to reduce the investor's cash commitment. • The LBO firm will seek to exit their investment within 3-7 years • Exit strategies are principally M&A sales or IPOs • Targeted IRRs are >20% • Prospective LBO candidates commonly include: • Divisions of large corporations which become free-standing • Private companies acquired from founders • Publicly held companies that are taken private
Characteristics of a Private Equity Transaction • Key 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 40% of the purchase price, with the balance of the acquisition cost coming from debt financing) • The high debt levels utilized to fund the transaction increases the return on equity for the private equity buyer, with debt categorized as senior debt, which is provided by banks and usually secured by the assets of the target company, and subordinated debt, which is usually unsecured and raised in the high yield capital markets
Characteristics of a Private Equity Transaction (continued) • If 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 view that this newly private company will be resold in the future (typically three to seven years) through an IPO or private 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 strategy (and the IRR should be risk-adjusted to reflect higher leverage) • The “general partners” of the private equity fund commit capital to the transaction alongside “limited partners”, who are the equity investors described above • In addition, management of the target company usually also have a meaningful capital exposure to the transaction
Target Companies for Private Equity Transactions • For 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 shareholders • Without this ability, the investors will not achieve acceptable returns and the eventual exit strategy may be impaired • To achieve strong cash flow, management of the target company must be able to reduce costs while growing the company • The best potential target companies generally have the following characteristics: • Motivated and competent management: it is crucial that management is 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)
Target Companies for Private Equity Transactions (continued) • 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, ideally, to also pay down debt over time • The fund initially forecasts cash flow that incorporates cost savings and operational initiatives designed to increase cash flow post acquisition • This forecast includes the risk-adjusted maximum amount of debt that can be brought into the capital structure, which leads to 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
Target Companies for Private Equity Transactions (continued) • Leveragable 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 dividends
Target Companies for Private Equity Transactions (continued) • Asset sales and cost cutting: a target company may have assets that are not used in the production of cash flow • For 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 • Another reason to sell assets is to facilitate diversification objectives • 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 budgets • However, for certain target companies, the principal focus is on facilitating growth rather than cutting costs
Target Companies for Private Equity Transactions (continued) • Quality assets: a good target company has strong brands and quality assets that have been poorly managed, or has unrealized growth potential • Generally speaking, service-based companies are less ideal targets compared to companies that have significant tangible assets of high quality because a service company’s value is significantly linked to employees and intangible assets such as intellectual property and goodwill • These types of assets don’t provide collateral value for loans, compared to assets such as inventories, machinery, and buildings
Participants • Private Equity Firm: also called LBO firm, buyout firm or financial sponsor • Select the LBO target (often with assistance of an investment bank) • Negotiate the acquisition price, secure debt and close transaction • Make all major strategic and financial decisions • Determine how and when to exit the investment • Investment Banks • Introduce potential acquisition targets to PE firms • Help negotiate acquisition price • Provide loans or arrange bond financing • Arrange exit transaction • Investors: also called Limited Partners • Management • Co-invest with the PE firm: both will do very well if there is a successful exit • Accept lower cash compensation, but also receive options and other forms of incentive compensation
Cash Distribution and Exit • 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 partners • At 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 between 1% and 3% 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
Cash Distribution and Exit • 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 partners • The management fee resembles fees paid to mutual funds and hedge funds (higher than mutual funds and about the same level as 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
Cash Distribution and Exit • Successful private equity firms stay in business by raising a new fund every three to five years. • Each 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 investment
Teaming Up With Management • Private 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 • 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 dealing • In 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
Leveraged Recapitalization • A leveraged recapitalization of a private equity fund portfolio company involves the issuance of debt by the company some time after the acquisition is completed, with the proceeds of the debt transaction used to fund a large cash dividend to the private equity owner • This 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 fees • However, the new debt can cause the value of outstanding debt to decline as the company’s risk profile increases • Employees and communities can also be harmed if the increased leverage results in 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)
Secondary Market • A secondary market has developed for private equity as banks, and other financial institutions attempt to sell their private equity investments to reduce the volatility of earnings and rebalance portfolios • In addition, individuals and institutional investors are also sellers of limited partnership interests in private equity funds • Secondary 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 fund • Buyers of secondary interests include large pooled investment funds and institutional investors, including hedge funds
Fund of Funds • A private equity fund of funds consolidates investments from many individual and institutional investors to make investments in a number of different private equity funds • This 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 represent about 15% of committed capital in the private equity market
