Private Equity 1 L7: Private Equity: Ch16&19
Private Equity 1 L7: Private Equity: Ch16&19 Private Equity Private equity can be broadly defined to include the following different forms of investment: Leveraged Buyout: Leveraged buyout (LBO) refers to the purchase of all or most of a company or a business unit by using equity from a small group of investors in combination with a significant amount of debt. The targets of LBOs are typically mature companies that generate strong operating cash flow Growth Capital: Growth capital typically refers to minority equity investments in mature companies that need capital to expand or restructure operations, finance an acquisition or enter a new market, without a change of control of the company Mezzanine Capital: Mezzanine capital refers to an investment in subordinated debt or preferred stock of a company, without taking voting control of the company. Often these securities have attached warrants or conversion rights into common stock Venture Capital: Venture capital refers to equity investments in less mature nonpublic companies to fund the launch, early development or expansion of a business 2 L7: Private Equity: Ch16&19 Private Equity – focus on LBO Although private equity can be considered to include all four of these investment activities, it is common for private equity to be the principal descriptor for LBO activity Investment firms that engage in LBO activity are called private equity firms, buyout firms or financial sponsors The term financial sponsor comes from the role a private equity firm has as the “sponsor”, or provider, of the equity component in an LBO, as well as the orchestrator of all aspects of the LBO transaction, including negotiating the purchase price and securing debt financing to complete the purchase Private equity firms are considered “financial buyers” because they don’t bring synergies to an acquisition, as opposed to “strategic buyers”, who are generally competitors of a target company and will benefit from synergies when they acquire or merge with the target 3 L7: Private Equity: Ch16&19 Leveraged Buyouts The purchased company's balance sheet is leveraged to reduce the investor's cash commitment. The LBO firm will seek to exit their investment within 3-7 years Exit strategies are principally M&A sales or IPOs Targeted IRRs are >20% Prospective LBO candidates commonly include: Divisions of large corporations which become free-standing Private companies acquired from founders Publicly held companies that are taken private 4 L7: Private Equity: Ch16&19 Characteristics of a Private Equity Transaction a company or a business unit is acquired by a private equity investment fund that has secured debt and equity funding from institutional investors such as pension funds, insurance companies, endowments, fund of funds, sovereign wealth funds, hedge funds and banks, or from high net worth individuals The high debt levels utilized to fund the transaction increases the return on equity for the private equity buyer, with debt categorized as senior debt and subordinated debt If the target company is a public company, the buyout is “going private”. The newly private company will be resold in the future (typically 3 to 7 years) through an IPO or private sale to another company Most private equity firms’ targeted internal rate of return (IRR) during the holding period for their investment has historically been above 20% The general partners commit capital to the transaction with limited partners Management of the target company usually also have a meaningful capital exposure to the transaction 5 L7: Private Equity: Ch16&19 Target Companies for Private Equity Transactions For an LBO transaction to be successful, the target company must generate a significant amount of cash flow to pay high debt interest and principal payments and, sometimes, pay dividends to the private equity shareholders. Here are the main characteristics: Motivated and competent management Robust and stable cash flow Leveragable balance sheet Low capital expenditures Asset sales and cost cutting Quality assets 6 L7: Private Equity: Ch16&19 History of PE The first LBO transaction was completed in 1955 Warren Buffet and Nelson Peltz made leveraged investments Kohlerg Kravis & Roberts (KKR) In 1980s, LBOs were known as corporate raids Michael Milker and junk bonds Few LBOs during 1990s In 2000s (before the crisis), grow in LBOs again By the end of 2007, no debt available to support large private equity transactions Page 289-292 7 L7: Private Equity: Ch16&19 Participants Private Equity Firm: also called LBO firm, buyout firm or financial sponsor Investment Banks Introduce potential acquisition targets to PE firms Help negotiate acquisition price Provide loans or arrange bond financing Arrange exit transaction Investors: also called Limited Partners Management Co-invest with the PE firm: both will do very well if there is a successful exit Accept lower cash compensation, but also receive options and other forms of incentive compensation 8 L7: Private Equity: Ch16&19 Capitalization of Acquired Company Portfolio Company Capitalization • • 9 Debt (~60-70% of overall cap structure) o Senior bank debt, two types: Revolving credit facility (Revolver) which can be paid down and re-borrowed as needed Term debt (senior and subordinated) with floating rates o Junior debt, two types: High yield (typically public markets) Mezzanine debt (subordinated notes, typically sold to banks, institutions and hedge funds) Other key features: – Warrants – Payment-in-kind (PIK) toggle allows no interest payment and increase in principal Equity (~30-40% of overall cap structure) o Preferred stock o Common stock L7: Private Equity: Ch16&19 Pay Down Debt During Holding Period LBO Objective: Pay Down Debt During Holding Period Initial: Acquired for 8.0x LTM EBITDA of $125.0 Future: Sold for 8.0x LTM EBITDA of $137.5 Future $1,000 $350 $650 Source: Training the Street, Inc. 10 $1,100 Initial L7: Private Equity: Ch16&19 Equity Equity $725 Debt $375 Debt Creating High IRR From Investment LBO: Three Ways to Create Returns Assume the Target company was acquired for 8.0x LTM EBITDA of $125.0 1. Deleveraging 2. Deleverage & Improve Margins 3. Deleverage, Improve Margins & Multiple Expansion Sources of Funds Total Debt $650.0 $650.0 $650.0 350.0 350.0 350.0 $1,000.0 $1,000.0 $1,000.0 $167.6 $212.3 $212.3 125.0 164.5 164.5 8.0x 8.0x 9.0x Transaction Value 1,000.0 1,316.0 1,480.5 +/- Net Debt1 (482.4) (437.7) (437.7) Equity Value $517.6 $878.2 $1,042.8 8.1% 20.2% 24.4% Total Equity Total Year 5 Assumptions Cumulative Excess Cash to Repay Debt Projected EBITDA Assumed Exit Multiple IRR Returns (5-Yr Exit) Note 1: Total Debt - Cumulative Excess Cash to Repay Debt = Net Debt Source: Training the Street, Inc. 11 L7: Private Equity: Ch16&19 Assets Under Management (AUM) Private Equity Assets Under Management Reached $1.2 Trillion in 2008 Leveraged buyout assets under management 1, 2003 – 2008, $ in billions $1,249 30 70 Rest of World Asia Europe North America $906 $679 $478 $399 4 6 134 12 $401 2 13 143 4 22 183 8 32 15 45 +38% 399 293 241 750 553 225 243 269 2003 2004 2005 398 2006 2007 2008 Note 1: Assets under management defined as sum of funds raised in the current year plus the previous four years. L7: Private Equity: Ch16&19 Source: McKinsey Global Institute; Preqin Assets Under Management (AUM) 2005 Global Allocations to Private Equity LBO Funds by Type of Limited Partner Banks Investment 4% companies 5% Other 2 8% Private equity fund of funds1 37% Endowments / foundations 6% Insurance companies 7% Corporate pension funds 10% 13 Public pension funds 23% Note 1: Assets come from pensions, other institutions, and wealthy individuals. Note 2: Includes wealthy individuals. L7:McKinsey Private Equity: Ch16&19 Source: Global Institute; Preqin Changing Cost of Debt Private Equity Deals Post-Credit Crisis: More Expensive Debt Average Spread of Leverage Buyout Loans (bps over LIBOR) +450 Credit Crisis +400 +350 +300 +250 +200 97 98 99 Source: Standard & Poor’s 14 L7: Private Equity: Ch16&19 00 01 02 03 04 05 06 07 08 2H-08 Availability of Debt Debt Available to Private Equity Dropped 96% from Q1 2007 to Q4 2008 U.S. and European syndicated corporate debt issued to financial sponsors, $ in billions $283 $270 Europe North America 108 $200 142 $157 $138 $134 $151 175 128 62 Q1-06 15 Q2-06 -96% 24 79 82 $161 51 75 72 75 101 125 60 Q3-06 Q4-06 Note: Figures may not sum due to rounding. L7: Private Equity: Ch16&19 Source: McKinsey Global Institute; Dealogic Q1-07 Q2-07 Q3-07 $68 $66 31 25 $37 38 41 20 18 Q1-08 Q2-08 Q3-08 137 Q4-07 $12 7 6 Q4-08 Fancy terms Bridge loans – intermediate financing for a PE fund to facilitate an acquisition 16 until permanent debt is obtained. Equity bridges – loans provided by banks to temporarily cover the equity commitment of a PE fund Covenant-lite loans: eliminate borrowers to maintain certain financial ratios PIK toggle: offers a borrower with a choice regarding how to pay accrued interest: 1) pay interest completely in cash, 2) pay interest completely “in-kind” by adding to the principal amount Club transactions – co-invest in a target company Stub equity – let public shareholders of a target continue to own equity in a company that is purchased by PE funds. L7: Private Equity: Ch16&19 Teaming Up With Management Private equity firms typically make arrangements with management of a target company regarding terms of employment with the surviving company, postclosing option grants and rollover equity (the amount of stock that management must purchase to create economic exposure to the transaction) prior to executing definitive agreements with the target Teaming up with management can potentially trigger a target’s takeover defense, including poison pills, if management owns more than 15% of the target’s stock. Poison pill: aka shareholder rights plan. The typical shareholder rights plan involves a scheme whereby shareholders will have the right to buy more shares at a discount if one shareholder buys a certain percentage of the company's shares. Management buyout – MBO Page 296 17 L7: Private Equity: Ch16&19 Leveraged Recapitalization A leveraged recapitalization of a private equity fund portfolio company involves the issuance of debt by the company some time after the acquisition is completed, with the proceeds of the debt transaction used to fund a large cash dividend to the private equity owner This action increases risks for the portfolio company by adding debt, but enhances the returns for the private equity fund Although the provider of the debt in a leveraged recapitalization is undertaking considerable risk, they are generally paid for this incremental risk through high interest payments and fees Employees and communities can also be harmed if the increased leverage results in destabilization of the company because of inability to meet interest and principal payments (employees can lose their jobs and communities can lose their tax base if the company is dissolved through a bankruptcy process) 18 L7: Private Equity: Ch16&19 Secondary Market A secondary market has developed for private equity as banks, and other 19 financial institutions attempt to sell their private equity investments to reduce the volatility of earnings and rebalance portfolios In addition, individuals and institutional investors are also sellers of limited partnership interests in private equity funds Secondary market sales fall into one of two categories: the seller transfers a limited partnership interest in an existing partnership that continues its existence undisturbed by the transfer, or the seller transfers a portfolio of private equity investments in operating companies Sellers of private equity investments sell both their investments in a fund and also their remaining unfunded commitments to the fund Buyers of secondary interests include large pooled investment funds and institutional investors, including hedge funds L7: Private Equity: Ch16&19 Fund of Funds A private equity fund of funds consolidates investments from many individual and institutional investors to make investments in a number of different private equity funds This enables investors to access certain private equity fund managers that they otherwise may not be able to invest with, diversifies their private equity investment portfolio and augments their due diligence process in an effort to invest in high quality funds that have a high probability of achieving their investment objectives Private equity fund of funds represent about 15% of committed capital in the private equity market 20 L7: Private Equity: Ch16&19 Organizational Structure A private equity fund is usually structured as a limited partnership that is owned jointly by a private equity firm (General Partner) and other investors such as pension funds, insurance companies, high net-worth individuals, family offices, endowments, foundations, fund of funds and sovereign wealth funds (all of which are Limited Partners) The General Partner manages and controls the private equity fund Private equity investments are channeled through a new company (NewCo) that receives equity investments from a private equity fund and management of the target company and debt financing from lenders and bond investors The proceeds of the debt and equity capital received by NewCo are then used to acquire the target company 21 L7: Private Equity: Ch16&19 Organizational Structure Ownership of a Private Equity Fund Limited Partners (Investors) General Partner (Private Equity Firm) Fund-of-funds, public and corporate pension funds, insurance companies, endowments, foundations, high net-worth individuals, family offices, banks, sovereign wealth funds, etc. Manages the fund NewCo (Investment) 22 L7: Private Equity: Ch16&19 Private Equity Fund (Limited Partnership) NewCo (Investment) NewCo (Investment) NewCo (Investment) Limited Partners During the period of time that capital is invested, Limited Partners have very 23 limited influence on how the capital is spent as long as the fund adheres to the basic covenants of the fund agreement Some of these covenants relate to restrictions on how much capital can be invested in any one company and the types of securities in which the fund can invest In addition to management fees and carried interest, the General Partner sometimes receives deal and monitoring fees from portfolio companies in which the fund has invested Some Limited Partners have objected to this arrangement and insist on applying deal and monitoring fees to reduce the management fees or splitting such fees 50/50 or 80/20 with the General Partner Page 356 L7: Private Equity: Ch16&19 Limited Partner Defaults When Limited Partners fail to make a scheduled payment, private equity funds 24 must consider how to cover the missed contributions, how to treat the Limited Partner and how and whether to replace the unfunded commitment Most partnership agreements permit the defaulted amount to be called from other Limited Partners, but there are sometimes caps on the replacement amounts that can be called Some agreements allow the partnership to borrow to cover the defaulted amount or to offset amounts distributable to cover the defaulted amount In the event of a default, the General Partner generally has sole discretion regarding what measures to take In theory, the General Partner may be able to convince a court to require a Limited Partner to honor its capital contribution obligations However, General Partners have historically been reluctant to sue their investors based on the concern that this action would have a negative impact on futureEquity: fundCh16&19 raising L7: Private Organizational Structure NewCo Funding and Investing Private Equity Fund and Management of Target Equity of NewCo Cash Target Co. Shareholders Cash Equity Assets Debt Stock Lenders Cash NewCo • Target company shareholders sell shares (or assets of target) for cash o Potential for some shareholders to “rollover” and participate in upside • Cash paid by NewCo is funded by lenders and private equity fund (and management investments) o Cash flow from NewCo/Target Co. is used to service debt payments 25 Source: Training the Street, Inc. L7: Private Equity: Ch16&19 Taxes The organizational structure of the private equity fund is developed with a view to maximizing incentive compensation for the General Partner (GP) and tax considerations are paramount The GP earns compensation based on their management of the fund (management fees usually equal about 2% of the assets under management and carried interest is approximately 20% of the profits of the investment activity) Carried interest has historically been considered for tax purposes as an allocation of a portion of the partnership’s profits, which allowed capital gains treatment (historically a 15% rate, rather than ordinary income treatment, which could be as high as 37%) However, the Dodd Frank Act requires carried interest to be treated as ordinary income instead of capital gains, causing a significant reduction in GP net compensation 26 L7: Private Equity: Ch16&19 Compensation Management Fee: Usually 2% of total capital commitments until the end of a four to five-year investment horizon, and then 2% of unreturned funded capital thereafter (declining as investments are sold or realized) Carried Interest: This is an incentive payment that will be paid (after a Preferred Return is obtained by Limited Partners) to create a80/20 split in profits between Limited Partners and General Partners (subject to a Clawback) A Clawback is a contractual provision applied at the liquidation and winding up of a fund that adjusts distortions in compensation to General Partners based on the timing of gains and losses, obligating the General Partner to return a portion of prior distributions of carried interest for redistribution to Limited Partners Page 353 Portfolio Company Fees and Expenses: Paid directly by portfolio companies to the private equity firm based on the following fees and expenses Additional Costs: In some cases, a number of additional costs can be imposed 27 L7: Private Equity: Ch16&19 Preferred Returns Most compensation arrangements include preferred returns, which must be 28 paid to Limited Partners (after return of capital) before carried interest is paid to General Partners There are two different ways to apply preferred returns: pure preferred returns and hurdle rates with catch-ups A pure preferred returns approach provides that the carried interest percentage is applied only to profits in excess of a specified return The effect of this is to reduce carried interest as a percentage of total profits However, a hurtle rate with catch-up provision approach can eliminate this negative outcome for the General Partner if total investment returns are high This approach usually provides that a carried interest percentage is applied after returns exceed a predetermined hurdle rate: an absolute rate, or the yield on a changeable rate such as one-year U.S. treasuries, LIBOR, or the S&P 500 L7: Private Equity: Ch16&19 Hurtle Rates With Catch-Ups Preferred Returns Catch-Up Provision • A General Partner catch-up provision can eliminate the negative consequences of a pure preferred return carve out for Limited Partners if investment returns are high enough. An example follows: o For ease of reference, assume the following carried interest formula: 1) 100% of profits (after investor capital is returned) are allocated to Limited Partners until they have received a pure preferred return of 8%, after which 2) 100% of profits are allocated to the General Partner until the General Partner has received 20% of cumulative profits. 3) All remaining profits are allocated 80% to the Limited Partners and 20% to the General Partner (the General Partner also shares in the 80% profit allocations to the extent of its investment in the fund). • In this example, if total profits equal or exceed a 10% return, the General Partner receives 20% of total profits and the interim allocations of the preferred return are ultimately without economic substance. At lower return levels, the outcome is different. • Therefore, an important factor in evaluating a carried interest formula which has a preferred return is whether there is a General Partner catch-up. This is an area where there remains substantial variation. • While the General Partner catch-up allocation is often 100%, it is not uncommon to see interim allocations of 80% to the General Partner and 20% to the Limited Partners. Source: Schell, James M. Private Equity Funds: Business Structure and Operations. Law Journal Press, 1999, pp2-16. 29 L7: Private Equity: Ch16&19 Closed End Funds Most private equity funds are “closed-end” funds, meaning that Limited Partners commit to provide cash for investments in companies and pay for certain fees and expenses, but they cannot withdraw their funds until the fund is terminated This compares with mutual funds where investors can withdraw their money any time The General Partner in a private equity fund usually commits at least 1% of the total capital and the balance is committed by Limited Partners These funds are normally invested over a four to five-year period and then there is a five to eight year period during which the fund will exit investments and return capital and profits to all partners 30 L7: Private Equity: Ch16&19 Exits Exit Characteristics of Leveraged Buyouts Across Time Year of original LBO Type of exit: Bankruptcy IPO Sold to strategic buyer Secondary buyout Sold to LBO-backed firm Sold to management Other/unknown No exit by Nov. 2007 % of deals exited within 24 months (2 years) 60 months (5 years) 72 months (6 years) 84 months (7 years) 120 months (10 years) 19701984 19851989 19901994 19951999 20002002 20032005 20062007 Whole period 7% 28% 31% 5% 2% 1% 26% 6% 25% 35% 13% 3% 1% 18% 5% 23% 38% 17% 3% 1% 12% 8% 11% 40% 23% 5% 2% 11% 6% 9% 37% 31% 6% 2% 10% 3% 11% 40% 31% 7% 1% 7% 3% 1% 35% 17% 19% 1% 24% 6% 14% 38% 24% 5% 1% 11% 3% 5% 9% 27% 43% 74% 98% 54% 14% 47% 53% 61% 70% 12% 40% 48% 58% 75% 14% 53% 63% 70% 82% 13% 41% 49% 56% 73% 9% 40% 49% 55% 13% 12% 42% 51% 58% 76% Note: The table reports exit information for 17,171 worldwide leveraged buyout transactions that include every transaction wi th a financial sponsor in the Capital IQ database announced between 1/1/1970 and 6/30/2007. The numbers are expressed as a percentage of transactions, on an equally-weighted basis. Exit status is determined using various databases, including Capital IQ, SDC, Worldscope, Amadeus, Cao, and Lerner (2007), as well as company and LBO firm web sites. Source: Kaplan, Steven N. and Per Strömberg. “Leveraged Buyouts and Private Equity.” Journal of Economic Perspectives, Vol. 23, No. 1, Winter 2009, p129. 31 L7: Private Equity: Ch16&19 Regulations Historically, in the U.S., the SEC has generally not imposed registration requirements on managers of private equity funds because most managers of private equity funds manage 14 or less funds, and therefore qualify for exemption from registration under the Investment Advisers Act of 1940 However, new regulation eliminates this exemption, requiring all managers of private equity funds with assets under management of greater than $30 million to register as investment advisers with the SEC Although this regulation does not subject private equity funds to the same expansive regulation as mutual funds and other types of registered investment companies, private equity funds are subject to reporting, books and records, and anti-money laundering requirements In addition, they must cooperate with SEC examination requests 32 L7: Private Equity: Ch16&19 Regulations Although there are fewer regulations imposed in the U.S. on private equity funds compared to mutual funds, private equity funds and fund managers must comply with a number of regulations under federal law, including the following: Annual Privacy Notices Supplemental Filings Pursuant to the Investment Advisers Act of 1940 Filings Pursuant to the Securities Exchange Act of 1934 ERISA-Related Filing Private Placement Limitations Anti-Fraud Rule Investment Advisors Act of 1940 Investment Company Act of 1940 33 L7: Private Equity: Ch16&19 FASB 157 Historically, private equity funds valued assets at cost or used the latest round of financing as the basis for determining fair value However, in November 2008, FASB 157 changed the method for deriving fair value and the amount of disclosure regarding how fair value is determined During 2008 and 2009, Limited Partners received valuation disclosures for some portfolio companies that showed dramatically lower values than were previously disclosed because of contraction in earnings and multiples For example, for a hypothetical buyout in 2007, a company’s EBITDA may have been $100 million and a private equity fund may have purchased the company at an enterprise value/EBITDA multiple of 10x, funding the purchase with 60% debt ($600 million) and 40% equity ($400 million) If, during 2008, the company’s EBITDA dropped to $66.7 million and comparable companies multiples dropped to 9x, the portfolio company’s equity would be wiped out, assuming an unchanged debt amount of $600 million (9 x $66.7 = $600 million, which equals the debt obligation, leaving no equity value) 34 L7: Private Equity: Ch16&19 Secondary Market A private equity secondary market enables Limited Partners and new investors to buy and sell private equity investments or remaining unfunded commitments to funds Private Equity Secondary Market Negotiated purchase price ($) Secondary Buyer Transfer of Limited Partnership interest in private equity fund, or interest in portfolio company(s) 1 Selling Limited Partner Unfunded obligations also assumed GP approval for transfer required General Partner Note 1: The most basic secondary transaction involves an investor selling its limited partnership interest in a fund. In some instances, however, a portfolio of direct company interests may be be sold instead. 35 L7: Private Equity: Ch16&19
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