Private Equity Overview

Overview of Private Equity

• Private equity (PE) includes venture capital (VC), leveraged buyouts (LBO), and distressed debt
• LBO is the largest sector in PE, focusing on mature companies
• PE is concerned with small, private companies
• It is the smallest industry compared to hedge funds, mutual funds, etc.
• Blackstone is the leader in PE, while Vanguard is the leader in mutual funds
• General Partners (GPs) manage PE funds

Fundraising and Investments in Europe

• Total investments in Europe in 2022: 130B euros
• Total investments in venture capital (VC) in Europe in 2022: 18B euros
• PE investment as a percentage of France's GDP: 0.91%

Venture Capital (VC)

• VC finances innovative companies in terms of technology and business model
• Examples of VC-backed companies: GAFAM (Google, Amazon, Facebook, Apple, Microsoft)
• Expected IRR in VC: 30%, but reality is around 15%
• Only 1/4 of VC firms achieve IRR above 15%
• The most common exit route in Europe: trade sale (55.8%)

Partnerships

• A limited partnership is a business arrangement where investors (Limited Partners, LPs) join together to create a fund
• LPs contribute capital, have no say in investment decisions, and are protected by liabilities
• GPs are responsible for day-to-day management, not protected by liabilities, and receive carried interest
• Repartition of ownership: 99% from LPs, 1% from GPs
• Phases of a funding cycle: investment phase and payout phase
• Profits are split between LPs and GPs: 80% to LPs, 20% to GPs

Restrictions and Concerns

• LPs impose restrictions on GPs, including minimum investment size, fundraising limits, and investment guidelines
• GPs may have opportunistic behavior, and LPs may fear this
• LPs may restrict GPs' investment activities, such as limiting investment size and reinvestment of profits

The VC Industry

• 4 stages of firm development: start-up, development, growth, and maturity
• 4 stages of investment: seed, early-stage, late-stage, and exit
• IPO is a riskier exit strategy, while M&A is generally safer
• First VC fund was founded in 1946 by a Harvard professor
• US dominates global VC fundraising, with a significant impact from the Clarification of the Prudent Man Rule in 1979
• VC cycle: fundraising, investment, company growth, exit, and returns

Valuation

• EV (Enterprise Value) is the total value of a business's assets, excluding cash and capital structure
• Equity value is the value left for shareholders after debts are paid
• Comparables method: 1) identify similar firms, 2) search for measures of value, and 3) apply those measures to the company
• Problems with the comparables method: difficulty in finding similar firms, misguided valuations, and lack of flexibility
• DCF (Discounted Cash Flow) method: compute FCFs, terminal value, WACC, and NPV
• Problems with DCF method: lack of comparable companies, terminal value sensitivity, and beta estimation
• Option pricing model: computes the value of flexibility in investments, using binomial trees
• Problems with option pricing model: sensitivity to variables, estimating volatility, and reducing real-world problems to simple models### Retention Ratio
• Quantifies the expected dilutive effect of future rounds of financing on venture capitalist's ownership
• Required Current Percentage Ownership (given dilution) can be calculated using a formula

Structuring the Deal

• To start the integration process, a corporation must:
  • Apply for a corporate charter
  • File an application with the Secretary of State
• Bylaws:
  • Mandates stating how the company will operate
  • Rights or powers of its stockholders, directors, officers, and employees
  • Can be amended or repealed by the board or by a vote of the stockholders
• 3 steps of the termination of a firm:
  • Liquidation: converting remaining fixed assets and inventory into cash
  • Winding up: paying taxes, leading to the proper time and conditions for dissolution
  • Dissolution: the corporation ceases to exist legally
• Financing the firm using stage financing, where venture capitalists set milestones to reach
• Venture capitalists fear entrepreneur's opportunism, so they use stage financing to mitigate this risk

Valuation

• Pre-money valuation: post-money valuation - amount of investment
• Post-money valuation: post-money = pre-money + investment
• Example of pre-money and post-money valuation calculation

Shares

• Preferred shares:
  • Have a higher claim on assets and earnings than common shares
  • Often pay a fixed dividend before common shareholders
  • Do not usually have voting rights
• Common shares:
  • Represent ownership in a company and usually confer voting rights to shareholders
  • Dividends are not guaranteed and can fluctuate
  • Shareholders have a residual claim on the company's assets after debts and preferred shareholders are paid in a liquidation event
• Convertible preferred equity: gives the holder the right to convert preferred shares into a specified number of common shares
• Conversion ratio: number of common shares shareholders may receive for every converted preferred share
• Conversion price: price of each common share that must be reached for conversion to be beneficial

Term Sheet

• Closing date: the date at which the transaction is expected to be completed
• 3 types of liquidation preference and their differences:
  • Non-participating preferred stocks: fixed dividend, no right to participate in additional profits
  • Full participating preferred stocks: fixed dividend, share the rest with common stockholders on an as-converted basis
  • Cap on preferred stocks participation rights: limits the amount that holders of preferred shares can receive from a company's distributions or liquidation events
• Optional conversions: the possibility to convert preferred stocks into common stocks
• Mandatory conversions: forcing conversion into common stocks, often during IPOs
• Lock-up clauses: restrict selling shares after an IPO for a certain period
• Investor information rights: the firm must provide information to major investors
• Investor's right to maintain proportionate ownership: if new shares are issued, existent shareholders have the right to buy some of it to maintain their percentage of ownership
• Non-competition agreement: agreement in which the founder and the team must stay in the company for at least 1 year

Distressed Debt Restructuring

• Debt restructuring: renegotiation of existing debt contracts
• When does it happen? When the firm cannot make payments or violates covenants
• Examples of troubled debt restructuring: Alstom, Eurodisney, Eurotunnel, Ferruzzi Group
• Covenants: debt/Equity, max debt/EBIDTA, min interest coverage
• Distinguishing between viable firms and non-viable firms
• Direct and indirect costs of financial distress
• When is debt restructuring efficient? For viable firms

Private Workout vs. Public Workout

• Private workout: negotiation between the management of the firm and the syndicate (creditor) only

• Public workout: filing for bankruptcy, court-imposed restructuring plan

• Advantages of private workout: lower direct costs, shorter length, secrecy

• Characteristics of a public workout: court-imposed plan, transparency, legal oversight

• How to choose between the two: depends on the viability of the firm, deterioration of liquidation values, country's inclination, difficulty of implementing a private workout### Private Equity (PE) Firms

• Notable PE firms: KKR, Blackstone, Bain, Merril Lynch

LBO of RJR Nabisco by KKR in 1989

• Deal value: 31Batthetimeofpurchase,over31B at the time of purchase, over 31Batthetimeofpurchase,over55B inflation-adjusted today
• Result: failed to generate value for investors, considered a failure

Most Successful PE Deal

• Blackstone and Hilton: generated $12B for investors after going public in 2013

Twitter's Value

• Down 55% compared to when Elon Musk bought it

LBO Characteristics

• Very long-term investment, typically 8-10 years
• Not suitable for all investors due to the long-term commitment

GP Compensation in LBOs

• Charge 1.5%-2% management fees
• Charge 20% carried interest, but only if the hurdle rate of 8% is reached

LBO Timing

• Typically occurs when a firm is in its mature phase and has slowed down
• Purpose: restructuring, bringing efficiency, and rejuvenating the company

Incentives for LBOs

• Huge leverage (high debt): motivates management to work hard and generate significant cash flows
• Decreased number of shareholders: concentrates profit among a few hands, incentivizing management to work hard

Sponsor Goals in LBOs

• High annualized return on equity investment (IRR)
• High absolute return (MoM)

LBO Steps

• Create a holding company (Newco) owning 100% of the target
• Holding company lives for 5-7 years
• Exit: IPO, sale to another LBO fund, or trade sale

Good LBO Target Characteristics

• Resilient cash flow
• History of strong earnings
• Leading market position or protected niche
• No major market disruption expected
• Growth potential
• Good visibility on CAPEX needs
• Operational improvements and cost savings possible
• Asset reorganization (e.g., selling real estate)
• Attractive at exit for pre-identified buyers
• Strong management in place or identified

Due Diligence Process

• Initial due diligence (3-4 weeks): draft business plan, exchange views on financing and valuation, and letter of intent
• Full due diligence (2 months): access to data room, finalize financing and valuation, and draft sale and purchase agreement
• Negotiations: finalize sale and purchase agreement
• Finalization (1-3 months): finalize operation, documentation, and regulatory filings

LBO Role after Acquisition

• Acts as an active partner and coach to the management team
• Holds veto rights over important decisions
• Provides strong support in financing, M&A, and exit-related aspects
• Holds significant power, including the ability to change key management personnel

Lock-up Clauses

• Managers are required to hold their shares for a certain period after the IPO
• Ensures they remain committed to the company's long-term success

Good/Bad Leaver Clauses

• Good leaver clauses: provide favorable treatment to individuals who leave the company under certain positive or neutral circumstances
• Bad leaver clauses: provide less favorable treatment to individuals who leave the company under negative circumstances

IRR Formula

• IRR = (1 + (Total Value / Initial Investment))^(1/Number of Years) - 1

Money on Money (MoM) Multiple

• MoM = Value at which you sell the shares / Value at which you bought them

Leverage and ROE

• Leverage amplifies ROE when the cost of debt is less than ROA/ROCE
• The larger the proportion of debt to equity, the more sensitive ROE is to changes in ROA/ROCE

Creating Value

• Grow the business
• Expand margins (same sales)
• Expand multiples (EV/EBITDA, P/E)
• Reduce debt level (delever) by the end
• Tax savings with tax consolidation

FCF Calculation

• FCF = EBIT(1-T) + Depreciation - Inc in NWC - CAPEX

Debt Calculation

• Principal = Annuité x {1-(1+6.5%)^-6) / 6.5%}

Dividend and Debt Repayment

• Dividend is the annuity, which is used to repay interest and debt

Valuation Methods

• Comparables: to have a "ballpark value" of the firm
• DCF

EV (Enterprise Value)

• Total value of a business's assets, excluding cash, and indifferent to the firm's capital structure
• Can be calculated using either the market capitalization or the Net Present Value of all FCFF in a DCF model

Equity Value

• The value left for shareholders after all debts have been paid
• Calculated by subtracting debt from the EV