Private Equity An active investment model Contacts Deloitte Garrath Marshall Audit Partner gmarshall@deloitte.co.uk Yasir Aziz Audit Director yaziz@deloitte.co.uk LPEQ Douwe Cosijn Chief Executive Douwe.Cosijn@lpeq.com Michael Mills Senior Adviser LPEQ Introduction Private equity ( PE ) is a unique investment model based on a clear alignment of interest between the private equity investor and the management team they back. This alignment is based on setting a clear strategy for the business, a rigorous focus on operational improvement and value creation. This paper seeks to explore the main elements of the PE investment model in each of the buy, hold and sell stages of investment. PE has always been recognised as a fundamentally different ownership model to those used by investors in public equities. The current review by the Financial Conduct Authority of the Asset Management industry, and particularly its focus on the differences between active and passive investment strategies, provides an interesting backdrop, allowing the many significant differences between the PE model and those of public equity investors to be highlighted. Three key fundamental differences stand out in comparing the PE investment model with those of public company investors in the UK market. The first is that a PE investor believes that, in order to realise the contemplated value creation opportunity, investors (the PE house, on behalf of its fund investors, plus the management team) should aim to take outright ownership and control of the business. In the public equities universe, even activist investors will invariably keep their stake below the relevant threshold in order to avoid a mandatory takeover obligation.
The second key difference relates to access to information about the underlying business. Generally, PE managers have good information prior to making an investment through the due diligence processes undertaken. And during the investment holding period they continue to have full access to information, including cash flow forecasts, budgets and plans, both by virtue of contractual rights and through board representation. Investors in public companies are constrained by insider trading legislation from receiving non public information and (with the exception of activist investors in some situations) are generally highly reluctant to be made insiders for any significant period of time because of the inability then to buy or sell shares in the relevant company. In the public equities universe, forecast financial information, as far as investors are concerned, tends to be provided by sell side analysts rather than the company s own board. The third key difference between the PE model and those of public equities investors is that in the formers key investment decisions are taken by the firm as a whole, rather than one or two individuals, and review, challenge, consultation and sharing of ideas and knowledge are all seen as necessary parts of good investment practice. Box 1 provides some detail regarding typical governance structures used within PE firms. As well as a strategy to grow revenues and profitability and strengthen the competitive positioning of the business, the strategy will invariably also articulate a proposed path to exit for the business, generally involving a strategic sale or IPO of the business. Box 1 Example Governance structures A typical governance structure for the PE manager of a buyout fund would be to have a deal team member (i.e. an employee of the PE house) who is responsible for an investment (but more typically a number of investments within the PE portfolio) who is nominated to be a director on the board of the portfolio company. This allows the deal team member to be involved in the decisions being made at the portfolio company and influence these decisions through their seat(s) on the board. The deal team member will often report into a review committee which will meet regularly to discuss progress of specific deals against the exit strategy. The review committee will then often report into an investment committee which for many PE houses is where many of the investment decisions are made (for example, changes to operational strategy for particular deals, if additional funding is required exit decisions and valuations of investments held in the portfolio). Whilst it is not always the case, the most effective investment committees will often have independent members as part of the committee (either independent non executive committee members being external from the PE house or independent in that they are not part of the deal team, such as a finance director or operations director). Following recent regulations aimed at alternative investment fund managers (through the European legislation known as the Alternative Investment Fund Managers Directive ( AIFMD )), PE managers that are within the scope of the Directive are required to demonstrate a level of independence as part of the Fund s valuation process which often can result in greater levels of independence at the investment committee level. This greater independence is to foster a increased level of challenge as part of the investment decision making framework. Deal Team Member Board of Directors Investment Committee Portfolio Review Committee Director Director Director Director Portfolio Company Deal Team Member Portfolio Company Deal Team Member Portfolio Company Deal Team Member Portfolio Company The investment committee will work closely with the board of directors (and typically there will be some overlap in membership between the investment committee and the board of directors for a PE House) where the board of directors would often set the parameters in which the PE fund will operate (for example, outlining the strategic direction of where the PE fund will make its investment decisions, the asset types, locations, typical deal size and maturity etc.) and the investment committee will then operate within these parameters to make specific investment decisions. The rest of this paper reviews the PE investment model in the Buy, Hold and Sell phases in an investment s life, contrasting it, where pertinent, with the typical public equities investment model. The appendix to this paper contains two case studies provided by the respective PE houses illustrating the PE investment model in practice, each involving an investment thesis predicated on the implementation of substantial strategic and operational change. 2
Buy phase While each PE house will undoubtedly have variations to the following summary and differences will arise where, for example, a structured auction process for the underlying business is being undertaken, this section seeks to summarise the main approach and process applied within the PE model in the phase up to the point an investment is made. The steps are set out below in broadly sequential order, though there are inevitably elements of overlap in practice depending on particular circumstances. Reference by the deal team to other colleagues within the PE firm, including investment committees and other forums, will tend to take place several times through the process, as outlined in Box 2 below. Deal origination and initial screening PE houses devote substantial resources to deal origination, using their business and financial networks and desk top research and analysis to find new deal opportunities that fit within the relevant investment strategy and meet the investment criteria specified by the PE house. In particular, those involved in deal origination are looking for opportunities where they judge that substantial value can be created. They will often seek to build relationships with businesses in a geographical area or a particular sector with a view to being well placed in the event that the business has a funding need some time in the future. The aim of much of this activity is to create so called proprietary deal flow, where there is full access to information, less competition and prices may be lower. Deal origination may also include participation in structured sale processes (or auctions ) conducted by investment bankers or other intermediaries, though PE houses argue that they only do so where they have a proprietary angle that enables them to justify paying a higher price than the competition. Deal opportunities that meet the criteria specified by the partnership will be tabled for consideration at partnership meetings (or the relevant forum specified by the partnership s governance model); and those that are approved will move on to the next step in the process. Box 2 Pre-deal decision framework Whilst each PE house will have its own unique investment governance making framework which will depend on the size and scale of the organisation, the fundamental elements of the deal structures will follow the process outlined below. Preliminary screening of investment opportunities Final screening of investment opportunities Allocation of resources, e.g. staff and budgets for due diligence Preliminary offers Final offers The level of involvement from the more senior executives within the PE house will typically increase as the deal progresses through the deal flow as deals come closer to being executed. There will often be gates outlined at each stage through which a deal will need to pass before it is progressed, for example the preliminary screening of an investment might be for high level factors such as strategic fit within the portfolio and the macroeconomic factors of the country in which the potential investment is based. Where the potential investment does not pass each gate, it will not be progressed to further rounds of considerations. Best practice in the industry would also be to fix monetary amounts which can be incurred by the PE house on each potential deal at each stage in order to limit the costs incurred on deals in their early stages of deal assessment. Development of value creation strategy Based on the available information and working closely with the executive management team that the PE house intends for the target business (which may be the incumbent team or a new management team specially formed by the PE house for the deal in question), the deal team will develop a value creation strategy for the business. As well as a strategy to grow revenues and profitability and strengthen the competitive positioning of the business, the strategy will invariably also articulate a proposed path to exit for the business, generally involving a strategic sale or IPO of the business. The strategy will be underpinned by a detailed business plan and financial forecasts, including a planned time frame and projected valuation range for exit. Transaction pricing and structuring Based on the financial forecasts underpinning the value creation strategy, the deal team will aim to develop its thinking as regards deal pricing and structuring. This will generally involve significant financial modelling, including a review of sensitivities and other risk analysis. A key objective in developing a deal structure is to ensure an alignment of interests among key stakeholders, particularly between the management team and the PE investors. The incentive plans for the management team of a PE backed company generally offer a significantly greater opportunity for wealth creation for the individuals involved than those of typical public companies, and the link between performance and reward is generally also much greater. In addition, management teams of PE backed businesses are generally required to invest significant amounts (dependent on their individual circumstances) in the business in order also to align interests on the down side. 3
As regards financial structuring, the PE investment model has historically involved financial engineering as one of the sources of investment return for the equity holders; and financial structuring remains a key part of the PE tool kit, offering more flexibility than for the typical public company. As the deal team s thinking evolves, it will engage also with other providers of capital, including banks, other investors and other providers of senior and junior debt and other financial instruments, in order to structure the proposed deal. Due diligence Comprehensive due diligence is undertaken by PE houses prior to making an investment. The aim is to validate the investment thesis and the key information, assumptions and judgements underpinning it, and is likely to include commercial, legal, tax, financial and technical aspects, with external professional firms and key industry and business contacts of the PE house being involved alongside the firm s own personnel. Legal documentation, investment approval and completion Once the proposed deal structure has been agreed in principle with the various stakeholders and the PE house s own approval authority and while due diligence is being undertaken, legal documentation for the deal is prepared, usually by an external legal firm engaged by the PE house. Amongst other things, the PE house will generally seek to ensure it has legal rights in respect of: board representation, consent limiting certain actions by the company, voting control regarding material matters, access to information and appointment of board members. As the proposed deal progresses, the deal team will prepare an investment recommendation paper for approval by (usually) the PE house s investment committee. This paper contains all relevant information to enable the investment committee to deliberate on whether to approve the making of the investment, offering the opportunity for the investment committee to challenge the investment thesis. At the relevant investment committee meeting, the deal team will generally present the opportunity to the committee and would expect to be questioned in detail about all material aspects. The committee would then make a determination whether to pursue the investment, and specify any conditions which their approval is subject to, including potential additional due diligence steps to be undertaken prior to completion of the transaction in due course. Hold phase The PE investment model during the Hold phase is considered below under three headings: i) exercising influence through the board; ii) monitoring processes within the PE firm; and iii) periodic valuation of the investment portfolio for reporting purposes. Exercising influence through the board The PE fund manager will generally seek to ensure it has board representation supported by voting rights and full access to information, and will seek to be highly active in influencing strategy and monitoring performance. In contrast, the typical long only active investor in a public company will generally communicate twice yearly with investee companies, at the time of interim and annual results, recognising that they are in the business of running diversified portfolios rather than getting involved with investee companies in issues of strategy and performance. The key areas of board influence and interaction for a PE fund manager are discussed below, contrasting the PE model with the typical public equities model. i. Board composition and incentivisation As noted above, board composition for PE firms is based heavily upon alignment of interests and strong incentivisation. A key skill within PE is the ability to put together strong, highly motivated executive teams and to assess these teams over time and make changes quickly when deemed necessary. Because of the incentivisation offered by PE firms and the preference by many executives to avoid the public company arena, PE firms have access to a strong pool of managerial talent, often including serial entrepreneurs who have successfully worked with the firm more than once. As regards non executive directors, the PE ownership model emphasises strategy and performance, and non executive directors (other than the PE firm s own representatives) are likely to be chosen for their industry knowledge, strategic insight and ability to add real value to the portfolio company. In the typical public company, for very good reasons, governance issues such as audit, remuneration, risk management and compliance are often seen as more important areas of capability for non executive directors. ii. Communication with shareholders and other stakeholders Public companies tend to have a disparate group of shareholders, from large institutional shareholders to small retail investors, growth and value investors, long term shareholders and hedge funds, all having different objectives and concerns. In addition, public company boards often have to deal with media and political scrutiny, threats from activist investors and short sellers and higher levels of corporate governance scrutiny, amongst other things. 4
In contrast, a PE board has a much more straightforward stakeholder management and communication picture. The PE fund (represented by the PE firm) will usually be the only non management shareholder, there for the duration and 100% behind the company s strategy, since the PE firm would have been centrally involved in its development. In addition, the PE firm is much closer to the business through its board role and therefore likely to be better informed about the business than are investors in public companies. As regards to other stakeholders, a PE backed company will, almost by definition, have a lower public profile than a listed company and would be expected therefore to attract less media and political scrutiny. iii. Development of strategy As noted above, the strategy of a PE backed company tends to be arrived at during the pre investment phase through a combined effort between the executive team and the PE firm s deal team. There would also usually have been input from senior colleagues within the PE firm, during the various partnership discussions prior to the investment being made. Strategic initiatives, ideas and priorities, as well as a time frame for their delivery, will have been arrived at and developed by the board as a whole. In contrast, within a public company, the proposal and development of strategy tends in practice to be undertaken largely by the executive team, with the board s role being to challenge and shape those proposals. iv. Performance oversight and improvements to operational performance The PE investment model has at its heart a critical emphasis on performance management and oversight. Key performance indicators ( KPIs ), generally focusing on revenue, operating margins, cash metrics and delivery timeframes, are defined up front and monitored closely at board meetings, with swift interventions being made following instances of underperformance. While public companies also have KPIs, these arguably tend to be more for purposes of reporting strategic progress to shareholders on a twice yearly basis. Public company boards arguably are more focused on meeting profit targets and market expectations and avoiding surprises for investors, than on a relentless and detailed focus on such detailed performance metrics. A number of PE firms also emphasise their ability to add value to their portfolio companies through active involvement in improving operational performance. This may involve sharing best practices, knowledge sharing, streamlining/creating synergies between similar/complementary portfolio companies, introductions to industry operating partners and other initiatives to help portfolio companies improve their operations. v. Level of engagement The PE firm s representative on a portfolio company board would generally be expected to have a substantially greater degree of involvement with the investee company than a typical public company non executive director. Outside of the formal board and committee meetings, the PE director would generally be expected to engage with the company through site visits and ad hoc meetings, phone calls and emails with the executive team on an ongoing basis. Monitoring processes within the PE firm The key means by which a PE investor exercises influence over an investee company and monitors its investments is through board representation, as noted above. Most PE firms supplement this with regular reviews of portfolio companies by a committee or other forum established by the partnership for this purpose. At such meetings, detailed papers will be presented by the relevant investment teams addressing a range of specified matters, such as performance against the deal plan, financial forecasts, management s performance, strategic aspects, risk management and exit strategy. These reviews enable a partnership approach to be taken to investments, with challenge, support and ideas being provided to the deal team to help it determine the appropriate course of action for the portfolio company in question. Periodic valuation of investment portfolio for reporting purposes For a fund manager investing in public equities, valuations are based on quoted market prices and IT systems are generally in place to provide real time valuations of a portfolio on an ongoing basis. In contrast, the valuation process for PE fund managers requires significant judgement to be applied by those involved and can be laborious and resource intensive. Most PE firms provide quarterly or semi annual unaudited valuations of fund portfolios to investors as well as annual audited financial statements which will include the fair value of the assets. Following the introduction of the Alternative Investment Fund Managers Directive ( AIFMD ) (implemented in the UK in 2013), PE firms are obliged to have appropriate and consistent procedures so that a proper and independent valuation of the assets can be performed. Most PE firms undertake the valuation process in house (rather than using an external valuer), in which case there is a requirement that the valuation task is functionally independent from the portfolio management and the remuneration policy, and other measures ensure that conflicts of interest are mitigated and that undue influence upon the employees is prevented. This independence is achieved usually by having the valuations determined by a valuations committee or board. 5
Most PE firms will have in place a detailed valuation policy, which will have been included in the legal documentation supporting the fund s launch. This policy will usually be consistent with the International Private Equity and Venture Capital Valuation Guidelines (which have been endorsed by most national and international PE and Venture Capital associations) and generally will be required to be in line with International Financial Reporting Standards. In applying the valuation policy to its investment portfolio, most firms will use valuation procedures broadly along the lines set out in Box 3. Box 3 Outline of typical Valuation Process Initial Review Final Review Each investment is initially valued by the deal team responsible for the investment, with a detailed valuation paper being produced setting out the underlying financial information, the proposed basis of valuation, metrics used including valuation multiples, issues and an initial valuation. These papers will then be reviewed by specified colleagues, which may include an in house valuation specialist and/or a senior member of the finance function. Issues and queries raised will then be discussed with the deal teams. Revised papers will then be circulated to the members of the valuation committee and an initial meeting of the committee would follow, at which papers would be reviewed and issues and queries raised. Amended papers would then be prepared addressing the issues and comments raised, and these would be circulated to valuation committee members (and board members, if relevant) ahead of a meeting to discuss and determine the valuations to be used. Initial Valuations Revised Valuations Sell phase In contrast to the public equities fund manager, exiting from a PE investment is generally a lengthy and involved process. In contrast to a sale of public equities, a PE exit will generally be based on a sale or IPO of the entire business, which could potentially give rise to a valuation being achieved that reflects a control premium and/or integration synergies achievable by a buyer. Strategically, exit will have been on the PE firm s agenda from the early pre investment screening stages of its involvement with the portfolio company. The preferred exit, potential buyers for the business, valuation multiples, IPO market conditions, industry trends and other aspects will have been monitored through the life of the investment. And, throughout the period of ownership, the business will have been prepared for exit, with the aim of ensuring it is an attractive M&A or IPO prospect and that potential issues have been resolved when the time comes. In terms of the exit process, the PE firm will generally seek to appoint professional intermediaries to run a professional and structured process, designed to ensure competitive tension between potential buyers for the business and to keep open its exit options. In certain situations, the PE firm might seek to run a dual track process, preparing both for an IPO and a trade sale. Conclusion What is clear from this review of the PE investment model is that it is a fundamentally different form of investment from other investment models. At its best, it is an intensely active form of investment, rigorously focused on value creation across all phases of the investment process, from deal origination through to exit. 6
Appendix case studies Visma software Nordic region 2006-2014 HgCapital Established in 1996, Visma is a leading provider of mission critical business Software as a Service ( SaaS ) software and outsourcing services to small and medium sized enterprises in the Nordic region and the Netherlands. Headquartered in Norway, the company provides accounting, resource planning and payroll software, outsourced bookkeeping, payroll services and transaction process outsourcing to its customer base of over 400,000 enterprises. In May 2006, HgCapital invested in Visma through a public to private acquisition of the company from the Oslo Stock Exchange. In 2010, HgCapital completed the partial sale of 63% of its investment to KKR, retaining a 17% equity stake in the business and remaining actively involved alongside KKR. In 2014, as part of a larger transaction (in which HgCapital re invested in the business through a subsequent fund alongside KKR and Cinven), HgCapital realised its remaining stake in the business, giving rise to an overall return on its investment in Visma of 5.2x original cost and a gross IRR of 33% p.a. The Visma investment case was predicated on three main areas: i) the scope to grow revenues both organically and by acquisition; ii) opportunities to improve profit margins; and iii) the conversion of one time revenues into recurring subscription based revenue streams. HgCapital and, from 2010, KKR worked closely with management to drive the value creation agenda. In addition to active engagement through the board, based on substantial experience within the software industry, HgCapital and KKR supported management with experienced project and strategy executives who could help implement initiatives to boost revenue growth: implementing group wide Net Promoter Score programmes to improve customer satisfaction and enable cross selling; converting one time revenues to recurring subscription packages which enhance future up sell potential, and investing in cloud based technology. In addition, the PE firms deal expertise and experience of M&A enabled them to provide support to the executive team in undertaking more than 75 bolt on acquisitions, mainly in the Nordic region. Visma s financial performance during HgCapital s investment period improved dramatically. Total revenues grew from NOK 2.3 billion in 2006 to NOK 7.1 billion in 2014, a compound annual growth rate of 15%; and EBITDA increased from NOK 305 million in 2006 to NOK 1.5 billion in 2014, a compound annual growth rate of 22%. Over the same period, operating margins improved from 13% to 21%; and the levels of employment, product innovation and R&D investment all more than doubled. 7
Punch Powertrain automotive Belgium 2010-2016 Gimv Founded in Belgium in 1972, Punch Powertrain is a manufacturer of automatic transmission systems for use in automobiles. The main components are manufactured in Belgium, whereas the assembly is carried out in China. It has R&D activities in Belgium, the Netherlands and China, and customer service centres in China and Malaysia. In March 2010 Gimv, the Belgian investment company, invested 18 million in the business, taking a 46% equity stake, alongside LRM, a Flemish investment firm, and Capricorn Venture Partners, a Belgian based technology investor. In 2013, Gimv and the other financial shareholders sold 30% of their stake to New Horizon Capital, a China focused PE fund; and, in August 2016, the company was acquired by Chinese industrial conglomerate Yinyi for 1 billion, giving Gimv an IRR of 60% p.a. and a money multiple of 17x on its investment. The investment proposition had three key strands: to expand the customer base by targeting Asian (and particularly Chinese) automotive OEMs, recognising that there was a growing demand there for clean powertrain solutions suitable for city traffic; to grow production capacity to meet the demand from the growing customer base; to invest heavily, both organically and through M&A, in product development to address the global drivers within the automotive market towards fuel efficiency and emissions reduction. During the six years of Gimv s investment, the planned investment strategy was executed. In seeking to grow the customer base, the company decided to position Punch Powertrain as the leading independent supplier of automatic transmissions to a range of smaller Chinese car manufacturers; and, in order to make the transmissions affordable, the company took steps to reduce the cost of the total transmission by shifting suppliers and moving to smarter designs. The client base expanded from two customers in 2010 to around 20 in 2016; production capacity tripled; headcount rose from 210 to over 1,200; and, from a single product in 2010, the company in 2016 offered a wide range of automatic transmissions for vehicles with internal combustion, hybrid or fully electric powertrains. More than 200m was invested in capacity expansion and product development, including three acquisitions that allowed for more in house technology and a broader engineering base. This publication has been written in general terms and we recommend that you obtain professional advice before acting or refraining from action on any of the contents of this publication. Deloitte LLP accepts no liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication. Deloitte LLP is a limited liability partnership registered in England and Wales with registered number OC303675 and its registered office at 2 New Street Square, London EC4A 3BZ, United Kingdom. Deloitte LLP is the United Kingdom affiliate of Deloitte NWE LLP, a member firm of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee ( DTTL ). DTTL and each of its member firms are legally separate and independent entities. DTTL and Deloitte NWE LLP do not provide services to clients. Please see www.deloitte.com/about to learn more about our global network of member firms. 2017 Deloitte LLP. All rights reserved. Designed and produced by The Creative Studio at Deloitte, London. J12176