Overview of Private Equity. Private Equity Private equity can be broadly defined to include the...
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Transcript of Overview of Private Equity. Private Equity Private equity can be broadly defined to include the...
Overview of Private Equity
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 EquityLeveraged 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 yearsExit strategies are principally M&A sales or IPOsTargeted IRRs are >20%
Prospective LBO candidates commonly include:Divisions of large corporations which become
free-standingPrivate companies acquired from foundersPublicly held companies that are taken private
Characteristics of a Private Equity 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 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 timeThe 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
sponsorSelect the LBO target (often with assistance of an investment bank)Negotiate the acquisition price, secure debt and close transactionMake all major strategic and financial decisionsDetermine how and when to exit the investment
Investment Banks Introduce potential acquisition targets to PE firmsHelp negotiate acquisition priceProvide loans or arrange bond financingArrange 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
Private Equity Ownership
General Partner(Private Equity Firm)
Limited Partners (Investors)Fund-of-funds, public and corporate pension funds, insurance companies,
endowments, foundations, high net-worth individuals, family offices, banks, sovereign wealth funds, etc.
Private Equity Fund(Limited Partnership)
NewCo(Investment)
NewCo(Investment)
NewCo(Investment)
NewCo(Investment)
Manages the fund
Ownership of a Private Equity Fund
Private Equity Acquisition
NewCo Funding and Investing
Source: Training the Street, Inc.
• Target company shareholders sell shares (or assets of target) for casho Potential for some shareholders to “rollover” and participate in upside
• Cash paid by NewCo is funded by lenders and private equity fund (and management investments)o Cash flow from NewCo/Target Co. is used to service debt payments
Private Equity Fund and Management of Target
LendersTarget Co. Shareholders Assets
Equity
Debt
Equity of NewCo Cash
Cash
Cash
Stock
NewCo
Capitalization of Acquired Company
Portfolio Company Capitalization
• Debt (~60-70% of overall cap structure)o Senior bank debt, two types:
Revolving credit facility (Revolver) which can be paid down and re-borrowed as needed Term debt (senior and subordinated) with floating rates
o Junior debt, two types: High yield (typically public markets) Mezzanine debt (subordinated notes, typically sold to banks, institutions and hedge funds) Other key features:
– Warrants– Payment-in-kind (PIK) toggle allows no interest payment and increase in principal
• Equity (~30-40% of overall cap structure)o Preferred stocko Common stock
Maximize Debt of Acquired Company
Private Equity Debt Multiples
U.S. LBO Debt Multiples: Total Debt / EBITDA
Source: S&P's Leveraged Lending Review
4.9x 4.8x
4.1x 4.0x3.4x
4.1x3.8x
4.3x4.6x 4.8x
5.6x
4.5x
5.7x5.4x
4.8x4.2x 4.1x 4.0x
4.5x4.9x
5.2x 5.4x
6.2x
4.9x
0.0x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
97 98 99 00 01 02 03 04 05 06 07 08
Deals < $50MM EBITDA Deals > $50MM EBITDA
Pay Down Debt During Holding Period
LBO Objective: Pay Down Debt During Holding Period
Equity
Debt
Initial
Equity
Debt
Future
$350
$650
$725
$375
$1,000
$1,100
Initial: Acquired for 8.0x LTM EBITDA of $125.0
Future: Sold for 8.0x LTM EBITDA of $137.5
Source: Training the Street, Inc.
Creating High IRR From Investment
LBO: Three Ways to Create Returns
Assume the Target company was acquired for 8.0x LTM EBITDA of $125.0
Note 1: Total Debt - Cumulative Excess Cash to Repay Debt = Net DebtSource: Training the Street, Inc.
1. Deleveraging2. Deleverage & Improve Margins
3. Deleverage,Improve Margins & Multiple Expansion
Sources of Funds
Total Debt $650.0 $650.0 $650.0
Total Equity 350.0 350.0 350.0
Total $1,000.0 $1,000.0 $1,000.0
Year 5 Assumptions
Cumulative Excess Cash to Repay Debt $167.6 $212.3 $212.3
Projected EBITDA 125.0 164.5 164.5
Assumed Exit Multiple 8.0x 8.0x 9.0x
Transaction Value 1,000.0 1,316.0 1,480.5
+/- Net Debt1 (482.4) (437.7) (437.7)
Equity Value $517.6 $878.2 $1,042.8
IRR Returns (5-Yr Exit) 8.1% 20.2% 24.4%
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 ExitSuccessful 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
Assets Under Management (AUM)Private Equity Assets Under Management Reached $1.2 Trillion in 2008Leveraged buyout assets under management 1, 2003 – 2008, $ in billions
Note 1: Assets under management defined as sum of funds raised in the current year plus the previous four years.Source: McKinsey Global Institute; Preqin
225 243 269398
553750
134 143183
241
293
399
6 1322
32
45
70
4 24
8
15
30
2003 2004 2005 2006 2007 2008
Rest of WorldAsiaEuropeNorth America
$401$478
$679
$906
$1,249
$399
+38%
Assets Under Management (AUM)
2005 Global Allocations to Private Equity LBO Funds by Type of Limited Partner
Note 1: Assets come from pensions, other institutions, and wealthy individuals.Note 2: Includes wealthy individuals.Source: McKinsey Global Institute; Preqin
Private equity fund of funds1
37%
Public pension funds23%
Corporate pension funds
10%
Insurance companies
7%
Endowments / foundations
6%
Investment companies
5%
Banks4%
Other2
8%
Private Equity Investments:2000-2005
Private Equity Investments Pre-Credit Crisis, 2000 – 2005
The first half of the 2000’s was characterized by a robust LBO market. Because leverage levels and acquisition multiples were at reasonable levels, most deals completed during this period should prove to be resilient through the global economic slowdown and credit freeze that began in the second half of 2007.
Source: Dealogic; Standard & Poor’s
4.2x 4.1x 4.0x4.6x
4.8x 5.3x6.4x
5.8x6.4x 6.7x 7.0x
8.1x
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
2000 2001 2002 2003 2004 2005
Leverage vs. Acquisition Multiples (of EBITDA)
Leverage Multiple Acquisition Multiple
$0
$100
$200
$300
$400
Global LBO Activity $ billions
LBO volume
Private Equity Investments:2006 to mid-2007
160
693
$0$100$200$300$400$500$600$700$800
Global LBO Activity, $ billions
4.5x
5.8x
0x
2x
4x
6x
8x
Leverage Multiple (of EBITDA)
Private Equity Investments Leading Up to the Credit Crisis, 2006 – 1H 2007
From 2006 through the first half of 2007, a credit market bubble led to a corresponding bubble in the private equity market. LBO deal volume and acquisition multiples increased significantly, buoyed leverage multiples that were considerably above historical norms. As a result, some companies acquired during this period have experienced financial duress in the wake of weakening economic and credit conditions. In addition, others may experience financial difficulties in the future as deteriorating cash flows no longer cover interest payments and massive debt balances become due.
Source: Dealogic; Standard & Poor’s; Morgan Stanley Financial Sponsors Group
2000-2005Avg. Vol. / Yr
2006-2007Avg. Vol. / Yr
2000-2005Average
2006-2007Average
6.7x
8.7x
0x
2x
4x
6x
8x
10x
Acquisition Multiple (of EBITDA)
2000-2005Average
2006-2007Average
Private Equity Investments:After mid-2007
Private Equity Deals Post-Credit Crisis: Smaller in Size
Source: Dealogic
251
422
294
519
171 14397
155 13474
$0
$100
$200
$300
$400
$500
$600
Q3 06 Q4 06 Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08
Average LBO Deal Size, $ millions
Credit Crisis
Private Equity Investments:After mid-2007
Debt Available to Private Equity Dropped 96% from Q1 2007 to Q4 2008U.S. and European syndicated corporate debt issued to financial sponsors, $ in billions
Note: Figures may not sum due to rounding.Source: McKinsey Global Institute; Dealogic
6282
60
101
175
128 125 137
38 4118 6
72
75
79
51
108
142
7524
31 25
207
Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07 Q1-08 Q2-08 Q3-08 Q4-08
Europe
North America
$134
$157$138
$151
$283$270
$200
$161
$68 $66
$37$12
-96%
Private Equity Fund RaisingPrivate Equity Fund Raising Dropped Significantly During 2009Leveraged buyout fundraising, 2003 to Q1-2009, $ in billions
Note: Figures may not sum due to rounding.Source: McKinsey Global Institute; Preqin
40 35
116168 194
238
2412 28
68
9887
118
602
7
11
11 13
27
510
2
4 7
16
0
2003 2004 2005 2006 2007 2008 2009E
Rest of WorldAsiaEuropeNorth America
(annualized Q1-09)
$89
$399
$301$281
$198
$71$54
-78%
Balancing Equity and DebtPrivate Equity Deals Post-Credit Crisis: More Equity and Less Debt
Note: Debt / EBITDA multiples shown for deals with adjusted EBITDA > $50 millionSource: Standard & Poor’s
30%
32%
34%
36%
38%
40%
42%
44%
97 98 99 00 01 02 03 04 05 06 07 08
Average LBO Equity Contribution (% of Purchase Price)
3.5x
4.0x
4.5x
5.0x
5.5x
6.0x
6.5x
97 98 99 00 01 02 03 04 05 06 07 08
LBO Debt / EBITDA Multiples
Credit Crisis
Changing Cost of Debt
Private Equity Deals Post-Credit Crisis: More Expensive Debt
Average Spread of Leverage Buyout Loans (bps over LIBOR)
Source: Standard & Poor’s
97 98 99 00 01 02 03 04 05 06 07 08 2H-08
+250
+300
+350
+400
+450
+200
Credit Crisis
Availability of DebtDebt Available to Private Equity Dropped 96% from Q1 2007 to Q4 2008U.S. and European syndicated corporate debt issued to financial sponsors, $ in billions
Note: Figures may not sum due to rounding.Source: McKinsey Global Institute; Dealogic
6282
60
101
175
128 125 137
38 4118 6
72
75
79
51
108
142
7524
31 25
207
Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07 Q1-08 Q2-08 Q3-08 Q4-08
Europe
North America
$134
$157$138
$151
$283$270
$200
$161
$68 $66
$37$12
-96%
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 FundsA 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