FNCE213 Entrepreneurial Finance Course - PDF

FNCE213 Entrepreneurial Finance Dr Victor Ong Adjunct Finance Faculty Lee Kong Chian School of Business, SMU Introduction Course format Presentation style lecture format coupled with some interactive discussions of content and topical issues Will periodically run...

FNCE213 Entrepreneurial Finance Dr Victor Ong Adjunct Finance Faculty Lee Kong Chian School of Business, SMU Introduction Course format Presentation style lecture format coupled with some interactive discussions of content and topical issues Will periodically run some video clips of private equity and venture capital topics from youtube Case studies will be reviewed as part of the course Guest speaker session from the private equity and venture capital industry towards the end of the course (depending on availability and time constraint) Assessment Case studies Mid term exam Group project presentations Final exam Course readings Ramsinghani: The business of venture capital 2nd Edition Ippolito: Private capital investing: The handbook of private debt and private equity I will also be using material from Cyrille De Maria: Introduction to Private Equity, Debt and Real assets 3rd edition and Antonella Puca Early Stage Valuation – A Fair Value Perspective New lecture slides available on ELEARN every Friday Course requirements and grading Grading Class Participation 10% Case Studies 10% Mid term 20% Group Project 20% Final Exam 40% Total 100% Instructor’s background Dr Victor Ong Over 20 years in the energy and infrastructure investment area both from a buyside investor (real estate PE, infrastructure PE fund, corporate VC fund) and corporate finance advisory perspective Worked in MNCs (Royal Vopak, Trelleborg), Real estate private equity (Colony Capital), Corporate finance advisory (Galway Capital Asia), and multilateral government sponsored infrastructure fund (Infraco Asia – UK AID & World Bank) Teach both postgraduates and undergraduates at SMU (Private Equity and Venture Capital Investing, Project and Infrastructure Financing, Entrepreneurial Finance) Currently consulting with a Hong Kong private credit fund on fund raising initiatives and a Malaysian family office on early stage infrastructure investment projects BBA (Hons) National University of Singapore, MBA in Finance (Alliance Manchester Business School) DBA (Singapore Management University) My personal hopes for the class (non-academic) To be able to share my knowledge on the topic with the class specifically in private equity and venture capital which is my core industry experience and research interest To get students motivated to pursue postgraduate education in the field specifically in private equity and venture capital I also teach project and infrastructure financing in the MAF program that focuses on infrastructure PE investments Alternative investments course at NUS Business School involving real estate investments and hedge funds Have students explore a potential career path in private equity or venture capital No guarantees but I have arranged for student internships in the past with infrastructure PE funds and family offices Requirement that students need to do well for the class before considering their application To develop the next generation of PE fund managers or deal advisors/consultants Introduction to Entrepreneurial Finance (Session 1) Life cycle of a venture Source: Smith, Smith, and Bliss (2011) Life cycle of a venture Sources of new venture financing Sources of venture financing Un-intermediated finance Business angels (Angel investor) & Corporate Venture Capital (CVC) Portfolio company Business angel Portfolio company (investor) Portfolio company  Business angels Angel investor: an affluent individual who provides capital for a business start-up Usually in exchange for ownership equity or convertible debt Invest their own money Unlike PE/VCs who manage the pooled money of others in a professionally-managed fund Fills the gap in seed funding between FFF and VC No “set amount” of investment Range from a few thousands to a few millions Investment horizon shorter than 5 years Looking for investment potentials that provide 10x return Examples: Usually high net worth individuals: Ron Conway and SV Angel team (Silicon Valley); Xu Xiaoping and Zhen Fund  Incubator and accelerator Founders get help to quickly grow their businesses and better their chances of attracting VC investment at a later point Incubator “incubates” disruptive ideas Focus on innovation E.g., Y Combinator; SMU Institute of Innovation & Entrepreneurship; incubators at other universities (e.g. NUS) and companies, etc Accelerator : “accelerates” growth of an existing company Focus on scaling a business E.g., Y Combinator; 500 Startups  Corporate Venturing In house VC program (fund, incubator and accelerator) to aid developing new business opportunities Similar investment process on startups like VC investing (syndication with independent VCs) Move faster, more flexibly, and more cheaply than traditional R&Ds Arm’s-length relationship with its parent company; median life span around one year, average lifespan 2.5 years (easier disengagement) Primary goal: gaining strategic benefits (rather than profits as for VC investing) Most recent artificial intelligence AI startups are funded by CVCs Internal External R&D CVC VC Intermediated Finance Private equity Venture capital VC funds invest in high growth start-ups using little or no leverage Buyouts Buyout funds invest in mature established companies, using substantial amounts of leverage to finance the transaction Limited Partner (LP) The investor which allocates the money to VC/PE funds General Partner (GP) The venture capitalist, who raises money through a ‘fund” legal or special purpose vehicle Company The entrepreneur who receives the money and generates value which will translate into returns for the GPs and LPs Why Entrepreneurial Finance The principle of modern capitalism  Who are the entrepreneurs? What common traits do successful entrepreneurs have? How are they able to create value where others have failed? Can entrepreneurship be nurtured? Why do some societies or countries have been more successful in nurturing entrepreneurship compared to others? Are policies and incentives effective in developing entrepreneurial talent? Discuss in your groups and share your ideas on these issues Characteristics and profiles of entrepreneurs Some associated characteristics and profiles of entrepreneurs Self confidence Visionary Awareness Realism Interpersonal relationships Emotional Stability Diligence Decision making Any others that the class can think of? Overview of PE/VC investment PE and VC investment industry definitions Private Equity industry snapshot Global PE assets under management is expected to reach USD 8.5 trillion by 2028F (CAGR of 10% from 2022 to 2028F) with dry powder exceeding USD 2 trillion by 2028F (source: Preqin 2024 Global Private Equity report) 155 funds closed in 3rd Qtr 2023, a 38% decline from 2022 (source: Preqin 2024 alternatives report) These funds raised a collective $145.3 bn, a 19% increase from the same period in 2022 5,438 PE deals completed in first 9 months of 2023 with value of $618 bn Represent 60.3% of total deal flow in 2022 by volume and 48.5% by value compared to previous year With interest rates expected to peak in 2024, this should translate to better fund raising and deal making environment Private Equity deal flow and realizations DEAL FLOW AND EXITS EXPECTED TO RECOVER WITH INTEREST RATES STABILIZING DURING 2024 Venture capital fund raising and dry powder status WEAK FUND RAISING AND DRY POWDER CONDITIONS WILL MODERATE ENTRY VALUATIONS Private Equity stakeholders PE managers and investors PE managers are known as General Partners (GPs) while investors are known as Limited Partners (LPs) GPs are compensated by way of management fees (percentage of assets under management) and performance fee (i.e. carried interest) GPs are seasoned finance professionals skilled in deal structuring and firm operations LPs are mainly pension funds, educational endowments, financial institutions, insurance companies and sovereign funds The legal agreement governing the relationship between LPs and GPs is called the Limited Partnership Agreement (LPA)  Private Equity returns and business model PE performance returns PE funds typically have 10 year investment horizon and are called fund vintages Target to earn IRRs of more than 20% or an investment multiple of 1.8x for their investors Median annualized net IRR of 18.8% for PE funds in the 5 years to March 2021 (Preqin) GPs of PE funds get compensated through a management fee and a carried interest from LPs Performance persistence: top quartile PE managers are able to replicate superior returns How does PE make their returns Financial Engineering (Leveraging) Require low interest rate environment Buoyant debt market Value creation – focus on operational improvements Governance improvements Sales and marketing Top 20 PE firms by capital raised in last 10 years Source: Preqin PE remains as the highest performing asset class Outperformance of Private Equity Annual PE returns show negative correlation with S&P 500 returns: PE offers diversification benefits to traditional stock/bond portfolios PEVC Fund Structure Warburg, Pincus & Company (company) General Partner Warburg, Pincus Venture, Partnership (LLP) Limited Partners Limited Partners Insurance Other Venture Pension Funds Funds Corporations 33 SMU Classification: Restricted  Private Equity Structure: 2 & 20 fee structure Private Equity Firm Limited Partners (LPs) 2% annual mgt fee General Partner LP 1 LP 2 LP 3 Committed capital Limited Partnership Fund 1 Agreement Deal funding Deals or portfolio investments GP Carried Interest 20% gain or 80% gain or profit Deal 3 Deal 4 profit on Deal 1 Deal 2 on investments investments  How a waterfall distribution works Limited Partner (LP) General Partner (GP) Gain or profit to be shared as carried interest Committed capital Distributions until all capital returned Minimum hurdle rate required by LPs before gain sharing or carried interest can be earned by GPs of PE funds European waterfall versus American waterfall Waterfall distribution with catch up feature Extra knowledge GP or Manager’s Invested Capital: $200 million LP or Investors Profit Share Receive Investment Proceeds (net of fees & expenses): $400 million Capital Repaid: $200 million $200 million Preferred Return: (8% of capital in) $16 million $4 million Catch Up: (25% of preferred return) $36 million Share of Balance: $180 million (20:80 ratio) $144 million Total Received: Total Received: $40 million $360 million Source: Funds - Private Equity, Hedge and All Core Strategies by Matthew Hudson  J Curve effect in PE Due to the structure of PE investments, PE cash flows follow a J curve effect With a vintage period or investment horizon of about 10 years, PE funds typically spend the first 3 to 4 years investing and the remaining 5 to 6 years exiting investments or harvesting Depending on the LPA, PE funds may be able to extend their investment horizon depending on certain conditions Source: Mercer  PE fund types and strategies Unlike hedge funds that invest mainly in publicly listed entities, PE funds invest mainly in privately owned assets but there are PE deals which also involves publicly listed assets The more common PE fund types and strategies includes the following: Buyout funds Growth or Pre IPO Co-investment Secondaries PIPE (Private Investment in Public Equity) Infrastructure and Real estate PE funds Fund of funds  PE strategies – Cont’d Buyout funds Strategy requires majority or a 100 percent acquisition of the shares of the private company or involve a publicly listed entity Involves working with management in MBO, MBI or BIMBO Buyouts with significant leverage are known as LBOs (Leveraged Buyouts) Growth/Pre IPO Investments targeted at SMEs to position them for a listing in 6 to 12 months Co-investments Syndicated investment involving 2 or more PE funds due to deal size, expertise, risk or other considerations Secondaries Investing or acquiring a portfolio of investments from another PE fund in a form of a “packaged deal”  PE strategies – Cont’d PIPEs Private investment into public equity or private instrument into public equity Deal structure involves a convertible loan to the public company which can be converted into shares of the company under certain provisions Infrastructure and real estate funds PE funds which invest in either completed infrastructure and real estate projects (brownfield) or provide development funding to build new greenfield projects Example toll roads, powerplants, pipelines, storage terminals, hotels, commercial buildings Fund of funds Invest in other PE funds based on their knowledge of GP track record and expertise Involves double layer fee structure and hence returns have lagged other PE strategies  Overview of PE fund strategy performance Perfomance of PE funds strategies using Multiple Perfomance of PE funds strategies using DPI (Total Value/Paid in) 140.00 1.80 120.00 1.60 100.00 1.40 1.20 80.00 1.00 0.80 60.00 0.60 0.40 40.00 0.20 - 20.00 Growth/Pre Co- Growth/Pre Fund of Co- Buyout Fund of funds Secondaries Buyout Secondaries IPO investments IPO funds investments Mean 1.73 1.62 1.56 1.61 1.53 Mean 130.64 91.63 90.08 77.90 106.01 Median 1.56 1.40 1.48 1.52 1.48 Median 123.80 50.00 90.46 31.28 123.50 Source: Preqin Source: Preqin Historical performance using Preqin’s PE database of PE vintages from 1973 to 2018 show buyout PE funds outperforming the other strategies with growth/pre-IPO and secondaries coming close behind using multiple and DPI as performance metrics Investor Preferences on fund strategies Source: Cyril De Maria – Introduction to private equity 2nd edition and Preqin  Venture Capital Private financing for relatively new business in exchange for equity Usually entails some hands on guidance The company should have an exit strategy Sell the company: VC benefits from proceeds from sale Take the company public – VC benefits from IPO Many VC firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive VC funding Some large corporations have a VC division – corporate venture capital Corporate VC investments are typically linked to the core business of the parent company Cisco Intel Capital Singtel ventures SPH ventures  Choosing a venture capitalist Some guidelines Look for financial strength Choose a VC that has management style that is compatible with your own Obtain and check references What contacts does the VC have, and how can they help you scale up your business? What is their exit strategy? Some reputable VCs with Singapore presence Vertex Ventures B Capital Group (Eduardo Saverin) Ninja van Golden gate ventures Carousell, Gojek, Redmart, 99.co Sequoia capital Monk’s Hill Ventures  Venture capital stage of investments Venture Capital investments can be broken into several stages Seed stage There is a product concept and idea of how the product will serve the market Funding is needed to build a prototype Early Stage Series A and B Commercialization of product Funding needed to scale the product and enable it to enter new markets Late Stage: Series C Develop new products for next stage of growth or even acquire companies which could be in the value chain or competitors Technology growth / Growth-Pre IPO Prepare the company for exit opportunities via IPO or trade sale Top 20 VC firms by capital raised Source: Preqin Venture Capital Deal numbers by stage Majority of VC deals funding is targeted at the seed and early stages Early stage deals present VC funds with the opportunity to negotiate better valuation terms and capture upside potential Early stage deals also involve higher risks for the VC investor Gap in management teams Market development and technology uncertainties Source: Crunchbase  Family offices Investment vehicles set up by family owned businesses to make investments in businesses to diversify from core business Typically set up by 2nd generation with the objective of long term sustainability to the business Choice of investments depends on the knowledge base of the family members in the family office Typically small PE investments from USD 10 mn to USD 15 mn in ticket size Mostly brick and motar type business and shy away from high tech venture capital investments Family member may hire professional investment managers to staff the family office Some examples of family offices in Singapore Triplestar (Tat Hong Group) Blacktip partners (Oxley properties) RGE family office (April – Asia Pacific Resources international Ltd) IGE Group (Myanmar)  Multilaterals and Sovereign investors Multilaterals are institutions supported by state governments to support investments that accomplishes objectives which are deemed positive for the institutions or enterprises that belong to the state government supporting these funds Some multilaterals like the world bank or IFC (International Finance Corporation) will invest directly in infrastructure projects as a General Partner or can even function as an LP investing into other PE funds PE funds being invested into by multilaterals will have to fulfil certain investment mandates like environmental protection and sustainability Sovereign funds are an important player in PE deals both investing directly into private assets and as LPs investing into PE funds Sovereign funds that have a significant PE portfolio include the following: GIC Temasek Abu Dhabi Investment Authority (ADIA) China Investment Corporation (CIC) Top 10 Sovereign Wealth Funds Globally Rank Country Sovereign Fund Assets (USD bn) Inception Origin 1 Norway Government Pension Fund Global 1,035.24 1990 Oil 2 China China Investment Corporation (CIC) 941.4 2007 Non commodity 3 UAE Abu Dhabi Investment Authority (ADIA) 683.0 1976 Oil 4 Kuwait Kuwait Investment Authority 592.0 1953 Oil 5 Saudi Arabia SAMA Foreign Holdings 494.0 1952 Oil 6 China - HK Hong Kong Monetary Authority Investment Portfolio 456.0 1993 Non commodity 7 China SAFE Investment Company 441.0 1997 Non commodity 8 Singapore Government of Singapore Investment Corporation 390.0 1981 Non commodity 9 Singapore Temasek Holdings 375.0 1974 Non commodity 10 Qatar Qatar Investment Authority 320.0 2005 Oil and Gas Source: Sovereign Wealth Fund Institute https://www.swfinstitute.org PE Investment Process – macro overview Sourcing Selection Negotiation Monitoring Contacts: advisors, Resources Letter of Intent (LOIs) Annual General teams and partners and term sheets Meetings (AGM) and Expertise Presence in the board representation market Time commitments Manage external advisors (lawyers) Annual reports and Conferences and Market intelligence associations in terms of network performance reviews and databases Control fees and costs Sponsorship events Exit or additional Due diligence funding required List of fund managers to work with Source: Cyril De Maria – Introduction to private equity 2nd edition  Steps from first contact to deal conclusion Primary Further Valuation Negotiation Structuring Closing Analysis Audits Low Probability of deal conclusion High Source: Cyril De Maria – Introduction to private equity 2nd edition The amount of time it takes to conclude a PE or VC deal varies depending on the complexity of the deal, size and motivation of the parties involved Time to complete a typical PE deal can vary from 4 to 6 months to as long as 2 to 3 years (e.g. real estate and infrastructure deals) Due to the high risks involve in deal failure, GPs need to maintain a good deal pipeline and manage due diligence costs at the early stages where probability of deal success is low PE and VC Governance – Investment Committee Most PE and VC funds will have an investment committee set up for investment and funding approval for deals Investment committees are staffed by the senior management of the GP team Partners and directors of the PE fund An external consultant or independent advisor A representative from the LP (not a common occurrence) The purview of the investment committee will involve but not limited to the following: Approval of new investments by the PE fund Significant due diligence budget above the signing approval of the deal lead Change in strategies of a portfolio company or an exit opportunity Taking on a co-investment partner  Class Activity 1 Imagine you are an investor or limited Partner and have to institute a PE investment program with a USD 500 million capital allocation Given what you have learn so far, what would be your preferred investment strategy Becoming a General Partner and start investing directly into private assets and companies Invest into other PE funds State your assumptions in terms of your past experience, background and credentials in the PE industry Get into groups and discuss for 15 minutes and select a representative to present your position Performance measurement PE and VC performance measurement is a topic of significant interest for both industry and academia Unlike mutual funds and listed funds, the PE and VC fund industry does not have a performance benchmark This makes it challenging for investors to compare the performance of PE funds against an accepted benchmark Some PE performance metrics will incorporate a listed benchmark PE performance metrics used by the industry and academia include the following tools Net IRR Multiple (Total value over paid in – TVPI) DPI (Distributions over paid in) RVPI (Residual value over paid in) PME (Public Market Equivalent) Performance measurement (Cont’d) Net IRR Definition: Discount rate that sets the NPV of a project or investment equal to zero Incorporates fees and expenses incurred by the GP Established performance metric used by the industry but is now under scrutiny by industry and academia IRR calculations are sensitive to the cash flow timing element which can also be manipulated by GPs to “window dress” performance Also assumes reinvestment at the same IRR can be achieved which is unrealistic Over a PE horizon (10 years) this can potentially result in biased estimates PE funds are increasingly using other performance metrics as an alternative to IRR for investment evaluation and in fund raising presentations Performance measurement (Cont’d) Multiple (TVPI: Total Value over paid in) Definition: Proceeds of PE deals including what is left in the fund over initial investment provided to the PE fund or GP from investors Shows how much investors are getting back after each dollar being invested into the fund Covers both cash distributions to investors and the residual value left in the fund Becoming a preferred performance metric of both industry practitioners and academics DPI (Distributions over paid in) Compares the total amount of money paid out or distributed by a fund to its LPs to date against the total amount of money paid into the fund by the LPs Preqin shows this metric in terms of a percentage where 100% shows outperformance but it can also be a decimal number Problems occur when fund is not yet at its end of life or when the fund has failed to invest its capital and there are opportunity costs to the LPs Performance measurement (Cont’d) RVPI (Residual Value over Paid in) Shows the current value of all remaining investments (portfolio companies) within the fund expressed as a ratio to the total amount paid in to-date Useful in the early part of the fund’s life when there has not been many cash distributions and reflects how portfolio companies in the fund has been revalued Can give an inaccurate picture of low expectations during the early stage of the fund as companies are sold for higher valuations PME (Public Market Equivalent) Replicates the cash flow pattern of a PE fund by buying an index of listed assets when the fund draws down capital and selling the index when the fund disposes of the asset Only performance measure that takes into consideration context of investment and risk Challenges involve difficulty in finding a listed benchmark for some PE strategies PME also does not account for capital that is committed but only invested capital Performance measurement (Cont’d) The constitution of the TVPI varies during the horizon of a PE fund At the early stages when the fund starts to invest, RVPI makes up the bulk of the contribution to TVPI As the fund matures and exits investments, DPI makes an increasing contribution to TVPI Performance Persistence in PE Performance persistence is a topic of considerable interest in both academic and industry Academic studies that have mentioned PE performance persistence includes Kaplan and Schoar (2005) Performance of PE funds net of fees equals approximately the S&P500 index Performance persistence is strong across later fund vintages Better performing fund partnerships are able to raise follow on funds and larger funds Braun, Jenkinson and Stoff (2014) Performance persistence of top quartile and bottom quartile PE funds Performance persistence of top quartile fund managers decline with industry competition while that of bottom quartile remains unchanged Korteweg and Sorensen (2017) Significant long term persistence and a differential of 7 to 8 percent in annual returns between top and bottom quartile funds Performance Persistence in PE (Cont’d) Bucher, Mohamed and Schwienbacher (2016) Risk is an important driver of performance persistence after analyzing PE cash flows Hochberg, Ljungqvist and Jorgensen (2013) Presence of GP skill in the performance persistence of VC funds Cavgnaro, Sensoy and Weisbach (2019) Changes in skill and expertise of an LP are critical drivers of returns when investing in PE funds However there are academic research that criticises PE performance against benchmarks Phalippou and Gottschalg (2009) finds an average net of fee performance of 3 percent below the S&P500 index Phalippou (2020) mentions PE fund returns as seen by money multiples translate into a per annum return of 11 percent which is considered nondescript when compared to small capitalization public indices since 2006 Class activity 2 Imagine that you are a limited Partner and am looking to invest in a PE fund and you have arranged to meet several GPs to explore investing into their PE fund Get into groups and discuss the following: What are some of the materials you will request from the GP? What are some of the questions that you will pose to the GP? What are some of the attributes of the GP which will convince you to invest in the PE fund Do also state the assumption of the kind of LP fund that you are representing, for example: Pension funds Endowments Sovereign fund Multilateral Fund (World Bank, IFC) Concluding Remarks Q&A  FNCE213 Entrepreneurial Finance Mr Victor Ong Adjunct Finance Faculty Lee Kong Chian School of Business, SMU Fund raising and deal sourcing process (Session 2) PE and VC Fund Raising Issues  Fund Raising Process – Not a fun process Fund raising is an exercise that most GPs dread as it is neither glamourous or the most exciting part of the life of a GP Some PE funds, especially those fully backed by SWFs or multilaterals are spared this agony For most GPs, this is a painful process that many would like to do without but few can escape from Fund raising process for experienced fund managers with sound relationships with Limited Partners can be a breeze Some GPs have completed a fund raising process in as little as 6 months while some have taken more than 2 years and are still trying Fund raising involves two closing milestones – first close and second closing The first close can occur when about 40 to 60 percent of the target size has been achieved Final close usually occurs within 12 months of the first close Conducting the first close allows GPs to start making investments and collecting fees Fund Raising process stages 12 months duration Prepare Soft Launch First Close Final Close Assemble team and Meet with investors Aim to complete first Wrap up fund raising develop strategy to test concepts close at 50% of the after 12 months of fund size first close Draft initial pitch Seek inputs and deck feedback – avoid Beware of fence Find blockbuster hard sell tactics sitting or laggard LPs deals with 3x-5x exit in Identify target 4 years and start universe of investors Obtain soft Make first investment raising Fund II commitments from Qualify investment at least 25% of lead leads investors Repeat process Source: Ramsinghani  Fund Raising Process – the mechanics After receiving funding commitments from LPs, the fund raising team together with a lawyer will need to complete the following: Private placement memorandum (PPM): finalize PPM and circulate to all closing LPs Subscription agreement: document needs to be reviewed by investors to ensure accuracy and compliance with securities laws Limited partnership agreement (LPA): terms governing the contractual relationship between GPs and LPs General Partner agreement: essentially the articles of incorporation for PE fund company Side letters Steps to a fund raising close are led by a lawyer and after the execution of the Limited Partnership agreement, a certificate of good standing is obtained by the lawyer Date of certificate of good standing becomes the closing date Wire transfers of funds are then completed  Fund marketing materials – PPM The PPM, an equivalent of a business plan involves a clear and concise presentation deck, and a two page executive summary which is the essential marketing tool for the fund raising exercise A good PPM will have the following key sections Investment team – General Partners’ backgrounds Investment strategy Portfolio construction Performance track record Brief summary of terms and conditions of investment opportunity The PPM averages about 50 pages to 70 pages in length and the bulk of the PPM is focussed on legal terms and conditions Focus of the LPs should be drawn to the team, performance and strategy sections  Fund marketing materials – PPM (Cont’d) The PPM can be segregated into the following elements: Executive summary (3 to 5 pages): Primary reason why the LP should invest in the fund Market opportunity Background, history, and performance of the firm Management team Investment focus areas Summary of terms Market opportunity and investment strategy (5 to 8 pages) Investment process (3 to 5 pages) Organization and management team (5 pages) Selected transactions/investment summary (5 to 8 pages, 1 page per transaction) Investment terms (10 pages) Risk and Regulatory considerations (20 pages)  Presentation slide deck The fund raising slide deck presentation should be no more than 15 slides for a 20 minute presentation Remember LPs are busy folks with numerous engagements daily LPs like most busy executives also have a limited attention span and tolerance for a presentation that drags on for too long Key points of the presentation should highlight the following: Team set up: demonstrate expertise in terms of number of investments, strong relationships of team members, complementary skills Investment strategy and market opportunity Ability to access proprietary deal flow and pipelines Returns Demonstrate that the team has the ability to make investments and generate returns Key fund terms Fund Size $250 million Commitments Institutions $20 million minimum Individuals $5 million Investment Size Approximately $15 million to $20 million per investment Fees 2% annual management fee and 20% carried interest Industry focus IT software, Healthcare, Education, Fintech Investment Strategy Growth and Pre IPO stage, early stage start ups, Small and medium sized enterprises (SMEs) Geographic Focus Asia Pacific region Term 10 years with an extension option of further 2 years Investment Structures Equity, preference shares, convertible notes Investment term Anticipated year 1 to year 4. Due to stage of investments the holding period may be up to 5-7 years or longer Portfolio construction Target portfolio will have a mix of start-ups with and governance higher risk profiles (up to 30%), medium risk profiles of growth pre-IPO firms (up to 40%) and lower risk profiles of mature SMEs (30%). Governance and management of portfolio will be via board seats and active engagement with founders Source: Ramsinghani  Most common negotiated fund terms Carried interest or promote Percentage of profits or “carried interests” shared by LPs and GPs Typical carried interest are split 80% to the investors and 20% to the fund managers but there could be variations depending on the IRR targets Management Fees Annual fees paid for the operating budget of the fund Typical fees are 2% to 2.5% per annum of committed capital paid quarterly Clawback Process of recovering excessive profits if any from fund managers or GPs especially when deal losses occur at latter stages Key person If key members leave the fund, investors can trigger punitive actions Side letters Fundraising Timeline for Venture Capital T=0 T = +2 months T = +4 months Identification D-Day Distribution of First verbal target market Structuring of informative commitments the fund material T = -1 month T = +3 months T = +5 months T = -6 months T = +6 months 1st draft placing Meeting with Sending of legal Pre-marketing Closing memorandum investors documents Source: Private Equity and Venture Capital in Europe by Stefano Caselli  Role of placement agents Placement agents advise PE and VC funds seeking to raise a new fund and play an interactive role between LPs and GPs in the PE and VC community Best funds typically do not need a placement agent but some LPs do prefer to deal with placement agents especially those with a credible reputation Experienced placement agents can provide the following benefits to GPs Ready database of current LPs that have appetite and allocation for PE and VC funds Provide efficiency in fund raising efforts using targeted approach rather than scatter gun approach that some GPs will use Provide guidance on latest funding trends and current fund terms required by LPs in the LPA Credibility to access established LPs especially for new fund managers Advice on how to craft fund raising marketing materials and the PPM Good placement agents may require significant fees but will allow GPs to focus on core functions  Some common fund raising mistakes Failing to know the basic constraints of the targeted investors or LPs Some LPs are just not able to invest in a first time fund without any recent track records Do your research on LPs prior to engaging in a process Certain geographical areas and sectors are preferred by specific LPs, make sure your fund focus in aligned with LPs investment preferences Being unprepared for the fund raising presentation to the LPs Presentation has to be rehearsed repeatedly until it is near perfect Being late and having inattentive team members can be fatal Coming across as arrogant and aloof during the initial fund raising meetings Remember at the end of the day you are asking for other people’s money Critical when pitching to Sovereign wealth funds from the middle east – be mindful of the culture sensitivities  Fund raising case study – An SWF investor Established Real estate and distressed opportunities fund with head office in Los Angeles Have raised 3 prior vintages (Fund I, II and III) LPs include pension funds, endowments, fund of funds and insurance firms Wanted to reach out to potential sovereign investors for Fund IV Through senior contacts at HQ, obtain useful notes and contact details of an SWF investor Process started with a few conference calls and a process of mutual staff engagement Weekly calls for a period of 3 to 4 months First on site meeting and presentation after 5 months Key factor in positive discussions: asset management capability of the fund and a portfolio asset in the existing vintage that was of interest to the SWF investor SWF investor also tested the PE fund’s capabilities in evaluating investment leads Outcome: SWF investor supported fund vintage 4 and contributed to a co-investment fund vehicle to invest in hospitality assets in Australia Recent PE and VC fund raising ranked by size Source: Preqin Bloomberg article on PE fund raising After reading the Bloomberg “KKR struggles to lure money to a new Fund” Why do you think KKR had problems with their fund raising efforts? Is there a paradigm change in how investors view fund strategies adopted by KKR and other similar buyout funds? What do you think are the new funding themes by PE investors after reading the article? Why are PE investors changing their allocation strategies? Any volunteers to kick start the discussion Class activity 1 Imagine that you and four of your colleagues have been working in a PE firm for about 8 years as investment managers and now feel the need and start your own PE fund How would you go about executing the fund raising initiative? How large will your fund be and what kind of sectors will you target? Will you target a specific PE or VC investment strategy? Who will be your targeted investors or LPs? Will you use a placement agent? Get into groups and discuss Sourcing for investments  Deal sourcing – Both art and science It is an art as success depends on the strength of the network of contacts of Partners in a PE or VC firm and their relationship building skillsets Partners have typically more than 20 years in the industry starting in a bulge bracket investment bank, top tier accounting firm or blue chip strategy consulting firm Partners also have to demonstrate track record building a deal pipeline in a PE fund Some partners also have an operational background although some PE funds have split investment and operational teams Deal sourcing is also considered a science Robust processes and systems are needed to ensure the deal pipeline is adequately maintained and a screening process in place to ensure mediocre leads are eliminated Some firms have standard deal screening processes in place and ensure investment staff are adequately trained to use these processes Typical VC fund Investment process Sourcing and Investment Post Due screening of negotiation investment Exits opportunities diligence and closing monitoring VC deal sourcing processes is somewhat similar to PE but the network and contacts where deals are originated from can be different VC firm partner network which includes entrepreneurs and past co-investors are considered reliable sources Other sources include incubators and accelerators, technology lawyers, angel investor networks, banks, patent offices, consultants Different deal sources have both advantages and disadvantages VC or PE fund partners will have their preferences on which sources to utilize  Deal origination – methods for sourcing General publicity of the fund – get the word out Sponsor or attend corporate seminars and conferences on PE and VC issues SVCA conferences, AVCJ, Preqin, Investment Bank client conferences Visiting companies Either cold calling or through staff contacts Trade fairs organized by government agencies Enterprise Singapore, Singapore chamber of commerce, MAS Partner network involving entrepreneurs and angel investors Network with other funds for co-investment invitations Caveat: PE fund must already have some credentials to be invited as co-investor Relationships with banks, big 4 accounting firms or boutique advisory firms Deal sources: Pros and cons Source Pros Cons Key Success factors General enquiry No effort involved No quality control Establish quickly if High volume of opportunities with Mixed information quality opportunity is serious and if minimal fee commitments to Unclear if serious further information is easily advisors or intermediaries available Co-investor Serious player Co-investor will expect to be Be invited into deals which Due diligence data already in place invited back for future deals are proprietary. Established Potential for future relationships Co-investor may dictate terms standards for respective due and process diligence and structuring requirements Approaches from Deal is prepared to some extent with Being shopped around to Develop knowledge of the intermediaries or principals information available in a package others. Unreliable information intermediaries in the market if second rate intermediary and select superior players Proactive search in the market May lead to proprietary pipeline of Time consuming. Requires Having the right balance of deals. Investment team gets credit judgement based on time to invest in developing experience and harvesting leads Internal contacts of firm Maximising deal flow without major Risk of damaging internal Constantly invigorating advisor fee commitments relationships if deal goes sour network and contacts Deal sourcing and closing: A numbers game New deal First Due Meetings Closing leads Screen diligence 30 leads 15 6 3 1 to 2 deals PE funds or even a corporate M&A departments will look at a very large volume of deal opportunities before making a final investment As potential for deal failure is high in PE and M&A deals, significant volumes of deals must be kept running in the deal funnel PE teams need to control deal evaluation costs especially at the early stages Expect pressure on operating and maintenance budgets from LPs if the GPs do not deliver targeted cash distributions Profiles of entrepreneurs in emerging markets Early stage oligarchs: control diversified groups, business/politics intersection, related businesses, management based upon family and loyalty Later stage oligarchs; more ringfencing of business segments, introduction of professional management, separation of ownership and management, move towards corporate governance Smaller oligarchs: limited number of smaller businesses, looking for partners to expand, link with foreign partners to shore up position locally Diaspora: locals gone overseas to study work for a period in established companies and investment banks, come back to leverage credentials Multiple owner SMEs: companies set up by groups of friends/colleagues, founders in business, over time business interests can diverge during exit situations Single owner SMEs: companies set up by single individuals Some entrepreneurs have a combination of a few profiles mentioned above Characteristics of entrepreneurs (Asian context) Highly motivated as it is their money Develop packaging that will cater to what investors want to hear Will always have backup alternatives when it comes to potential buyers Will want family members or relatives to be retained and given roles in the firm Can change their minds about deal terms in an instant and forget past agreements Retaining “face” is paramount during seller and buyer negotiations Some myths that entrepreneurs have on PE Myth Fact PE is a zero sum game, somebody wins and PE only make money if the value of the firm appreciates somebody loses PE provides the entrepreneur or founder with the opportunity to diversify into other businesses or assets Valuation is the main criteria for a PE Getting a good valuation from a new PE may not be all good partner as tied to a partner who does not know the business Relationship may sour when expected returns do not pan out and align with pre-agreed valuation Realistic valuation ensures long term and stable partnerships PE investors do not add value as they have PE staff typically have had operating roles in other stages of no operating background their careers which can add value Invested in many companies and can provide useful solutions Access to portfolio firms which can add value to founders Taking PE money means losing control Minority investments by PE does not lead to loss of control However if entrepreneur acts irresponsibly, PE can trigger protection clauses and take control Some myths on PE (Cont’d) Myth Fact PE investors are only interested in exit Multilateral and sovereign investors have a long term strategy orientation towards deals PE have other options besides a 100% sale Other options include recapitalization with bank debt and dividend distribution, selling stake to another PE fund, finding strategic partners and partial IPO LBO PE deals result in significant reductions Academic research has shown this to be inaccurate, R&D in R&D investments and staff training investments and innovation activity actually increases in firms post LBO period Research on OBHR perspectives show staff competence in firms increasing after LBO Open auctions with sell side advisors Sell side advisors work with founders to reach out to investors in an auction process where shortlisted investors will be invited to submit bids for the asset or company Sell side due diligence is an integral process of an auction Includes reviewing historical earnings, credibility of forecasts provided by founders, working capital requirements and key risks Sell side due diligence is performed early in the investment process when entrepreneurs are looking to divest or find a PE partner engages external advisors to assist with the process Seller evaluates potential opportunities and risks of the company before engaging PE Sell side due diligence report provided to PE investors can be useful in guiding their own buyside due diligence Pros and cons of auctions Advantages Disadvantages Level playing field in bidding process: Owners’ expectation disconnected from sell potential investors can submit bids with side due diligence and may demand more confidence, minimize renegotiation extravagant pricing and terms in the latter stages Minimize surprises: being upfront with Owner never had the intention to go issues enhances seller credibility and forward with the sale but really wants to results in open and transparent check on current valuations negotiations Corrective measures: advisors can report Deal proceeds to an advanced stage and the to buyers that steps are being taken to owner suddenly changes his mind and correct issues identified, minimizing decides not to sell wasting everyone’s time disruption to negotiations Accelerate closing: seller’s advisors due From owners perspective: PE investors may diligence report helps to reduce cost of be just sniffing around for information and buyer due diligence not interested in making an investment Types of Advisors in PE and VC markets Investment Operate in the larger segment JP Morgan, Banks of market: $400 mn to $3 bn+ Goldman Sachs, UBS, Deutsche Accounting Operate in the middle market: EY, KPMG, firms $100 mn to $350 mn Deloitte, PWC Management Operate in the middle market: Bain consulting, Consultants $100 mn to $350 mn BCG, McKinsey Operate in the smaller Stoneforest, Make sure Boutiques & segments of the market Mazaars, Nihon they are individuals M&A, retirees credentialed $30 mn to $80 mn Class activity 2 Imagine that you are the business development executive in a PE or VC fund and your first assignment is to develop a deal sourcing mechanism for your firm How would you develop this deal sourcing platform What would be your primary deal sourcing strategy State your fund investment mandate in terms of sector, strategy and targeted deal size Provide your key performance indicators for your deal sourcing platform and any external advisor costs Get into groups and discuss Concluding Remarks Q&A  FNCE213 Entrepreneurial Finance Dr Victor Ong DBA Adjunct Finance Faculty Lee Kong Chian School of Business, SMU Due diligence process (Session 3) Video clip: Cold calling leads Watch the video clip of how a newly minted broker in wall street tries to reach out to a seasoned corporate raider who owns an LBO firm in Wall street Do you think he has been successful in his cold calling efforts Discuss after watching the video clip https://www.youtube.com/watch?v=y9OLhDacDYc https://www.youtube.com/watch?v=vziHnwB_mkM Managing due diligence Due diligence explained in a nutshell Art of sizing up an investment opportunity – its potential and risk – Ramsinghani Peter Thiel “Great companies do three things: first they create value, second they are lasting or permanent in a meaningful way and finally they capture at least some of the value they create” Identifying value creation and estimating its sustained advantage is the core of due diligence Due diligence processes can vary between PE and VC investments Early stage VC investments focussed on product development, market potential and management capabilities In contrast PE due diligence especially for LBO deals focuses on sustainability of cash flow generation and defensive aspects of industry Involves commissioning of third party advisors and co-ordinating work of the advisors Time span of due diligence typically takes 3 to 6 months depending on deal complexity Types of Due Diligence Type of due diligence Led by: Key features Business or commercial PE or VC investment team. Possible to use Business plan review. General third party market research firms or analysis of the company and investigation firms eg: Mbrain, Wood market. Background checks, Mackenzie, control risk, retired executives interviews with customers etc and vendors Legal and regulatory Law firm and in house general counsel Legal review of contracts, asset titles, litigation issues, review permits and licenses Finance and accounting Accounting firms: PWC, KPMG, Deloitte, EY Review of accounting etc statements, review of financials in business plan Technical Specialist firms: SMEC, Royal Haskoning Inspection of technical assets and systems, valuation check Environmental Specialist firms: SECS (Singapore Ensure assets comply with Environmental Consultancy and Solutions) environmental standards Due Diligence Checklist: VC perspective Criteria Description Product of service The product or service is described completely and concisely. The need for the product or service is evident. The stage of development – prototype, first customer, multiple customers is identified. Development road map included. Customers, revenue and Customer value proposition is quantifiable, high and recognizable. The market need is business model established. Product price points is identified along with gross margins and costs Market size Current target and addressable market size is estimated. It is a large and growing market, quantifiable to a certain degree. Management The key staff have the expertise and skills needed to run the business. Clarity on additional hires and timing of recruitment? Identify significant roles in the team. Competitors and competitive The product or service is better than the competition based on the features and/or advantage price. Is current and future competition identified and evaluated? Financials Are plans based on realistic assumptions with reasonable returns? Does it contain reasonable, justifiable projections for two to three years with assumptions explained? Exit assumptions Is there a reasonable exit time frame? Is there clarity on the target universe of buyers? Source: Ramsinghani Managing due diligence Third party advisors or consultants are motivated to maximise fees PE investment staff needs to know what is important and what is not PE staff needs to sieve out the problem areas which can potentially kill the deal in advance A two step staging approach works best to minimize exposure and costs Stage 1: sieve out and identify any potential deal killers if any Stage 2: Assess valuation assumptions from due diligence findings and fine tune valuation parameters for deal documentation Knowing how to extract the maximum value from due diligence for minimum costs requires experience from running multiple due diligence exercises Documentation flow during deal process Preliminary due Deal diligence and Formal due Final Deal sourcing negotiation diligence negotiation closing Non disclosure Term Sheet First drafts of Sales and purchase Final agreement or final deal agreements (SPA) documentation confidentiality agreements agreement Other related Finalize Contingent agreements i.e. Precedents (CPs) shareholders Preliminary letter agreements of interest (LOI) NDA or confidentiality agreement signed up front to protect parties NDA can be accompanied by preliminary letter of interest (LOI) to demonstrate strong interest from both sides to enter into negotiations Best to obtain legal counsel from an early stage to review documentation Non disclosure agreement (NDA) Allows for exchange of confidential information For PE and VC deals, this tend to be one way as target company does not need to collect information on PE or VC fund Key negotiating points include duration term of agreement, items covered, governing law, monetary remedies in terms of breach Tends to be difficult to enforce unless a specific breach of terms Although the NDA has become a standard template document a tendency not to let legal counsel vet through the document can be a mistake and cause problems at a later stage in the transaction Term sheet or LOI (Letter of Intent) Document that sets out key terms and conditions for closing the transaction Clauses are non binding except for the following: Confidentiality and exclusivity Due diligence costs Governing law Parties utilize the term sheet or LOI to ensure general agreement on basic terms which will be included in final agreements (Sales and Purchase agreement or shareholders agreement) Term sheet allows parties to commence regulatory and approval processes Contentious clause often encountered is the absorption or sharing of due diligence costs in the event of deal failure or a successful deal closing Typically signed before commencement of preliminary due diligence Case study: Acquisition of a majority stake in a listed Korean city gas company Target was a listed Korean City Gas company whose founder had gone into financial distress by investing into multiple unrelated businesses Deal value: USD 120 million Acquirer: SWF backed investor with overseas expansion plan to enhance valuations for SWF to exit via trade sale or IPO External advisors: Investment bank: HSBC and Korean affiliate financial institution Tax and accounting: KPMG Legal Counsel: Jones Day / Kim and Chang Technical and environment: internal engineering staff Due diligence lasted for more than 6 months due to difficulties in convincing senior management at the sovereign fund on the viability of the deal Outcome? Case study: Corporate VC investment into a broadband networking company Target was a technology company in the US involved in the manufacturing of broadband networking equipment (Edge router switches) Working product with some trials with potential customers Requires funding to scale up production and reach out to more customer accounts like telco carriers and internet service providers Enron ventures was alerted to participate the Series B funding by its technical partner, Cisco systems in 1999 Funding required: USD 5 million (Series B funding) Other investors: KKR, Toshiba, Mitsui Capital, Alcatel ventures, Spectrum equity Due diligence was conducted during a 2 month period where the team visited facilities, interviewed management and spoke with customers and vendors Leaned heavily on partner CISCO systems for technical assessments Outcome? Case study: Corporate PE investment into a marine navigation technology company Target was a technology company that develop software aided navigation system enabling LNG vessels to safely navigate back to a port during emergencies Working product available and being used by some launching customers Requires funding to scale up production and reach out to more potential customers in the middle east and Asia Pacific region Investor was a corporate investment arm of a European MNC with a marine division that manufactures related vessel and port infrastructure equipment Strong presence in the middle east with manufacturing facilities in China Deal value: USD 70 million (100% acquisition) Due diligence Accounting and finance due diligence by PWC to review business plan assumptions and current financials Case study: Corporate PE investment into a marine navigation technology company (Cont’d) Due diligence was completed after 4 months Legal due diligence done mainly with in house lawyers with some support from external law firms Being incorporated in Singapore, legal documents were of high quality Commercial: Wood Mackenzie to understand market potential for LNG shipping demand and industry related risks Technical due diligence completed with in house specialists from the corporate HQ which has developed similar systems and equipment Strategic development staff from HQ with financial modelling and due diligence experience brought in to co-ordinate external advisors Outcome? Video clip: Negotiation scene after due diligence Watch the video clip of a negotiation scene between Richard Gere (owner of a PE fund called Quantum Capital) and an acquirer representing a financial conglomerate Discuss after watching the video clip https://www.youtube.com/watch?v=Dl72zcA0XqE Class activity 1 You are an investment manager at a PE fund and have recently been approached by an intermediary representing a company that manufactures industrial gas products and owns several manufacturing plants in Southeast Asia Due to a succession issue, the owner founder is looking for a financial partner to monetize his ownership interest and also expand his business into other product lines Several relatives are working in the company and a significant number of staff whom have been with the company for many years Company has been affected by cyclical nature of products and production plant operations Discuss the steps you can take to explore this potential PE investment opportunity based on the material covered during the lesson How would you initiate discussions and commence due diligence Propose areas of due diligence to focus on and external advisors required Get into groups and discuss Internal and External stakeholders in Due D Internal and external stakeholders in a due diligence transaction typically have to work together to get the due diligence completed and the deal closed Instances where these two teams may have conflicting interests or agendas Relates to how contracting for external advisor services are done Internal stakeholders for a PE or VC transaction involves: Investment Committee Investment Manager or deal lead, either VP or director level Pool of about two analyst or associates Financial controller In house legal counsel Internal and External stakeholders (Cont’d) External stakeholders in a due diligence effort includes the following Financial advisor (investment bank or big 4 accounting firm) Tax and accounting due diligence firm Legal advisors (Law firm) Commercial or market research advisors Part of the work of a PE team is to negotiate service agreements and fee arrangements with external due diligence advisors Scope of work Terms and conditions Fee structure Segment work into phases which avoids the commitment of a large lump sum fee upfront Prudent strategy given the failure rate of deals at the due diligence phase Typical organization chart of a deal team Investment Committee Investment Manager (Deal lead) Finance Analyst Analyst Legal Counsel Manager Why does the finance manager not have a reporting structure to the deal lead unlike the project legal counsel? Class discussion point Negotiating fees and managing external advisors External advisors see PE deals as a golden opportunity to make their fee quota for the year It is important that PE firms manage the costs of due diligence when retaining advisors Some recommendations for managing external advisor cost can include the following Legal firms Request for a lump sum quotation based on a specific scope of work Hourly fee arrangements can give a PE manager a heart attack if the deal drags on Tax and accounting Breaking the work scope into stages especially when the deal involves a two stage bid auction format and cap the fees involved Commercial or market research firms Explore boutique firms that can do the work for a fraction of a full service firm Instead of full scale report, request for assumptions matrix and recommendations Request for competitive proposals and fee quotations from two parties whenever possible Top legal advisors for PE transactions Source: Merger Market Top financial advisors for PE transactions Source: Merger Market Due Diligence reporting External advisors will provide a due diligence report for their segment or expertise area Investment manager or deal lead of the PE deal team will compile an overall due diligence report Includes pertinent risk factors and potential deal killers or “show stoppers” Each external advisor will have to sign off on their section of due diligence and make recommendations on whether the deal can move forward Due diligence report is a major item that included in the investment memorandum provided to the investment committee for approval Some firms have standardized due diligence reports which have been electronically digitized Potential for artificial intelligence to provide inputs into due diligence assessments Family offices have also engaged interns to support due diligence reporting Main deliverable and outcome of a due diligence effort Generate accurate assumptions to develop the valuation model Form a recommendation on whether to proceed with the deal and to make an offer Financial projections and business plans at early VC investment stage At early stages of venture investments, practitioners rarely debate financial projections Practitioners test assumptions and capital required to achieve value enhancement Debate milestones that the financing will achieve How far is the venture from achieving cash flow positive in terms of time period and monetary perspectives As the venture investment reaches Series B or C stage, financial projections are reviewed in greater details Practitioners place less emphasis on business plans but use them to understand business aspects Due to fluid conditions, business plan sometimes becomes an irrelevant document “I don’t care much for business plans” quotes Brad Field, MD of The Foundry Group Study of more than 100 ventures, researchers concluded no difference in performance of new businesses launched with or without having business plans Starting point for passive investors but for experienced investors it becomes irrelevant Class activity 2 You have been invited by a seller to conduct due diligence and make an offer for a privately owned company which develops clean energy solutions. After the 2 months period you are required to submit a non binding bid for the company to the sellers to prequalify for the final binding bid. If your PE fund is successful with the prequalification bid, you will be given a further 3 months exclusivity period to submit a binding bid In order to prepare the valuation bid and legal documents for the bids, you will need to retain the services of a financial due diligence firm and a legal firm These firms typically charge on an hourly basis ($350/hr) for the financial due diligence firm and ($500/hr) for the legal firm These firms can also explore fixed lump sum agreements on a case by case basis Class activity 2 (Cont’d) How would you negotiate the scope of engagement and fee structure with both the firms given that you have $500,000 due diligence budget Deal is valued at around $50 million which translates to a due diligence budget of $500K Do mention what you would like the advisors to provide as part of their scope of services based on what you have learned during the class and the proposed fee You are also allowed to bring in negotiating tactics to sweeten the agreement and minimize your due diligence budget Do not exceed the $500K due diligence budget if possible and state your reasons if you need the Investment Committee to provide additional budgets Get into groups to discuss and prepare your engagement proposals to the advisors Concluding Remarks Q&A  FNCE213 Entrepreneurial Finance Dr Victor Ong DBA Adjunct Finance Faculty Lee Kong Chian School of Business, SMU PE Valuation Issues (Session 4) Relative valuation or comparable analysis  PE valuation issues Approach to PE valuation is determining the exit valuation either through (i) comparable analysis of multiples of similar companies or (ii) a DCF valuation PE investors typically use a combination of both approaches which is also meant to be a sanity checking mechanism PE investors do retain external advisors for deal valuation work but at the early stage, most of the work is done internally Valuation work requires the development of a financial model which forms the building block for a discounted cash flow (DCF) approach However at the early stage, PE teams utilize “quick and dirty” valuation estimates to kick start discussions with potential deal leads especially when there are time constraints Valuation proposal should be provided on a non binding basis and subject to due diligence More detailed valuation model can be developed during due diligence phase PE valuation approach Step 1 Step 2 Step 3 Step 4 Estimate earnings Apply an Discount estimated Valuation obtained or revenues at end appropriate value at a PE or VC is used to estimate of time horizon multiple to an target return the ownership earnings or revenue Ensure targeted interest that the PE figure rate is high enough or VC will acquire in to account for exchange for the Multiple derived multiple risks like equity investment operations, sector, from comparable regulatory and provided to the companies either in other risks firm the same industry or stage of growth Source: Ippolito  Worked example of PE approach Assume fund has 10% stake, that profit after tax (PAT) in 2022 is USD 7m and that the company can be sold for a P/E multiple of 12x in 6 years Results in proceeds to the PE fund = USD 7m x 12 x 10% = USD 8.4m Assume PE fund makes an investment at the beginning of 2022 of USD 1m IRR of the PE investment can be calculated as: 8.4 / (1+r)6 = 1 Or use excel to get the IRR figure of around 42.5% We can also alter the scenario assumptions and repeat the calculations This provides a straightforward but also quick assessment if what the entrepreneur is looking for is within the fund’s minimum IRR acceptance  Relative valuation (Peer analysis) Besides using Price to earnings (P/E) multiples, there are other valuation ratios that can be utilized for PE investment valuation purposes Examples of valuation ratios include: EV/EBITDA (Enterprise value / Earnings before interest, tax, depreciation, and amortization) EV = Market capitalization + Net Debt (= Total debt – cash and cash equivalents) Price/Sales Some companies, especially technology firms, may not be profitable yet and only have revenues Price/Net Tangible Asset Value Price to book value For specific assets like hospitality or energy infrastructure EV/Per room key EV/installed power capacity (megawatts) Comparing valuation ratios Multiple Features Application areas Frequency of use EV/Sales Never returns negative values (always Start up companies Medium-low computable) Companies with low operating Less impacted by accounting policies leverage EV/EBITDA Able to express the ability of Companies operating in stable Very high company to generate value through and mature sectors the operating activity Heavily used in manufacturing Not very influenced by accounting Always inserted inside a and tax aspects basket of multiples EV/EBIT Alternative to EV/EBITDA and relevant Heavily influenced by High for companies with fixed assets heavy accounting, tax and profile extraordinary policies Consider amortization policies and Used in all sectors more impacted by accounting policies P/E Simple to calculate and popular for Heavily impacted by High listed companies accounting, tax and extraordinary policies Used in all sectors P/BV Premium over asset value and used Used by companies with high Average with other methods proportion of equity Used for banks, insurance firms and financial firms Source: Ippolito  Transaction comparable analysis Transaction or acquisition comparable analysis is another valuation method which will enable PE investors to gauge an appropriate valuation for a target company PE investors would look at recent M&A transactions either completed by PE funds or Corporates in similar sectors and assess the valuation range for the completed deals Databases like Merger market, Capital IQ and Pitchbook track and report transaction data which will show EV/EBITDA and P/E ratios of PE and corporate M&A deals Challenge is to identify adequate sample observations of transactions in the same sector of the target company Transactions may also occur during periods of excess capital supply or dry powder which may inflate valuation ranges Transaction comparable analysis supported with sufficient data observations can complement relative valuation techniques Issues for using ratios for PE valuation Using relative valuation techniques for PE investment may be straightforward and practical approach but there are also problems Simplistic: multiple technique incorporates significant amount of information into a single number Difficult to segregate the effect of different drivers (e.g. growth) on value Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Static: multiple represents a snapshot of a firm in a point in time, and does not recognize dynamic changes in business and industry Different fiscal years and extraordinary events Due to these underlying issues, PE firms and advisors will use a combination of comparable company analysis, transaction comparables, and discounted cash flow valuation in PE investments Discounted Cash Flow (DCF) Valuation Discounted cash flow (DCF) valuation DCF valuation is an established technique used by corporate finance and project finance for the valuation of companies and infrastructure assets Will be utilized during the due diligence phase where more information is available to PE investors DCF valuation requires the use of forecast assumptions and cash flow projections that will impact the valuation of the target company Co-operation from the target company in providing required information is crucial in developing an accurate valuation of the target Important that the PE investor secures commitments from the target to support the due diligence phase In situations of tight due diligence deadlines, PE investors will hire external advisors for support Steps in DCF valuation method Select forecast Discount free horizon and Calculate Calculate Estimate cost of cash flow and forecast cash flow terminal value capital terminal value performance Duration of the flow projection period depends on various requirements which may be influenced by industry and sector characteristics Time horizon can have a critical influence on the deal valuation Using too short a horizon may potentially leave out important financial impacts in the longer term that will distort the true valuation of the company Using a horizon that is too long reduces the accuracy and reliability of the distant cash flows and values Forecast period should be that of the company’s competitive advantage, in project finance, its the concession period of the infrastructure project For practical purposes time period used should be 8 to 10 years Computing cash flow for DCF valuation Unlevered Free EBIT (Earnings before Taxes Cash Flow interest & taxes) (EBIT x Tax %) Depreciation and amortization Deferred taxes & other non cash expenses Increase in operating working capital Source: Leverage Buyouts by Paul Pignataro Capital expenditures Free Cash Flow and acquisitions (FCF) Computing EBIT Cost of goods sold Operating EBIT Revenue (COGS) Expenses OR Net Income Interest Taxes EBIT Historical EBIT figures can be obtained from the company’s financials during financial due diligence EBIT projections can be developed by the PE fund and financial advisors working in collaboration with the target company’s management or finance department Projections will be driven by revenue growth assumptions and cost cutting initiatives Identification of EBIT in financials Identification of EBIT (S&P Capital IQ)  Discounted cash flow (DCF) valuation When we can compute the free cash flow of a firm, the target firm value will be: FCF1 FCF2 Firm Value = + 2 +... (1+ r) (1+ r) However, we also need to determine the terminal value of the firm and estimate a sustainable growth rate (g) 𝐹𝐶𝐹𝑛 (1 + 𝑔) Terminal free cash flow computed as follows: 𝑟−𝑔 n period represents the terminal year of the cash flow projection Besides the sustainable growth rate for the terminal cash flow, the other component required for a DCF valuation is also the discount rate (r) Example of firm valuation using DCF (Corporate finance approach) SMU Manufacturing FCFs from year 1 to year 4 are -102.9, -34.1, 40.2, 79.5. The growth rate from year 4 on is 5%. Discount rate (WACC) is 8.5% Question) What is the firm value?  Terminal value approach for PE PE approach differs from the classic corporate finance valuation approach which uses perpetuity cash flow method for terminal value calculations PE or VC deals place emphasis on successful exits and utilizes an exit multiple for terminal value calculation Exit multiple most frequently used is the EBITDA multiple which can be either single digit or double digit multiple Single digit EBITDA multiple infers a reasonable or cheap valuation whereas double digit EBITDA multiple typically infers a high valuation PE managers reference past deal precedents in the same industry or business line to obtain exit multiples for PE valuation Deal multiples obtain from database providers like Merger Market, Preqin, Pitchbook, S&P Capital IQ etc Advisors are equipped with deal exit multiples from previous deal advisory assignments DCF valuation using PE approach Forecasts for years 1 to 8 as follows (USD millions): Depreciation and Capital Increase in Year EBIT Amortization Expenditures Working Capital Taxes 1 20 15 300 10 4 2 50 15 0 0 10 3 90 15 0 0 18 4 220 15 150 30 44 5 240 25 0 0 48 6 300 25 0 -20 60 7 325 25 0 -20 65 8 350 25 0 0 70 Assume a discount rate of 16% and a 12x EBITDA multiple for exit at the end of the 8th year. Questions: a) Calculate the PV of FCFs; b) How much should the PE fund offer if it wants to achieve 25% IRR? DCF valuation using PE approach (Cont’d) Answer: FCF = EBIT + DA – Capital expenditures – Increase in working capital - Taxes Year 1 2 3 4 5 6 7 8 FCF -279 55 87 11 217 285 305 305 Terminal value at end of 8th year = 12 × 350 + 25 = 4500 −279 55 87 11 217 285 305 305 + 4500 PV(FCF) = + + + + + + + 1.161 1.162 1.163 1.164 1.165 1.166 1.167 1.168 = 1,656.03 Using excel, offer required to attain 25% IRR = 877.5 m Developing Discount Rates for DCF valuation Developing Discount Rates for DCF valuation Discount rates for PE valuation Two types of discount rates typically used for firm valuation Equity valuation with a capital structure without any debt Discount rate used for this will be the cost of equity Re Computed using the CAPM model: Re = rf + (Risk Premium) x Beta of firm Where rf is risk free rate Risk premium = (Market Return – rf) Beta = Covariance (RA : Rm) / Variance Risk free rate typically the 10-year government bond of the country and Betas available from Bloomberg for listed firms Firm valuation with a capital structure that includes both debt and equity Discount rate for this will be the weighted average cost of capital (WACC) Forecast free cash flows (FCFs) will be used in the valuation where WACC is the discount rate that will be applied As PE investors will typically use leverage to boost returns, the WACC will be the discount rate commonly used for valuation Weighted Average Cost of Capital (WACC) We canuse theindividual costs ofcapital toget our “average” cost of capital for the firm which is the WACC This“average”is the required returnon thefirm’sassets, based on the market’sperception oftheriskof those assets Theweightsaredeterminedby how muchof eachtypeoffinancingis used Notation E = marketvalueof equity= # of outstanding shares times priceper share D = marketvalueof debt= # of outstanding bonds times bond price V = marketvalueof thefirm= D + E Weights wE = E/V = percent financed withequity wD = D/V = percent financed withdebt Example: Capital Structure Weights Suppose you have a target with a market value of equity equal to $500 million and a market value of debt equal to $475 million. What are the capital structure weights? WACC and Taxes We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital Interest expense reduces our tax liability This reduction in taxes reduces our cost of debt After-tax cost of debt = RD(1-TC) Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = wERE + wDRD(1-TC) Example: Computing WACC Equity Information Debt