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Private Equity 101

Private Equity 101. MBA Program Fall 2007. Private Equity Industry. Venture Capital. Seed F&F, Business Angels, Funds Start up F&F, B/A, informal VC , Funds Expansion VC Funds. Private Equity propre. Buyout PE Funds Turnaround Mezzanine. Private Equity Governance Structure.

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Private Equity 101

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  1. Private Equity 101 MBA Program Fall 2007

  2. Private Equity Industry Venture Capital Seed F&F, Business Angels,Funds Start up F&F, B/A,informal VC, Funds ExpansionVC Funds Private Equity propre Buyout PE Funds Turnaround Mezzanine

  3. Private Equity Governance Structure • Equity Ownership • Management fee • Cash Flows PE Firm • Proceeds (~20%) • ~ 1 - 5% of Equity • ~ 95 - 99% of Equity Institutional Investors (LPs) PE funds • Proceeds (~80%) • Proceeds • Equity Investment Portfolio companies

  4. Private Equity Governance Structure (2) PE Firms have an unlimited life as they manage a sequence of limited-horizon PE Funds as General Partners • time (in years) • t0 • 1 • 2 • 3 • 4 • 5 • 6 • 7 • 8 • 9 • 10 • 11 • 12 • 13 • 14 • 15 • 16 • 17 • 18 • 19 • t + 20 • PE Firm • … • PE-Fund A • Portfolio Company • Portfolio Company • Portfolio Company • Portfolio Company • A1 • A2 • A3 • … • PE-Fund B • Portfolio Company • Portfolio Company • Portfolio Company • Portfolio Company • B1 • B2 • B3 • … • … • PE-Fund C • Portfolio Company • Portfolio Company • Portfolio Company • C1 • C2 • … • … • …

  5. Terminology • A buyout can be defined as the purchase of a controlling stake in a business from its owners, typically with the following characteristics • Investment companies Investor-led buyout - IBO • Financed through a combination of equity and debt Leveraged buyout - LBO • Equity participation of current management Management buyout - MBO • Introduction of new management Management buy-in - MBI

  6. Typical Features of a Buyout • Increased financial leverage • Limited investment horizon • Standalone acquisition (exception “buy-and-build” transactions) • Triggers substantial change in acquired company • Restructuring • Strategic reorientation • Changes in management team • Layoffs • Divestitures

  7. Mechanics of a Buyout Debt Investors Debt Newco Holding Buyout Firm Equity Target „Portfolio Company“ Buys Equity of

  8. Mechanics of a Buyout A consolidated view shows the increased leverage factor Previous Debt Previous Debt LBO Debt Previous Equity Debt Investors Buyout Firm Equity

  9. The Buyout Manager’s Perspective • A buyout implies substantial changein the role of managers • Changing reporting relationships • New Incentives – Co-Ownership • Debt burden through leverage – Focus on Cash Flow • Changing responsibilities – Division Head -> CEO; CEO -> Owner • Higher clock-speed – working towards the exit • Greater identification with your company • Stretch budgets and ambitious targets • Need to work with advisors - consultants or GP investment managers

  10. Many Household-Name CompaniesUnderwent a Buyout

  11. Levers of Value Generation in Buyouts • Generation of returns from differences in the valuation applied to a portfolio company between acquisition and divestment independent of changes in the underlying financial performance of the business ("buy low - sell high strategy"). • Financial Arbitrage (A) • Financial Engineering (B) • Optimisation of capital structure and minimization of after-tax cost of capital of the portfolio company as consequence of the utilisation of financial knowledge and experience • Increasing Operational Effectiveness (C) • Implementation of measures that enhance overall productivity and effectiveness of operations. The configuration of a company's resources, i.e. how the different available resources are put to work, are being readjusted. • Levers of value generation • Increasing Strategic Distinctiveness (D) • Adjustment of the strategic objectives, programs and processes of the portfolio company • Reducing Agency Costs (E) • Decrease of the agency costs that arise of the owner-manager-conflict in the portfolio company • Mentoring or ParentingEffects (F) • Increase in revenues or decrease of cost due to the effect that the portfolio company benefits of being associated with the buyout association

  12. The Evolution of Buyout Value Generation Time 1980 1990 2000 Financial Arbitrage, Optimizing Corporate Scope, Financial Engineering Reducing Agency Cost Increasing Operational Effectiveness Increasing Strategic Distinctiveness Parenting Effect Value Potential

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