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Private Equity Investing

Professors Spiegel, Sunder & Tookes

Dolores ArtonThomas Ghegan

Founders Equity Inc.November 2007

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• The Private Equity Industry

• The Private Equity Process

• Founders Equity Portfolio Company Examples

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Private Equity Fund Structure• 10 years in total: 5 year investment period/5 year exit period

• As portfolio companies are sold, distributions are made

• Targeted IRR’s 25%+; 3x cash on cash return

Limited Partners

Private EquityFund

General Partner

Portfolio Companies

99% interest 80% of profits

Cashfor 99% interest

2% management fee

1% interest20% of profits (carry)

Cash or notesfor 1% interest

Cash

Eq

uit

y

Ow

ners

hi

p

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Who Invests in Private Equity?

• Pension & Retirement Funds

• Insurance Companies

• University Endowments

• Fund of funds

• Family Investing Offices

• High Net Worth Individuals

• Hedge Funds

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

EducationalInstitution

Endowment Mean

Yale Endowment

Real Assets

Absolute Return

Private Equity

Foreign Equity

Domestic Equity

CashFixed Income

Asset Allocation: Educational Institutions

Per

cent

of

Tot

al

Source: The Yale Endowment 2006 Annual Report.

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Fundraising has not slowed in 2007 despite the credit markets.$254 Billion Raised in 2006

$239 Billion Raised Through October 2007

$0.0

$50.0

$100.0

$150.0

$200.0

$250.0

$300.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007YTDOct.

Fund of Funds

Other Private Equity

Mezzanine

Venture Capital

Buyouts

Source: Private Equity Analyst

$ B

illi

ons

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Demand for Private Equity Funds Persists

• Continued Strength in Buyouts• Buyout Funds dominated 2007 with 132 funds raising $155 billion

YTD (up from $101 billion in 2006)

• Distressed Funds were $29.6 billion of the Buyout Funds

• Venture Fundraising remains sluggish• 102 firms raised $19 billion YTD

• Large buyout firms currently in the market to raise their largest funds to date• Carlyle: Targeting $17.0 billion fund

• Warburg Pincus: Targeting $12.0 billion fund

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Private Equity Deal Environment

• Correction in credit market led to slowdown in the number of transactions• Private equity firms announced $8.5 billion of new deals in October 2007,

compared to $42.2 billion announced in October 2006

• Effects of weakening financial market:• Financing has become less available and more expensive• Increased use of Material Adverse Change (“MAC”) clauses• Increased time to complete deals (especially large deals dependent upon public

credit markets)

• Average purchase price multiples continued to climb through May 2007:• 9.18x EBITDA for $500+ million deals• 8.24x EBITDA for deals between $250 million and $499 million• 7.64x EBITDA for deals under $250 million

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Private Equity Firms Various Strategies for Success

• Buyouts vs. Growth Equity

• Industry Specialization

• Operational Expertise

• Geographical Focus

• Origination Focus

• Focus on Particular Type of Transaction

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Founders Equity Investment Focus

Venture Investing Buy-Out/Corporate Finance

Seed Start-upEarly-

Growth

Accelerat-ing

Growth

Later-StageGrowth

Special SituationsGrowth/Mature

Small-Cap Market

Middle-Market

Large-Cap

Market

Concept Stage

Developmentand InitialImplementation of Business Model

Successful “Beta” Version; Few Customers

Successful Business

Model Rolled Out

AcceleratingGrowth,ProfitableBusinessPotentialIPO

Turnaround Situations: Financial RestructuringReplacingManagement, AlteringBusinessModel, etc.

$5-$100MMAcquisitionWith TargetedFollow-onAcquisitions

$100MM-$500MM

Above$400MM

Founders Investment Focus

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Founders Equity Lower Middle Market Focus

Founders Equity Focus

$422 Billion

Accumulated Under Management

97,000 Investment Opportunities

1 Billion +

3,100 cos

(3.2%)

$500 Million - $2 Billion

4,376 cos

(4.5%)

$20 - $150 Million

79,000 cos

(81.3%)

$150 - $500 Million

10,754 cos

(11%)

Mega LBOs

$144 Billion

(34.17%)

Large LBOs

$77 Billion

(18.3%)

Mid-Market

$171 Billion

(40.5%)

Small Market

$30 Billion

(7.1%)

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Founders Equity Annual Deal Sourcing

500 Potential Investment OpportunitiesReviewed

100 Spend More Time on Book

50 Deeper Analysis

20 Real Interest

4-6 Deals ClosedPer Year

Industry outlook Opportunities for growth? Identify risks Reasonable valuation expectations

Does it meet our investment criteria?

Quality of management Management callsOutside experts

Limited due diligence

Full due diligence

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• The Private Equity Industry

• The Private Equity Process

• Founders Equity Portfolio Company Examples

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The Private Equity Process

Sourcing Deals

Initial Evaluation

of Deal

Exit/ Sale of

Company

Portfolio Company

Monitoring/ Value

CreationFinancing

Transaction Closing

Due Diligence

Letter of Interest

Letter of Intent

Merger or Asset Purchase Agreement

Agreements:

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Sourcing Deals: Buy Right

• Auction Process• Investment banks work with companies to create an Information

Memorandum which is distributed to strategic and financial buyers

• Investment bank’s process focused on achieving highest value for the Seller

• Proprietary Sourcing• Contact companies directly (no intermediary)

• Networking with business brokers, accountants, attorneys and other industry participants

• Fundless sponsors

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Initial Evaluation: The First Look

Company Industry Financial• Management team

(bench strength)

• Value proposition and differentiation

• Business model economics

• Relationships with customers and suppliers

• Organizational model (e.g., incentive compensation)

• Competitive dynamics

• Industry size and growth

• Cyclicality

• Fragmentation vs. consolidation

• Identification of key risks

• Comparable company analysis

• Financial model (historical and projected)

• Working capital

• Capital expenditures

• Capital structure and leverage

• Investment security

• Target returns

• Valuation

Development of the investment thesis

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Valuation: In the Eye of the Beholder• IRR/ Multiple of Cost Analysis: “The Model”

• Incorporates the theory of a Discounted Cash Flow analysis

• Importance of sensitivity scenarios

• Focus on Free Cash Flow and debt covenants

• Public Company and Transaction Comparable Analysis• Only as good as the comparability of the companies used

• May need to interpolate between multiple sets of comps

• Value of Assets• Consider value based on assets rather than cash flow

•Triangulation across multiple methods is critical•Valuation is an art not a science

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Due Diligence: Trust but Verify

• Management• Background and reference

checks

• In-depth interviews

• Employment agreements

• Company and Industry• Speak with industry

experts, customers and suppliers

• Validate company value proposition and industry dynamics

• Quantify possible risks

• Accounting• Independent accounting

review

• Legal• Identify any outstanding

litigation and potential liabilities

• Intellectual property and patents

• Insurance• Understand scope of

coverage required and currently in place

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Financing: Establishing the Structure

$0.0

$20.0

$40.0

$60.0

$80.0

$100.0

Uses

Sources and Uses in a Leverage Buyout

$ M

illi

ons

Sources

Purchase Price

$100.0 MillionFees and Expenses

$100.0 Million

Senior Debt

Equity

Subordinated Debt

Key Terms

• Type of security (preferred equity or common)

• Pay-in-Kind (“PIK”) Coupon

• Term of loan

• Amortization schedule

• Rate

• Covenants

• Often a “bullet” loan

• May ask for warrants

• Often a “bullet” loan

• May ask for warrants

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Value Creation: Ideas into Action

• Board of Directors representation• Identify new Directors with relevant experience who can assist the

Company • Develop a “100 day plan”

• Augmenting the Management Team• If necessary, recruit new CEO/ CFO• Identify functional areas to add additional talent• Incentive key players

• Execution of the growth strategy• Buy and Build: Add-on acquisitions• Accelerating Growth: Investments in new products or markets• Transformation: Professionalize operations

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Exits: Realizing the Investment

• Initial Public Offering (“IPO”)

• Sale to strategic buyer (e.g., industry competitor)

• Sale to another Private Equity Fund (“Financial buyer”)

• Sale to management (Management buyout or “MBO”)

• Recapitalization (raise debt and provide a dividend to the equity sponsors)

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• The Private Equity Industry

• The Private Equity Process

• Founders Equity Portfolio Company Examples

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Stone Source

Sourcing

• Date Sourced: 10/26/2005

• Date Closed: 6/30/2006

• Source: Proprietary Referral: Fundless

sponsor

Investment Thesis: Transformation

• Unique marketing focus with products sold thru architects and designer

• Business model generates high margins with cash deposits upfront

• Large, fragmented market with opportunity for geographic expansion

• Excellent vendor relationships provide competitive advantage in product sourcing

• Opportunity to transform company from entrepreneurial company to professionally managed company

Company Overview

• Headquarters: New York, NY

• The Company sources and markets natural stone, ceramic tiles, glass

tiles, engineered stone and other materials with decorative surfaces

• Founded in 1988 by Jeff Green (CEO) and Mark Shedrofsky (COO

• 2006 Revenue: $44.9 million

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In The Swim

Sourcing

• Date Sourced: November 2004

• Date Closed: February 2005

• Source: Competitive auction / Proprietary referral

Investment Thesis: Accelerating Growth

• The pool supply industry is a stable $3.8 billion market with a definable universe of 7.6 million

residential pool owners and 260,000 commercial pools with recurring needs for pool supplies

• The pool supply market is a particularly attractive industry for direct marketing due to the prosaic,

consumable nature of the product lines and the repeatability of pool utility needs

• Strong historical cash flow with high predictability

• 60.0% of revenues visible from existing customers

Company Overview

• Headquarters: West Chicago, Illinois

• In The Swim (“ITS”) is the leading direct marketer of pool supplies to residential and commercial

consumers in the United States and is know as “America’s #1 Direct Source for Pool Supplies”

• The Company’s product offering focuses on “need-based” consumable and periodic maintenance

products utilized in swimming pool openings, closings and general maintenance

• 2006 Revenue: $71.9 million

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Richardson Foods

Sourcing

• Date Sourced: 3/21/2005

• Date Closed: 3/20/2006

• Source: Referral from deal broker

Investment Thesis: Buy and Build

• Opportunity to leverage underutilized manufacturing assets through operational

improvement and synergistic acquisitions.

• Base business operating at 30% capacity

• Strong distribution channels

• Professionalize management by partnering with seasoned industry executives

• Reinvigorate old brands through new sales and marketing initiatives

Company Overview

• Headquarters: Canajoharie, NY

• Richardson produces, markets and distributes bulk confectionary

products and specialty sauces under the Richardson, Beechies,

Dryden & Palmer and Gravymaster brand names

• 2006 Revenue: $17.6 million

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Richardson Foods: The Flood

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Richardson Foods:Turning Adversity to Advantage

• Improve Operations• Distinguishes the high performing employees• Opportunity to reconfigure equipment• Build relationships in the community

• Upgrade Equipment with insurance proceeds• Improve infrastructure reliability• Re-build better than new• Replace with upgraded performance• Fix historical pesky problems

• Change culture• Sense of urgency• Importance of a team• Pride of ownership

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APPENDIX

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Valuation - Cash Flow Analysis is Key

• EBITDA• The more EBITDA that comes from EBIT the better

• Embedded accounting assumption that D&A is a proxy for ongoing capital needs

• OCF is a more conservative measure

• Be skeptical of adjustments; think of as two types:• Simple add-backs

• Synergies and cost savings on the come

• EBITDA can be manipulated by changes in accounting practices

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Impact of Cost Structure

• Variable Costs• Move in a direct relationship with sales• Cost of goods sold and some SG&A (eg, cleaning supplies for

production) machinery, payroll taxes for factory workers, gas for delivery trucks, etc.)

• Warning: Some Variable Costs can become Fixed (i.e. hourly labor in a tight labor market)

• Fixed Costs• Can increase or decrease unrelated to sales growth• Corporate overhead (eg, officers’ salaries, rent, office supplies,

etc.)• Generally fixed costs grow at inflation as company grows – but

can sometimes be lumpy as you add high-salary management, etc.

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Leverage• Need to put in place proper Senior Credit Facility

• Asset Based Lenders vs. Cash Flow Lenders• Focus on asset values vs. business value

• Focus on liquidation value vs. potential sale price

• Revolvers can be one of two types• Asset Based (Eligibility and Advance Rates)

• Cash Flow Based (Typically subject to Senior Leverage and Total Leverage caps)

• Term Loans• A Loans – straight amortization w/ possible payment holiday for first 6 months to

one year

• B Loans – Amortize 1% in the early years and remaining amount in last 1-2 years.• Helps provide greater operating flexibility –maturity 6-8 years

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Overview of Credit Statistics

• Role of credit statistics• Used to give a snapshot of the capital structure and the risk profile

of deal

• Helpful to use when determining the optimal capital structure

• Necessary to analyze when setting covenants

• Understand potential revolver availability issues

• Certain benchmarks are particularly important (i.e. fixed charge coverage a minimum of 1:1)

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Key Credit Statistics

• Look at Trailing Twelve Month EBITDA/OCF to understand most recent actual performance

• Always understand adjustments used to arrive as “adjusted EBITDA”

• The following are key credit statistics and general guidelines as to their range

Key Credit Stats General Guidelines Total Debt/EBITDA <3.5x-4.75x

Senior Debt/EBITDA <2.0x-3.25x

EBITDA/Total Interest >2.0x

Fixed Charge Coverage > 1.0x

Other Covenants

Minimum EBITDA

Maximum cap ex

Restricted Payments

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Structuring Conclusion

• Easy to get “lost in the analysis” – don’t forget to step back and assess the business thesis/rationale• A good capital structure can only partially offset a mediocre

business.

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Plain Vanilla Convertible Preferred

• Simplest form of institutional private equity• Preference equal to face value; therefore, somewhat protected

from loss of principal because “first equity out” (before common)

• Convertible into common shares at conversion price• Example:

• $10.0MM invested• $10.0MM redemption value/preference• $40.00 per share conversion price• Convertible into 250,000 common shares• Owns 25.0% of company

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Participating Preferred Stock

• “Double dip” equity – investor gets back principal invested plus ownership in the company (i.e., converts into underlying common stock)

• Can be effective way to bridge valuation gaps as Investor willing to pay higher price per share for participating preferred

• Mechanics• One unit is convertible into both:• For example, $10.0MM investment at $90MM pre-money value

• $10.0MM of capital back redeemable preferred at liquidity event, plus

• 10.0% underlying ownership stake

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Dividends

• Dividend can be paid in cash, stock, or paid-in-kind (PIK)

• Cash/stock dividends• Usually 8-12% coupon

• Compounding vs. non-compounding (usually non-compounding)

• Usually accrue and paid at liquidity event (IPO, sale or liquidation)

• Example:• $10MM invested at $10.00 per share; 8% compounding dividend for 3 years

(e.g., $2.6MM)

• Private Equity Firm gets either $2.6MM in cash or stock (i.e. 86,571 shares assuming $30.00 IPO price)

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Dividends (cont.)

• PIK dividends yield better results for Private Equity Firm• Usually compounding

• Earn additional shares at deal price (e.g. above example would yield 259,712 shares vs. 86,571)

• Earn additional shares of underlying security (e.g. participating preferred results in “triple dip”)

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Overview of Typical Mezzanine Investment

• Deal Size: $10 million to $100 million• Current Cash Coupon: 12% to 14%• Target IRR at 5 Years: Market pricing (typically 13% to 16%)• Prepayment Penalty: Scheduled payments and/or Treasury

Makewhole• Transaction Fee: 0%-2.5%• Term: 6-8 years• Representation: Board seat or observation rights• Interest Can be PIK or cash or both, typically

compounded on a quarterly basis• Warrants On a deal by deal basis