10 - Private Equity

Question 1

What is private equity? (4)

Answer 1

Performs functional responsibilities of:

1. A source of capital for enterprises in addition to that available through public capital markets
2. Participation in M/A activity
3. Development of privately owned company for re-sale
4. “Hive-off” of a business conglomerate

Question 2

Types of PE transactions

Answer 2

• Purchase of a private company (e.g. family companies): source of expansion capital and management to develop company for trade sale or IPO, converting assets from fixed to liquid
• Purchase of a public company: M/A
• Purchase of division of publicly listed company

Question 3

Who are private equity investors?

Answer 3

• Direct investment: made by PE firms in other firms that are seeking expansion capital or have been identified as a buy out target (specific firms)
• Indirect investment: represents the equity component in direct investment. Represents capital contributed by those that invest in the funds controlled by PE firms (i.e. many companies over time)
• Also have funds of funds, whereby investors (ret/inst) investing in a diversified fund of PE funds
• Individuals with substantial net worth

Question 4

Who are the parties involved?

Answer 4

1. Investors: public and corporate pension funds, evaluate manager performance for choice
2. Seekers of PE involvement: normally firms that cannot raise financing directly from debt or public equity markets
3. PE fund: mostly closed structures (set amount), typically money is held for at least 5 years

Question 5

Nature of investment in PE fund

Answer 5

• Investors have their monies returned for successful projects within a particular time frame (5-10yrs)
• Each fund has a specific mandate, which details the industry/country of the investments
• J curve effect: initially negative returns for investors
• Managers will assess hundreds of potential investments, and conduct due diligence on around 10%

Question 6

Legal structure of PE fund

Answer 6

Limited partnership consists of:

• General partners, who are directly responsible for the limited partnership and face unlimited liability jointly and severally for all its debts and obligations
• Limited partners are passive investors who do not normally participate in management. Provided they remain passive, their liability to contribute to debts and obligations is limited to their contribution to capital
• Each partnership has a contractually fixed lifetime

Question 7

Fee structure of PE fund

Answer 7

• Fund managers receive a management fee based on the size of the fund (1-2%)
• Also receive a share of the capt gains (around 20% of the return-after fee reduction-in excess of specified return. If the return is not met, the manager receives no share in capital gains
• “2 and 20 rule”
• In addition, significant monitoring and transaction fees are paid. These are negotiated directly between the company and the PE firm

Question 8

Issues with outsider finance of a firm’s investment activity: 1. Sorting problems

Answer 8

• Investors engage in intensive pre investment due diligence and post investment monitoring: little or no info publicly available; these activities are not efficiently performed in large numbers
• Many pension and investment funds require due diligence as a condition of investment

Question 9

Issues with outsider finance of a firm’s investment activity: 2. Incentive problems

Answer 9

• Reputation plays an important role, so a “track record” is important for the performance rewards to a portfolio firm’s senior managers
• The portfolio senior managers also frequently own a significant share of the company’s stock, so benefit in cap gains goes beyond the 2/20 rule

Question 10

Typical capital structure for purchase of an investee company

Answer 10

Leveraged buyout: Equity/Debt = 30/70

Debt usually consists: 50% senior, 10% subordinated, 10% mezzanine (hybrid)

Question 11

Benefits of PE for firms

Answer 11

1. For investment in firms seeking expansion capital: injects both capital and non financial skills
2. For takeovers: aligns interests between SHs, owners, management; establishes long term focus; detailed due diligence conducted (S/W of company, dynamics of industry, potential growth; long term plan produced.
3. For direct investment in firms perceived to be potential takeover targets: minimal for the firms, other than prompting improved performance

Question 12

Benefits of PE for investors

Answer 12

• Can achieve higher rate of return than traditional investment
• BUT more risk and lower liquidity
• Diversification: low correlation with traditional asset classes (i.e. when market is down, PE is up)

Question 13

Limitations to investment in PE funds

Answer 13

-Asset class is illiquid (funds required for medium term 1-3 years (j curve), withdrawal of funds jeopardises whole fund’s performance, parcels of $10m or more

Question 14

PE exit strategy

Answer 14

• Objective is to eventually dispose of the investment at a substantial capital profit
• Time scale: 2-10 years
• Voluntary realisations:
• -Trade sale to another industrial company (common)
• -Repurchase of venture capitalist’s shares by entrepreneur
• -IPO