Private Equity PDF

Private Equity Introduction Teacher: Antoine Renucci Moodle: UPD_21_4MFCEZ08 Evaluation: 40 questions on QCM (20 on basic notions, 20 on exercises) There will be a case to solve to do by 2 or 3 on lecture 3: 08/10 -> Have a look at Moodle before the classes, because there will be some videos or exer...

Private Equity Introduction Teacher: Antoine Renucci Moodle: UPD_21_4MFCEZ08 Evaluation: 40 questions on QCM (20 on basic notions, 20 on exercises) There will be a case to solve to do by 2 or 3 on lecture 3: 08/10 -> Have a look at Moodle before the classes, because there will be some videos or exercises to do Lecture 1: 10/09/2021 -> Brief overview of PE PE includes Venture Capital, LBO and distressed debt investments (transform debt on equity). PE concerns small companies that are private and not public. Even if LBO is supposed to be for big companies, PE goes on for companies that are public but that are going to go private. Most of capital that is raise for PE is for LBO because you need big amounts of money. The main sector is LBO. General trend of PE investments is going up during the last 20 years. VC finances innovative companies in terms of technology (ex : Intel) and in terms of business models (ex : Starbucks). PE has a deep impact on employment. R&D spending by VC backed public companies has increased a lot last few years. VC has an important role to play as Apple, Google, Amazon and Microsoft are VC backed companies. PE and VC are risky but the return you get on 20 years is a two-digit return (exemple : 17%) PE is a small industry regarding mutual funds, pension funds, insurance companies, sovereign wealth funds (fund established by a state to help the country for example in Norway in order to help the way of life. Biggest one in the world comes from China) or hedge funds (invest in promising firms and sell some stocks they do not own what is called short selling: they promise super performance not correlated to the market) General Partners (GP) are the one who manage PE funds -> Partnerships A partnership is a structure that last between 12 and 15 years. Most of them only last for 13-14 years. A partnership is manged by general partners (GP), they are responsible of day-to-day- management (decide in which firm you have to invest). GP are not protected by limited liabilities (they can lose more money than what they invest in the company). If the partnership loose money; the GP are responsible for these losses, they have a risky position. 1 The limited partners (LP) are the investors who provide the partnership with funds, they contribute to capital. They can be mutual funds, pension funds, endowments (dotations), individuals or families. The LP do not choose the firms in which the partnership invests. The LP give some advice (part of the advisory board), they are not involved in the day-to-day management and of course they are protected that their liabilities only extend to the money they invest. More precisely, GP own 1% of the partnership while LP own 99% of the partnership that invest in diversified in portfolio companies. By managing the partnership, GP take management fees each year, between 1,5% and 3% of committed capital (money that LP have promise to contribute to the fund) in order to cover the administrative cost, to pay for the officers, this is a flat compensation. There is a second part where GP get money, the carried interest (fractions of profit that goes to GP) in 20% of profits. The 80% of profits goes to the LP. GP get 20% of the profit while investing only 1% in order to make them work hard as possible and because they are taking risk. GP do not only invest in companies, but they help those companies to grow up, to improve their performances, they have an advice role in these companies to help them. At the end of the partnership, the company is either sale or IPO and money is giving back to LP, then you have to pay back the GP (the 1% they invest), then you split the profit according to the carried interest that has been agreed between LP (80%) and GP (20%). Some variations can exist such as hurdle rate (+9% of the initial investment of GP) or catch up. As money is not going to be invest directly but gradually, LP give they money gradually not to let the money sleep in the bank account. Senior GP -> receive the main profit Junior GP -> do the day-to-day management and loses the bonus if he leaves before the end of the contract LP fears the opportunistic investments of GP, so LP put some restrictions: ● Restrictions placed on fundraising o minimum size of the fund: insures against adverse selection o maximum size of the fund: avoid GP’ overload, LP want GP to invest well and they want to spread the risk between different funds not to be so risky ● Reinvestments of profits o Is restricted because GP could re-invest to obtain higher management fees and the extension of the fund’s life: when the money is back, you have to give it back to the LP ● Investment of GPs’ personal funds in the portfolio firms o Is forbidden because LP have suffered from opportunistic GP so it is now written in the partnership agreement. 2 -> The venture capital industry VC industry covers the whole life of a company: ● ● ● ● Seed/Angel – Start up: cash-flow is negative during the concept business Early-stage VC – Development: operational Late-stage VC - Growth: Expansion Exit – Maturity: o IPO : depends on the year, it is a very risky way to exit your investments, cannot count on it because some time it is not the good time to become public ▪ The companies on which IPO worked usually come from California ▪ Largest IPO VC-backed : Airbnb o M&A : Some VC’s are specialised in the beginning of the company or in the late part of development of it because issues are not the same. First VC fund was founded in 1946 called ARD by the MIT President and a Harvard professor. Almost ½ of ARD’s profits came from a single investment of $70 000 in Digital Equipment Company in 1957, which returned $355 million. That’s what usually happen with VC fund, a very few of the investment enable to get a lot of profit and get a chance to be public. These companies are called unicorn. So, VC is risky because only a few of them can be labelled as successful. US are the place where VC was born, was developed and is a very big issue. The arrival of pension funds in the US enabled VC to develop a lot. Almost 0 in the mid 1970’s, about $100 billion in 2000 and about $33 billion in 2017. In 2020, there was a huge difference between the money invested and the fund raised. Same things happen in Europe. The biggest investors of VC in Europe are government agencies (20%), corporate investors (14%), pensions funds (12%), insurances companies (11%) or even private individuals (12%). Assets Under Management of VC is growing over years. In the US, the pension funds are the ones who invest the most in the VC industry. In 1979, a rule came out to prohibited pension funds from investing substantial amounts of money in PE or other high-risk asset classes. VC industry was well seen to diversification portfolio management. Consequence on level of funds invested by pensions funds: $64 million in 1978 while $4 billion in 1986. Gatekeepers (investment advisors) also helped funds about venture investments. How VC works? 1) Fundraising: VC raise capital for funds from LP’s 2) Investment: VC invest the money collected in high-growth companies 3) Company growth: VC provide advice to make the company grow ● Help the company find suppliers ● Help the company to hire best people ● Help the company to go public 3 ● Provide strategic advice 4) Exit about 5-10 years via an acquisition or IPO 5) Returns ● Return the money to LP and GP ● If you got some good result, LP will give you back some money back for your next deal Different types of VCs : ⮚ Independent VCs : KPCB, Sequoia Capital, Accel Partners,… o Close date : date of creation of the fund ⮚ Corporate VCs : Google Ventures, Intel Capital, Microsoft Ventures,… o These large firms dedicated money to finding small firms who may have no relation or relation with the big corporation to see how they grow and to detect how the industry is evolving over time o To give some incentives to the engineer: invest in your own investments programs ⮚ Banks o Each bank (financial institutions) also have their own VC but they aren’t possible to promise such a good carried interest o A way for banks to diversify their investments Business – Angels: ● are not venture capitalists ● individuals who were successful, they invest their own money in promising companies ● maximum investment: $ 1 000 000 ● play an important role because they invest even before VC invest ● they are part of early-stage investments (just after friends and family) How do VC choose their investments? ⮚ Most of the investments concerned late VC in US: they prefer less risky investment ⮚ The early stage and angel & seed receive a small part of the VC investment ⮚ The government is the one that usually invest in early stage because it is more risky In 2020, the Pharma & Biotech received a lot of money, even if it is still less than software and IT. These are the two sectors where the innovation take place. The VC projects share the following characteristics: ● High level of risk ● Asymmetric information between VC and entrepreneurs o Usually, VC have more information about the market that the entrepreneurs o Usually, the entrepreneurs have better information about the product than the VC ● Negative cash-flows during the first years 4 ● Intangible assets (difficult to evaluate or re-sell) ● High and fast growth industries: potential to make huge profits 5 Lecture 2: 24/09/2021 -> Valuation 1 1) Comparables Quick and easy way to obtain a value for a firm. Example: Step 1: Identify firms with similar characteristics ● ● ● ● Risk Growth rate Capital structure Size and timing of cash flow This information can be difficult to obtain because for the private companies we don’t know the details of the company. So, it’s much more difficult to valuate start-up companies rather than big companies. Step 2: Search for potential measures of value In public markets, common ratios are : ● PER = share price / earnings per share => Serves to measure equity value ● Market value / total revenue => Serves to measure enterprise value (total firm value) ● Market to book ratio = Market value of the firm’s equity / Shareholder’s equity on balance sheet Difficult to obtain share price if the company is private. In a start-up, there is not usually a lot of debt, so that means it usually financed with equity because banks don’t trust start-up to reimburse the debt Step 3: applicate those measures to the company you want to evaluate (just multiply) => see the 9/36 slide about the value of Chipgen Be careful, here we cannot use all the ratios. For example, we don’t consider PER ratio because it is negative. Furthermore, the two benchmarks are public company while we are trying to evaluate a private company, so the liquidity is very different! So, we must take into 6 consideration a minus 25 or 30% because of the non-liquidity of the private companies’ stocks. Accounting based comparable are less suitable for companies the are often unprofitable. We can for example considerer those measures that aren’t financial: ● Internet business: number of subscribers enrolled by a firm ● Biotechnology firm: number of patents awarded Problems of comparable method: ● The companies you use in the first step can be over-valuated which means you are going to over-valuate the company you want to valuate ● Some information can be unavailable ● Be careful of the difference between public company and private company 2) Discounted cash flows Step 1: Compute the cash-flows DEPR: even though it is not a cash flow, they impact on the tax the company will pay and tax is an outflow, so we take it into account Variation NWC = Variation BFR = BFR N – BFR N-1 BFR = Actif courant – Dettes courantes Step 2: Calculate the Terminal Value 7 Step 3: Determine the Discount Rate re > rd because it is riskier for equity rather than for debt. Debts are reimbursed first. Step 4 : Compute the expected rate of return on equity Step 5: If necessary, compute the relevant B The higher the debt, the risker for the shareholders is, so the beta grows up ! Sometimes, we don’t have the target beta but we know what the current beta is. ● Compute the beta of a zero-debt company 8 The unlevered beta reflects the risk in the industry and does not consider the risk of the way the firm in financed ● Take into consideration the financial structure targeted of the company Step 6 : Calculate the DCF DCF = -5 – 142 / (1,1375) + 106,5 / (1,1375) ^2 + 92 / (1,1375) ^ 3 + 1104 / (1,1375) ^ 3 En réalité, le taux d’actualisation est ici considéré comme le même dans toutes les années alors que la meilleure chose à faire serait de le changer, c’est-à-dire de le recalculer à chaque fois. All the positive part of the DCF comes from the terminal value that was computed in a “bizarre” way. This terminal value has a lot of hypotheses! => And don’t forget a sensitivity analysis, which means to try different values for the parameters! => Voir exemple cours sur Excel pour bien comprendre 9 Lecture 3: 08/10/2021 -> Valuation 2 DCF and comparables have the same problem: they don’t take into consideration flexibility. What flexibility means: ● Increase or decrease the rate of production ● Defer development ● Abandon a project Furthermore, the LP have multiple rounds of financing and that’s why option pricing is better because in takes into consideration the follow-on investments. I. Option pricing theory a. Definition Call option: right to buy (not obligation to buy) an asset at a specified exercise price on or before the exercise date b. The basics of call options ● Value of a call option at maturity (=exercise date) Call option value at the exercise date given at 85€ exercise price If spot < 85 => value = 0 If spot > 85 => value = spot – 85 ● Value of a call option before the maturity (=exercise date) Option value = Intrinsic value + Time premium (value of being able to wait) 10 When the current stock price is near the exercise price, the time premium is the highest because there is a lot of uncertainty on the fact that the option will be exercised or not. On what option value depends? ● Intrinsic value o Underlying stock price (PS) ▪ In a call, the higher the underlying stock price is, the higher the value of the call option is o Exercise price (EX) ▪ In a call, the higher the exercise price is, the lower the value of the call option is ● Time premium o Volatility of stock return (sigma) ▪ In a call, the higher the volatility of stock return is, the higher the value of the call is o Time of option expiration (t) ▪ In a call, the higher the time of option expiration is, the higher the value of the call is o Risk free rate (rf) ▪ In a call, the higher the risk-free rate is, the higher the value of the call is Black Scholes Option Pricing Model 11 ● ● ● ● ● c. From financial options to real options Exercise price = present value of the expenditures required to undertake the project Stock price = present value of the expected cash flows generated by the project Time to expiration = length of time that the investment decision can be deferred Standard deviation of returns: riskiness of the project o Volatilities: 20 to 30% (many small companies have volatilities between 40% and 50%) Risk free rate d. Example: The Mark Project The average of all the scenarios have a negative NPV. But even with an negative NPV, you can still me profitable to invest while calculating with option pricing model. If the first project is successful, then the second one should be successful as well. Whereas, if the first project is failing then the second one should not be successful. This possibility to abandon the second project based on the first one is something not take into account in the DCF but it will be in the option pricing model. Valuation with option pricing model En revanche, les CF sont risqués et incertains dont on les actualise au WACC Actualisé avec le taux sans risque car les CAPEX sont sûrs et constants 12 According to option theory, the second investment in a good one because it is worth 53,6 million. Total value of the project: 1) Project 1: - 4,6 2) Project 2: 53,6 Total: -4,6 + 53,6 = 49 million Néanmoins, ce modèle d’évaluation est très sensible comme on peut le voir dans les exemples suivants en changeant la volatilité ou les CF attendus. e. Weakness of using option pricing to value investments opportunities ● Estimating volatility can be difficult ● In general, quite difficult to reduce real world problem to simple problem (from example if the option can be exercised) ● The Black-Scholes formula is not appropriate for pricing a series of call that are nested 13 II. Venture capital method (revoir ce truc la) a. Introduction You get a share of the profit that depends on the amount your invested. Example b. Step 1: Computing the final value Value of the firm when you will sell it. You usually use : ● Multiple method ● DCF c. Step 2: Discount the final value d. Step 3 : Computing the required final percent ownership 14 e. Taking into account future dilution f. The required current % ownership Remarks: Entrepreneur pretends the company’s value is very high VC pretends the company’s value is low to get a higher a percentage of the sale A valuation of a company is not only a matter of figures but it is a big fight between entrepreneurs and VC. Lecture 4: 22/10/2021 15 -> Structuring the deal 0. Understand the incorporation (and termination) process of a firm Slides To begin the incorporating process, a company must apply for a corporate charter (= charte de la société). After the charter is authorized, corporate officers need to sign the bylaws (= réglèment intérieur). Bylaws are mandates stating how the company will operate and the rights or powers of its stockholders, directors, officers, and employees. Bylaws generally may be adopted, amended or repealed by either the board or by a vote of the stockholders. ● Liquidation Converting the remaining fixed assets and inventory into cash; the assets are distributed, and the board of directors ceases to exist ● Winding up Includes paying taxes, ... leading to the proper time and conditions for dissolution ● Dissolution The corporation ceases to exist legally Term Sheet Many companies incorporate in the state of Delaware because the tax rate is low in this State. Closing date: the date at which the contract starts 2 Venture Capitalists: ● Investor 1: 1 000 000 shares (25%) : 12 000 000$ ● Investor 2: 500 000 shares (12,5%) : 6 000 000$ Total amount raised = 18 000 000$ Price per share: 12 000 000 / 1 000 000 = 12$ 1. Understand the rationale of stage financing Slides There are different rounds of financing because the firm grows step by step (research, development, …) VC fears entrepreneur’s opportunism, means that entrepreneur might use the money for other purpose than the ones agreed on with the VC 16 There are often some objectives (milestones) that are prerequisite for obtaining additional cash fromm the VC. It is a way to incentive the entrepreneur to achieve what he has to do. The problems of such a process is the fact of having to bargain at every objectives again. 2. Compute a pre-money valuation and a post-money valuation Slides 1) First round of financing ● Implied Post – money valuation 1/6 (20/120) of the firm is worth 10m$ => Scorpio is worth 60m$ ● Implied Pre – money valuation Subtract amount of the investment from the post money valuation: 60 – 10 = 50m$ ● Dilution Initial shareholders: 100% -> 100/120 = 83,33% 2) Second round of financing ● Implied Post – money valuation: 1/5 (30/(120+30)) is worth 20m$ Scorpio is worth 5*20 = 100m$ ● Implied Pre – money valuation: 100 – 20 = 80m$ ● Dilution 17 83,33% -> 100/150 = 66,66% Term sheet Pre - money valuation: 30 000 000$ Post - money valuation: 30 000 000 + 18 000 000 = 48 000 000$ -> Look at Exhibit A ● Giving stock to the employees’ overtime is a way to keep them in the firm and avoid them to leave the company ● It is typical for the employees at the end to have 25% of the company ● Series A only means there are the first time that this type of shares are issued 3. Decide when to convert preferred equity into common stock Slides As preferred shares, they give their holders priority over common stock ● They receive a 5% dividend before any dividend is paid to common shareholders ● They rank ahead of common shareholders if Scorpio ever went bankrupt and its assets had to be sold off As convertible shares, they offer their owners the possibility of even higher returns. If the convertible preferred shareholders see a rise in Scorpio’s stock, they may have the opportunity to profit from that rise by turning their investment into equity. If the conversion ratio is 6, shares need to be trading above (100/6)16,66$ for investors to gain from conversion. If common stock finish at 10$, convertible preferred shareholders receive only 60$ worth of common stock in exchange for their 100$ preferred shares, so they are not going to convert them if they the price is lower than 16,66$. Participation with common stock on an as converted basis 9 000 000 shares and 30 000 000$ to be distributed to shareholders Number of preferred stocks: 1 000 000, 100$/share Conversion ratio: 6 Special dividend: 5% Preferred stockholders first receive 5%* 100$ * 1 000 000 = 5 000 000$ And you share the 25 000 000$ left “As converted basis”: - common stockholders: 9 000 000 common stocks 18 - preferred stockholders: 1 000 000 * 6 = 6 000 000 common shares => common stockholders receive 25 000 000 * 9 / (9 + 6) = 15 000 000$ => preferred stockholders receive 25 000 000 * 6 / (9 + 6) = 10 000 000$ Term sheet Liquidation preference, 3 possibilities: ● Nonparticipating preferred stock (very much like pure debt) o You get special dividend ▪ If the company cannot pay the special dividends, the series A holders cannot force liquidation (which is the case with bank that can force liquidation if they don’t receive their payments) ▪ If the firm was unable to pay the special dividend, the firm should pay the initial investment to investors plus the years of unpaid dividends (dividends that are not paid cumulated overtime) o You get your initial amount o The rest goes to the common stockholders ● Full participating preferred stock o You get special dividends o You get you initial amount o You share the rest left with the common stockholders calculated on an as-converted basis ● Cap on preferred stock participation rights o You get the special dividends o You get your initial amount o You share the rest left with the common stockholders an as-converted basis until the holders of Series A Preferred receive an aggregate of two times the Original Purchase Price Optional conversion ● You get 1 common stock from 1 preferred stock if you convert Mandatory conversion ● In case of IPO, the founders of a company have to right to force conversion ● VC try to avoid that the company does an IPO only to get rid of the preferred stock, so VC puts some lower bound o IPO with a price of 1.5x the original purchase price o IPO not less than 100 000 000$ Lock-up clauses ● Force to keep your shares during 6 months in the USA. o That way, they do not have any interest to say the shares are under evaluated at the IPO 19 o This enables to trust more the price at which the shares are sold at the IPO Information ● Enterprise has to provide information (in terms of quantity and in terms of quality) to the major investors ● Board of Directors shall meet at least 4 times a year Proportionate ownership (=droit préférentiel de souscription) ● If new shares are issued, the old shareholders have the right to buy some in order not to get diluted and to have the same percentage of ownership Non-competition agreement ● Agreement in which the founder and the team has to stay in the company for at least 1 year o In the Silicon Valley, there are non-competition agreement, but no one respect them ▪ Idea that skills and knowledge will be shared o In the Massachusetts, the non-competition agreement is very important, and everyone respect them ▪ Here, the most important thing is to respect the law Confidentiality ● You can present your company at a lot of VCs (what we call “shopping around”) or only have exclusive discussion o Good thing of shopping around: forcing competition for the investors and get a better price o Bad thing of shopping around: your idea is known by a lot of investors Right of first refusal ● If the founders want to get rid of a fraction of their shares, they have to first propose these shares to the investors Matters requiring approval from investors ● ● ● ● ● ● Make any loan or any advance Make any investment Enter any transaction Hire, fire of executive officers Change the principal business of the company Sell its main assets Protection clauses ● Not allowed to change the bylaws ● Not allowed to issue new shares that are upon the series A ● Impossible to increase or decrease the size of board of directors 20 Lecture 5: 12/11/2021: Distressed Debt Restructuring Debt restructuring = renegotiation of existing debt contracts Possibility to change any aspect of the debt contract ● ● ● ● Interest rate Maturity Collateral Debt can become equity We do debt restructuring usually: ● because the firm cannot make the payments it should to the debtholders ● because covenants are violated such as o Stock ▪ Max debt to EBIDTA ▪ Max debt to tangible net worth o Flow (=flux) ▪ Min interest coverage Example of covenants 1. When is debt restructuring appropriate? Pure Financial distress: fact that the firm defaulted its payment or violated debt covenants. It’s just a transient problem. This problem is not a threat for the future of the company ● Direct costs Lawyers’ fees, consultant fees, transaction costs to liquidate assets Fire sales: sell assets at a discount because you need cash to pay the stakeholders and because the seller does not have bargaining power while the buyer has bargaining power 21 ● Indirect costs But when there is only financial distress, clients may be reluctant to buy again so the pure financial distress problem can transform into an economic problem. Furthermore, when there is only financial distress, some engineers may want to leave the company, and this could lead to company to economic distress. So, it kind of exist a probability of going to economic distress when you are in financial distress 🡪In theory: the efficient outcome of financial distress is the negotiation of the original debt contract for viable firms Economic distress: much larger and deeper problem. Fact that firm has negative NPV project or registers a decline of its operating performance of the long run. 🡪In theory: No negotiation should occur, the firm should terminate for non-viable firms But, in practice, it’s not that easy to distinguish between pure financial distress and economic distress. Economic distress always comes with financial distress, but pure financial distress does not always come with economic distress, but it can. Economic distress 🡪 Financial distress Financial distress 🡪 Economic distress or not? 2. The choice of a procedure Two main procedures: ● Private workout o Bilateral (or multilateral) negotiation between the firm and its creditor o If one class of creditor or shareholders rejects the plan, a new plan must be submitted o There is a need to have an agreement between all the stakeholders o Advantages of private workout: ▪ Direct costs are lower: lower legal and professional fees ▪ Average length is shorter: workout is faster in private rather than in public ● Things can be quiet secret ● The faster it goes, the more money the firm saves ▪ No leakage of information ▪ No judge in the intervention to protect third parties ● The judge will consider the third-party perspective ● No third party involved ● It simplifies matters 🡪 Even if you start with a private workout, you can end up with a public workout 22 L1 > L2 Because as time passes, the value of the assets deteriorates ● Public workout o Bankruptcy filing (US Bankruptcy code) ▪ A third party such as Court has entered the process ▪ Chapter 7: go directly for liquidation ▪ Chapter 11: management submitted a reorganization plan to the Court of law. Within 4 months, creditors and shareholders can accept or reject the plan. ● The judge usually accepts the plan if it is fair even if some classes of creditors or shareholders have rejected the plan o Advantages of public workout ▪ Not all the stakeholders have to agree to conclude a management plan ▪ Less information asymmetry between the parties involved in the process ▪ Judge intervention to protect third parties ● Nobody will be discriminated in the process Final decision between private workout and bankruptcy filing depends on: ⮚ The viability of the firm o Economic distress 🡪 No point of reorganizing the company (chapter 7) o Financial distress 🡪 Choice between the private workout or chapter 11 ⮚ The deterioration of liquidation values between date 1 and date 2 (L1 > L2) o The quicker the deterioration is, the more likely you will avoid a private workout and go directly to bankruptcy filling o The value of the assets depends on economic condition ▪ Good condition: better value of assets ▪ Bad condition: bad value of assets ⮚ Country is which the firm operates (costs and the orientation of the bankruptcy procedure) o Countries where law is oriented in favour of creditors (pro-creditors) o Countries where law is oriented in favour of debtors (pro-debtors) ⮚ The difficulty to implement a private workout (nature and number of lenders) o Very hard to implement a private workout where they are several lenders involved o Nature of debt holders’ matter because it is easier to bargain with 1 bank rather with 1 000 000 debt holders 23 So private workouts are more frequent for: ● Firm with less numerous lenders ● Firms with a higher proportion of bank debt ● Firms with a higher proportion of intangible assets o Judge has no idea to value intangible assets Example If the firm had been liquidated in 1989, the claimants would have got 4 billion. Example in which the decision to reorganize the company was a bad idea. 3. Lender’s behaviour: tough vs soft Soft behaviour: ● Lenders accept to reduce interests’ payments or principal amount ● Extending the maturity of the loan ● Substitutes equity for debt If you know that your lenders are soft, you won’t be that incentive to be discipline. But soft lenders need to be credible. Tough behaviour: ● Increases interest payments or increase collateral ● Asks for a partial repayment of its claim ● 🡪 Tough behaviour accelerates the liquidation If you know that your lenders are tough, you will try as much as you can to avoid problems. It is a kind of discipline for the entrepreneur For the lenders, it can be a good idea to have a tough behaviour ex-ante to force discipline. But one’s the problem occur; lenders have more incentive to have soft behaviour to help the company. What we observe in general: 24 Small companies ⮚ Banks are usually tough with small companies ⮚ Trade creditors are usually soft Large companies ● Debt for equity swaps o Old debt becomes new equity o Original shareholders have to accept a high dilution ▪ They usually lose 95% of their initial wealth because of dilution ▪ Overall original shareholders lose money but much less that what they would have lose ● Banks are usually soft with big companies 4. Coordination problems Bank runs Single creditor: the creditor will accept an offer down to 50 (because it is the liquidation value) Two lenders: try to be the first to ask for the liquidation of the firm to get your 50 back before the other lender 🡪 Renegotiation problem The holdout problem Social point of view ● Liquidation first year: 80 000 000 ● Liquidation second year: 0,9 * 200 000 000 = 180 000 000 o Collectively, bondholders should accept the offer o Individually ▪ Accept the exchange offer: 2 * 0,9 = 1,8 ▪ Reject the exchange offer: 1 + (1*0,9) = 1,9 ▪ So, the offer will be overall rejected which does not lead to social optimum Conclusion: the dispersion of liquidation rights (having many creditors) might make the firm vulnerable to creditor’s run and prevent a successful outcome in case of debt renegotiation (holdout problem) 5. The case of Eurotunnel The outcome of this negotiation was not the one that was supposed. It went better than expected ● For banks: Eurotunnel suspended the payment of interest on junior debt less than one year after the commercial opening 25 ● For shareholders: IPO at 350, peak at 1200, and up and down around 400, and huge decrease that never stops ● Why was Eurotunnel such a mess? o Too many operators o Important conflicts between sponsors ▪ Constructors voluntary underestimated costs to win the bidding offer ▪ Banks unable to anticipate costs because of lack of expertise ▪ Once the construction started, constructors had all the bargaining power o Change of equity ownership to a project structure to a highly indebted public company ▪ Banks kept control of the Board while having only 8% of shares ▪ Banks transferred part of the risk to individual shareholders 🡪 One of the largest private workouts ever 1) How was Eurotunnel able to finalize a financial restructuring involving so many creditors? ● Two conflicting groups o Banks o Individual shareholders 2) Why did banks not trigger bankruptcy despite Eurotunnel’s chronic distress? ● Banks decided not to trigger bankruptcy because there was not liquidation value, because it has ever happened before (who would like to buy the tunnel?) ● Banks kept the firm highly leveraged o To access important information o To capture future CF 26 Lecture 6: 26/11/2021: Leveraged buy outs LBO is an acquisition of listed company. To pay to buy the firms, the buyer pays with a mix of ● Private equity funds (called “the sponsor”) o Some PE funds are specialized in LBO ● A lot of debt (the leverage) PE industry = LBO, VC and distressed debt 5% to all transactions are dedicated to LBO. The largest LBO were done few years ago. The biggest ever is also the famous ever that was undertaken by one of the biggest buyers: KKR. They bought RJR Nabisco for an amount of 55 380 000 000 USD. Some buyers are very well known and often do LBO: KKR, Blackstone, Bain, Merril Lynch or Goldman Sachs. It is a small industry in terms of how many players, but the amounts are huge. The next 10 largest are a bit more recent, Basically, there is no industry that really is predominant in LBO. LBO between RJR Nabisco and KKR in 1989 ● Generate little to no value for the investor ● Results were not that good 🡪 Fail example LBO between Blackstone and Hilton in 2007 ● At the time they invested, the expectation was high ● But 2007, the financial crisis started ● Investors could not have chosen a worst time to undertake this operation because some partners were Bear Stearns and Lehman Brothers ● BlackStone sold its stake in 2018, the fund generates a 1.32 billion dollars gain 🡪 Very successful How do GP’s make money in LBO? ● Charge 1,5% - 2% of management fees ● Charge 20% of carried interest ● Hurdle return: often 8% per annum o LP get their initial amount o LP get 8% of the profit o Then split between in GP and LP ● LBO is a very long incentive, to raise money from 8 to 10 years: LBO is not over a short period of time 🡪 not all investors can afford this type of operations because it is a very long investment I. Why LBO’s? 27 There are some important steps in a corporation. The first phase is when the company grows quickly and then there is a slow down when the company gets bigger. When, it is in a mature growth, there is a time when things slow down, and this is when LBO take place. In the case of KKR and Nabisco, Nabisco was a conglomerate with a lot of things that are not really related. Before the 1980’s, the stock market was not very developed, which was a problem for the company willing to grow. It was difficult to sell the shares to thousands of small investors, so company had to rely on internal capital markets (transfer of funds of different business units in the same firm). The outcome of one business unit is not correlated to the outcome of other business unit, which allowed a business unit to help another one to transfer funds. The problem is that the losses can sometimes become too big, or overall, it is not incentive for the business unit that have profit because they know they going to lose for others business unit. So that is here LBO came, they restructured them to make them more efficient. On the top of that, there are some incentives for LBO: ● Huge leveraged (very big debt) o Management of the firm that was bought are under pressure to work hard => downside because if they don’t work well, they are not going to reimburse the debt ● The number of shareholders is decreased ▪ The profit is concentrated in a few hands, so it is incentive => workhard (upside) Within this large conglomerate, the incentive to do very big profit is very low. So, one of the things done by LBO is to help company to have more incentive to do profits. II. Understand the basic principle Sponsors aim to make: o o High annualized return (IRR : internal rate of return) High absolute return (MoM : multiple of money) 1. How? A holding is created to buy the target. Holding is highly leveraged with 70% of debt and 30% of equity. The dividends that came from profit from the target allow the holding company to repay the debt. When we say that LBO firms are highly leveraged, we mean the holding. 2. The dynamics of the game Holding company has usually 5 to 7 years to pay back the debt it issued to pay the target. At date 0, shareholders own 30% of the target. At the end of the period, once the holding’s debt has been paid back to the bank, the shareholders own 100% of the target. 3. Exiting Time for the fund to exit by: 28 o o o IPO o Full cycle again: IPO, private, LBO, IPO, private, LBO,… Sale to another LBO fund Trade sale 🡪 See example It needs the target to give enough dividends to the holding to pay back the amount to the bank. If the dividends are too low management of the target is fired and the sponsor pays a difference, or the holding goes bankrupt. III. LBO targets Not all the firms are suitable to become a good target. To be a good LBO target, you have to : o o o o o o o o o Resilient (stable) cash flow History of strong earnings Have a leading a position on the market or a protected niche No major market disruption expected Growth potential Operational improvements / cost savings could be done Asset re-organization Attractive at exit for pre-identified buyers Strong management in place How to be sure that the LBO be successful? You cannot be sure but at least you can take some precautions: due diligence process 1) Initial due diligence (between 3 and 4 weeks, time during which you make a draft of the business plan, the parties involved exchange views about the financing and the valuation) 🡪 Letter of intent 2) Full due diligence (for 2 months, access to the data room to collect news about the target, finalize the way you want to finance the operation, draft sale and purchase agreement is concepted, negotiations start about the management package) 🡪 Firm offer 3) Negotiations (finalize the sale and purchase agreement) 🡪 Signing 4) Finalization (1 to 3 months to finalize the operation) 🡪 Closing 🡺 Not sure that this will lead to a profitable business The idea is to have an alignment of interests. To do so, the idea is to design a contract that incentive as much as possible the management to do good work: 29 o o Management of the target manages operations day-to-day LBO fund: active partner and coach to management, can fire the management if they going wrong Measure of success: o o MoM = value at which you sell the shares / value at which you buy the shares IRR = (equity proceeds at exit / initial equity invested) ^ (1/years) – 1 By using more debt in LBO, it increases the ROE but it is more risky for shareholders because the first ones to be paid are the creditors. IV. The sources of value creation 1) Grow the business 🡪 MoM = 126/50 = 2,5x 🡪 IRR = (126/50)^(1/5) – 1 = 20,304% 2) Expand margins Keep the revenues at the same level, but you expand the margins 3) Expand multiples (did not speak about it) 4) Delever 🡺 There is various possibility to have various creation, the best idea is to do a mix of all above are used by the funds Tax savings You can save paying tax by doing tax consolidation, you can reduce the tax bill. In this example, it enables to save 10 M€ of taxes each year. Tax consolidation, in France, is possible only if holding company owns at least 95% of the target. In the other european V. Case Study: Levain Corp 🡪 Do it on Excel 30