Private Equity CHAPTER 2

Private Equity CHAPTER 2

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Private Equity Firm It refers to investment firms structured in the form of limited liability partnerships which provide funding to businesses at different stages. Investments are pooled from wealthy individuals, pension funds, insurance companies, investment banks and other financial institutions. These firms invest in private companies or public companies which they wish to take private.

Private Equity Firm They buy either the entire company or at least the controlling interest with the majority of the purchase being financed by bank loan against the acquisition target s assets. The funding is used in expansions, technological innovations, acquisitions or solidifying balance sheets. The time horizon is very long. This investment has very high risk and thus high expected rate of return.

Emergence In the beginning of the 1900s, J.P. Morgan engaged in financing of industrial companies and railroads. At that time, it was the territory of wealthy individuals and families. The American Research and Development Corporation (ARDC) marked the rise of professionally managed private equity investments in 1946. Its focus was to provide financing to new and small businesses. However, this business was restricted to US. After the burst of dot-com bubble, low interest rates led to massive growth of private equity firms. It was the time of largest leveraged buyouts and expansions. Then it started gaining popularity in Europe and Middle East.

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Structure of Private Equity Firm Private equity firms are formed in the form of a limited liability partnership comprising of the General Partner (GP) and Limited Partner (LP). GPs are the fund managers who pool investments from outside investors known as the Limited Partners.

Outside Investors (Limited Partners) General Partner (Fund manager) Private Equity Fund (LLC) Portfolio of Investments

Structure of Private Equity Firm LPs (typically HNIs and institutional investors) do not interfere in the management of the firm and just provide capital and their liability is limited to the extent of their capital commitment. GPs have unlimited liability and they get involved with the portfolio companies and tries to add value to them. Private equity funds usually have a limited shelf life and a single firm may raise additional capital and manage several funds at the same time. GPs are paid management fees and performance fees. The management fee is generally 2% of the assets under management and performance fees is 20% of the gains.

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Life Cycle of Private Equity Raising Capital and Building Team Exiting the Investment Stages of Private Equity Sourcing Deal Flow Managing & Improving portfolio

Life Cycle of Private Equity Raising Capital and Building Team: The fund starts by circulating prospectus to investors who then commit to invest in the fund which are called later. It also builds a strong and capable management team. Sourcing Deal Flow: The fund then needs to finalize a target company for investment. It usually reviews hundreds of business plans and performs extensive due diligence on the prospective candidates. Funds are very selective when finalizing the target as they need to ensure that the investment will grow at a significant rate within a certain time frame.

Life Cycle of Private Equity Managing and Improving the Portfolio: These firms usually take active part in the management of their portfolio companies. They generally have some control over the board. The firms try to come up with different strategies to attract potential buyers. Exiting the Investment: The most important part of the process is the exit or sale of investment. It usually takes anywhere between three to ten years to exit an investment. It can be done through initial public offering or sale of company or through merger.

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Private Equity Strategies Private Equity Investing Strategies Leveraged Buyout Venture Capital Growth Capital Distressed Debt Fund of Funds

Leveraged Buyouts LBOs refer to the acquisition of an existing private company through use of leverage to fulfill the cost of acquisition. Leverage refers to the use of debt with a typical 9:1 debt equity ratio. The assets of the company being acquired are used as collateral. Leveraged buyouts can be of two types: management buy-out and management buy-in. The main purpose of a leveraged buyout is to increase the value of the firm through different methods involving new management skills, cost reduction, additional revenue generation.

Venture Capital These funds invest in new or growing businesses which they believe have long term growth potential. The investment is in the form of equity but sometimes can also be in form of convertible preference shares or convertible debentures/bonds. VCs also provide technical and managerial expertise to these companies. The different stages of venture capital investment are: formative stage, later stage and mezzanine stage.

Growth Capital It differs from the other forms of investment in its sector focus, criteria and investment size. It is also known as expansion capital. The investment is usually made in mature companies for expansion or restructuring purposes. It is usually structured as preferred equity.

Distressed Debt It involves purchasing debt of mature companies who are going through financial crisis or difficulties. The risk is very high as the bankruptcy of such company can render the entire investment worthless. The fund takes an active role in the management of the company to again reorganize and help it to become efficient in order to earn profits. It requires lot of expertise and resources to assess companies which have potential for recovery.

Fund of Funds It is investment in other funds. This investment strategy has high diversification and thus lower risk than other strategies. The fees is doubled.

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Valuation The valuation of private equity companies is very similar to valuing a publicly traded company. The difference between their valuations is due to the difference in discount rates or multiples. The different approaches used are: Market Comparables approach Discounted Cash Flow approach Asset Based approach

Exit Strategies Initial Public Offering Secondary Sale Trade Sale Recapitalization Liquidation

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Due Diligence Private equity firms use significant amount of leverage and thus are severally affected by fluctuations in interest rates and other market conditions. The choice of fund manager (General Partner) is very important as it determines the success or failure of the fund. Investors must carefully examine the fee structure and valuation methodology of the fund before investing.

Other Factors for Due Diligence Investment Process Investment Strategy Historical returns Risk management Asset under management Growth plans Management style Appropriateness of benchmark

Concept and Emergence of private equity Structure of private equity firm Life cycle of private equity Types of private equity investments Divestment in private equity fund Due diligence in private equity Risk and Return profile of private equity

Risk and Return Private equity firms have an empirical evidence of above average performance than the overall stock market. They have correlation of less than 1 with the other traditional investment instruments which makes them a valuable addition to a portfolio. The standard deviation for such investments has also been high signifying high risk inherent in this product

Risk and Return As per the graph in the previous slide, the private equity fund has outperformed the index consistently. However, the difference between top quartile and bottom quartile funds is huge making the correct choice of fund a very important factor.

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. Warren Buffett

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