1. Private Equity
L7: Private Equity: Ch16&19

2. 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 non- public companies to fund the launch, early development or expansion of a business
L7: Private Equity: Ch16&19

3. 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
L7: Private Equity: Ch16&19

4. 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
L7: Private Equity: Ch16&19

5. 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
L7: Private Equity: Ch16&19

6. 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
L7: Private Equity: Ch16&19

7. 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
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L7: Private Equity: Ch16&19

8. 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
L7: Private Equity: Ch16&19

9. Capitalization of Acquired Company
L7: Private Equity: Ch16&19

10. Pay Down Debt During Holding Period
L7: Private Equity: Ch16&19

11. Creating High IRR From Investment
L7: Private Equity: Ch16&19

12. Assets Under Management (AUM)
L7: Private Equity: Ch16&19

13. Assets Under Management (AUM)
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14. Changing Cost of Debt
L7: Private Equity: Ch16&19

15. Availability of Debt
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16. Fancy terms
Bridge loans – intermediate financing for a PE fund to facilitate an acquisition 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

17. Teaming Up With Management
Private equity firms typically make arrangements with management of a target company regarding terms of employment with the surviving company, post- closing 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
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L7: Private Equity: Ch16&19

18. 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)
L7: Private Equity: Ch16&19

19. Secondary Market
A secondary market has developed for private equity as banks, and other 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

20. 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
L7: Private Equity: Ch16&19

21. 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
L7: Private Equity: Ch16&19

22. Organizational Structure
L7: Private Equity: Ch16&19

23. Limited Partners
During the period of time that capital is invested, Limited Partners have very 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
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L7: Private Equity: Ch16&19

24. Limited Partner Defaults
When Limited Partners fail to make a scheduled payment, private equity funds 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 future fund raising
L7: Private Equity: Ch16&19

25. Organizational Structure
L7: Private Equity: Ch16&19

26. 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
L7: Private Equity: Ch16&19

27. 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
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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
L7: Private Equity: Ch16&19

28. Preferred Returns
Most compensation arrangements include preferred returns, which must be 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

29. Hurtle Rates With Catch-Ups
L7: Private Equity: Ch16&19

30. 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
L7: Private Equity: Ch16&19

31. Exits
L7: Private Equity: Ch16&19

32. 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
L7: Private Equity: Ch16&19

33. 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
L7: Private Equity: Ch16&19

34. 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)
L7: Private Equity: Ch16&19

35. 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
L7: Private Equity: Ch16&19