PE 101: Introduction to Private Equity

Private Equity and Venture Capital Club

James OGara Ryan Brewer October 2011

Todays Agenda
1. Overview of the Private Equity Industry / Asset Class 2. Basics of PE Investments 3. Current PE Industry Update 4. Useful Resources 5. Selected Case Studies

1. Overview of the PE Industry

Basics of Private Equity: Definitions

Private Equity as an Investment Asset Class

Alternative investments with a high-risk, high-return profile Typically investing in illiquid, non-publicly traded or unregulated securities High use of debt (financial leverage) to boost equity returns
Alternative asset classes
High Private Private equity equity Hedge Hedge funds funds Commodities Commodities Equity Equity Risk Medium High-yield High-yield bonds bonds Corporate Corporate bonds bonds Government Government bonds bonds Low Low <10% Deposits Deposits Medium 10 20% High >20%

Expected return

Range of Private Equity Investments

Focus of PE101

Private equity VC Early stage First stage Initial expansion of sales or manufacturing Growth capital Expansion stage Second stage Third stage Bridge loans Fundoffunds Buy & build Turnarounds Buyouts LBO

Seed

Start-up

Descrip- Retion search and proof of concept

Product development and initial marketing

Working Financing Financing capital for of major during the expansion growth transition from being privately to publicly owned

Investments in other funds

Equity to fund growth in an established business via internal expansion or acquisition

Existing business that experienced trading difficulties, with a view to reestablishing prosperity

Funds provided to enable a management team to acquire a product line or business

Industry History and Development

PE Advantages and Disadvantages

Advantages

Disadvantages

Historically attractive returns Levered returns on equity via high debt-toequity ratios Long-term strategy, ability to add value Diversification Limited correlation to public markets (in theory) Superior governance model Helps to solve the principal-agent problem at the board level No public company costs or need to perform well on a consistent quarterly basis Strong management incentives Typically employ generous stock incentive programs, require co-invest from managers Tax benefits Tax shield through debt Capital gains treatment for profits

Illiquid Typical 3-7 year holding period Usually majority ownership Difficult to mark-to-market High fees 2% annual management fee and 20% of profits (2 and 20) is typical, coming down somewhat Relies on leverage to enhance returns Needs healthy bond and loan markets High risk large range between returns of top and bottom quartile fund Increasingly competitive, particularly in some sectors/markets More deals are intermediated vs. proprietary, more auction processes Large capital inflows into emerging markets

2. Basics of PE Investments

Typical Private Equity Fund Structure

Private Equity Fund Life Cycle

Limited partnerships with a fixed life of 7-10 years Defined investment period Fund may target 7-20 investments over its life

Acquisition 5
Acquisition 4 Marketing and capital raising Marketing and fundraising Acquisition 3 Acquisition 2 Acquisition 1 Marketing and capital raising

Transaction sourcing

Year

-1

10

Typical Deal Cycle

From screening to close of transaction can often take 6 months or more Hold periods anywhere between 3 and 7 years are typical, depending on the type of investment

Life cycle

Screening of deal opportunities

Due diligence

Entry

Active ownership

Exit

Activities

Deal Flow Screening Stable CFs Strong Management Value Creation Dynamics

Market Company Operations (Growth and Synergies) Management Financials Legal

Acquisition price Management Management principles and Incentives structure Financing Structure Re-organisation Maximise Returns Establish and Align Interests monitor aggressive business plan

Strategic buyer IPO Other PE Secondaries

Key Personnel

PE firm partner Investment banks

PE firm team Partner Associate Investment banks Consultants Accountants Lawyers

PE firm partner Investment banks Lawyers

PE firm partner Consultants

PE firm partner Investment banks Lawyers Consultants

Deal Sources

Non-core asset from corporate

Management buy-out in need of financing

Undervalued public company (go-private)

Family-owned business with no succession plan

Distressed/ failing company

Sale of company by another PE firm

The ability to source transactions is a key success factor for PE firms Successful sourcing draws on deep industry relationships, a firms reputation, and appropriate timing A typical firm will evaluate (on some level) hundreds of potential opportunities per year

Due Diligence on Target Company

Valuation Considerations and Due Diligence Checklist

Firm level

Overview of the TargetCos strategy and business model Assess the feasibility of managements business plan Identify operational, market, financial, environmental and other risk factors and develop a mitigation plan Explore operational and market upside opportunities Analyse the cash generation and debt capacity of TargetCo Quantify the upside and downside

Industry and macro level

Macroeconomics outlook, sector thesis and trends Check regulation of the given industry Understand customer trends and behavior of the industry Analyse competitors within the same market segment

Deal Structure Overview

Financing Structure Investment (Legal) Structure Simplified

Limited Partners
Fund LLP Equity / Shareholder Loans

General Partner

Acquisition Co. Mezzanine

Bank

Seller BidCo Purchase Price Target Senior debt

Economics of the LBO Model

Investing in high cash-flow generating companies allows high leverage (debt) Pay-down of debt over investment life boosts equity value relative to earnings/enterprise value growth
At Initial Investment EBITDA Purchase Multiple Purchase Price Less: Debt (5x multiple) Initial Equity Investment At Exit EBITDA Exit Multiple Enterprise Value Less: Debt Remaining Exit Equity Value

100 8.0x 800 500 300

150 8.0x 1,200 250 950

1,200
250

800

Sources of 650 growth in equity

250 in debt repayment 400 in EBITDA growth (50 x 8x multiple) Potential for further growth through multiple expansion

Debt

500

950

Equity

300

EBITDA growth of 50 FCF repays 250 of debt

Exit

Initial Investment

Exit Considerations

Recapitalisation
Could be to a strategic party or another PE firm Sale to strategic is company-dependent (needs to be a strategic fit) Sale to PE firm is dependent on financing markets Typically only a partial monetization at IPO, followed by subsequent secondary offerings to sell down full stake Enables participation in future growth Not an exit, but rather a monetization event Company re-levers and uses proceeds to pay large dividend Often utilized if PE firm wants to partially monetize investment and either i) wants to retain upside in business, or ii) cannot receive value it believes is appropriate

Sale

IPO

3. Current PE Industry Update

Private Equity Fundraising

PE funds raised peaked in 2007-2008 Fundraising has been slow to recover after the financial crisis, large overhang of dry powder remains

Private Equity Funds Raised (US$ billions)1 800 700 600 500 400 300 200 100 297.1 260.0 127.6 661.9 676.5

0
2007 2008 2009 2010 1H2011
Note: 1 Includes all PE funds (buyout, VC, mezzanine, secondary, etc.). Source: Preqin

Private Equity Deal Activity

Deal volumes show a similar trend Aggregate values have recovered somewhat since hitting a 5-year low in mid-2009

Private Equity Deal Activity (US$ billions)1

Note: 1 Includes all PE funds (buyout, VC, mezzanine, secondary, etc.). Source: Preqin

Private Equity Exits

Exit volumes have recovered strongly from the financial crisis as the large volume of deals originated in 2005-2007 reach maturity

Private Equity Exit Activity (US$ billions)1

Note: 1 Includes all PE funds (buyout, VC, mezzanine, secondary, etc.). Source: Preqin

Private Equity Loan Market

The leveraged loan markets in the US and Europe began to rebound in 2010, with strong pricing gains and more access to leverage for private equity transactions This trend has continued in the first half of 2011, however the recent European debt crisis and continued market volatility in the US has brought volumes virtually to a halt in 2H 2011 so far Pricing is decreasing and yields increasing in both the leveraged loan and high-yield bond markets

European Market ( billions)

US Market (US$ billions)

Source: S&P LCD

Recent Trends and Challenges

Trends
Growth in Emerging Markets Increased Specialization Emphasis on Value Creation Expanding Secondary Market Challenges Recent Fund Performance Regulation

Funds increasingly turning to higher growth emerging markets as US/EU stagnates Risk of over-heating in several markets: China, Brazil, India

Demand from LPs and more competitive marketplace leading firms to increasingly specialize in a particular geography or sector
Larger firms expanding sector teams or raising separate, specialized funds (Carlyle model) Reduced availability of leverage means firms are more reliant on value creation for return Creation or investment in separate portfolio company teams Secondary market for LP interests developed in mid-2000s and has continued to expand Many large secondary funds raised in the last 2 years

Returns performance of many funds raised in 2005-2007 has been poor Fundraising difficulties for funds that have underperformed, firms raising smaller funds Industry is increasingly being targeted by regulators/politicians, particularly in Europe Accusations of asset-stripping, outsized compensation, poor employment record

4. Useful Resources

Private Equity Resources

Industry Associations

BVCA: www.bvca.co.uk EVCA: www.evca.eu Emerging Markets Private Equity Association: www.empea.net

News

Subscribe to NYTimes DealBook for daily emails aggregating major PE stories http://dealbook.nytimes.com/ eFinancial News: Comprehensive industry news source www.efinancialnews.com FT Private Equity coverage www.FT.com/privateequity PE Hub: Daily email with industry news and commentary, venture-focused www.pehub.com S&P LCD: Like their facebook page for free access to leverage finance market stats www.facebook.com/lcdcomps

Library Databases

Capital IQ: Very useful for deal info and downloading excel financials / valuation stats for public companies Bloomberg: Transaction searches and public company data (also get their iPhone app, its amazing) VentureXpert

Venture Capital Report Directory

Academic and Research Resources

The Coller Institute at London Business School

Website aggregates research and case studies on private equity from the academic community Semi-annual publication, Private Equity Findings, very useful for summary of latest PE research Blog on their website: http://www.collerinstitute.com/

Textbooks and Reference Material

LBS Professors Eli Talmor and Florin Vasvari

Guy Fraser Sampson

Josh Lerner Felda Hardymon Ann Leamon

Orit Gadiesh Hugh MacArthur

Peter Temple