4.1 Private Equity Assets Flashcards
3 major categories of Private Equity
1) Venture capital - start ups
2) Growth equity - non controlling interest in successfully growing companies
3) Buyouts
From the investors perspective payouts to most PE Investments resemble? What does it mean?
Resemble payouts to long out-of-the-money call positions.
This reflecting PE’s frequent losses and sporadic large gains (particularly in venture capital)
Equity kicker?
Right/option to purchase equity stock of the companing
Mezzanine debt?
Debt with an option to convert debt to ownership
Distressed debt?
2 types:
1) Debt in troubled issuers (may go bankrupt, etc)
2) Debt in price distressed assets (selling for significantly below the face value)
Vultures?
Distressed debt investors
Differences between Hedge fund and PE investment strategy regarding distressed debt?
Hedge fund investors aim to earn short-term profits from event-driven/ distressed strategies, the results of which are based on resolution of bankruptcy proceedings.
Leveraged loan?
Loan to companies with bad credit rating or a lot of debt already
Typical size of VC investments & value of companies?
5m average investment
10-100m average value of company
Return expectations of VC investors?
10-20x
Typical Growth equity investment size and requirements?
25m typical investment
At least 100m in size (25-50m annual revenue)
So substantial control by PE investors
Venture Capitalist’s involvement in investment?
Act as advisers or as directors on the company’s board, set goals, and can hire and fire key managers
Provide access to service providers (e.g., accountants, lawyers, consultants, investment bankers) and, to other businesses that may buy the start-up company’s product.
Cash burn rate
Rate at which the company uses up their supplies of cash
How VCs attain ownership in start ups?
By receiving preferred stock or equity linked securities
Why do VCs invest in Convertible preferred stocks?
Provides the right to convert preferred shares to common shares = an implicit call option to share in the upside.
What are debentures and convertible notes (bonds)
Debt securities that are not secured by collateral and may have the right to change to equity
What is follow on financing?
Financing from existing investors
Which option investment resembles a VC investment?
Buying a call option. The investment is the premium paid
What is a 20-bagger?
The investment payout is 20x initial investment
VC Investments skew amd kurtosis?
Both large positive
Prudent person standard (prudent man rule)
That fiduciaries should exercise the same care in investing as they would do for their own portfolio
What did the 1979 rule clarify in relation to the VC investments?
That they should be considered on a portfolio basis = high risk VC investments are allowed however, if they are diversified
5 stages of VC financing
1) angel
2) seed capital
3) first stage/start up/ early stage
4) second/late stage/expansion VC
5) mezzanine VC
Angel investment stage key characteristics?
- No business yet
- test the idea, MVP created, alpha testing (adherence to requirements)
- Team is assembled
- little financing (50-500k)
Seed capital investment stage key characteristics?
- institutional investors start participating
- viability of the product is not established yet
- 1-5m is raised
- prototype is developed & marketing begins
- Beta testing occurs (product shared for free with customers for feedback)
- team assembled
Seed capital investment stage due diligence includes?
- start up team management
- market analysis for demand of product
- feasibility of getting the product to market while there are no competitors
First stage/ start-up / early stage VC investment stage key characteristics?
- Begins when start up company already has a beta tested viable product, BUT commercial viability not established yet
- The product is generating revenues
- At least 2m VC investment
- second round testing by users
- sales have been established, management team already working
- at least 1 VC on board
- financial goal is to break even
Second/later/expansion stage investment stage key characteristics?
- also called formative stage
- product is demonstrating commercial viability = market penetration is established
- company is break even or even showed first profitable quarter
- start up is successful and is growing
- may need additional capital to establish receivables
Mezzanine investment stage key characteristics?
- final stage prior to IPO or being sold to a strategic buyer
- second generation product can be in production/distribution
- borrows convertible/ traditional loan to buy out early investors or to finance costs associated with going public
- company is already a proven winner with a successful track record
What is the J Curve in VC investing?
First stages of investment show negative IRR, later stages show positive IRR (going towards final IRR)
3 categories of VC companies for purposes of VALUATION?
Their main characteristics?
1) Angel stage - inaccurate financial projections because of lack of substantial revenues. Key: identify risks, as their resolve the valuation increases
2) Growth stage - proven concept and revenue. Valuation: compared to other public co’s or VC method (potential exit value and the investor’s target return to determine post money valuation)
3) late stage - proven track record, accurate fin projection. Valuation: DCF analysis and analysis of comparable firms
Why do VC investors do more extensive sector/product DD than financial DD than other PE investors?
Because of a lack of quality comparisons
Enterprise value formula
Equity value + outstanding debt - cash
Value of VC in using EBITDA valuation formula? When is it used?
Value = EBITDA x EBITDA multiple
Used when the long term cash flows cant be projected reliably
How to adjust EBITDA valuation formula to take into account uncertainty?
Value = (EBITDA x EBITDA multiple) / (1+IRR)^T
Where T is years until exit
IRR = required rate of return
Why VC use high IRRs (discount rates)?
1) Start up stage and risk
2) illiquidity
3) compensation for VCs efforts (active investors)
4) adjusted for founders bias (founders often have upward biased cashflows)
IRR in early and later stages of VC investment?
EARLY: 50-70%
LATER: 30-60%
What is PRE MONEY valuation? Based on what is it usually
Valuation negotiated by investor with company’s shareholders prior to new investment round
Post money valuation (POST) formula and meaning?
Value of company right after a new investment
Value = PRE + Investment amount
New investors ownership proportion formula?
VC ownership = Investment / POST
VC Business Plan is used for what? And should include?
1) State business strategy: market and resources needed (expenses, HR, assets)
2) clear, comprehensive and INTERNALLY CONSISTENT
3) 2 main objectives:
- provide info for VCs
- internal plan for start up’s development
4) executive summary and 9 essential components
9 essential components of a start up business plan?
1) market
2) product/ service
3) IP rights
4) Management team
5) Operations
6) Prior operating history
7) Financial statements projections
8) Amount and schedule of financing
9) Exit opportunities for VCs
What is a compound option in the VC world? Example? Value of a compound option?
Compound option= option to buy an option
Ex: start up seeks 200k angel capital for 1 yr, after which it is expected to receive $1 million of seed capital. If the project remains successful, the seed capital may lead to $3 million of early-stage financing
The capital invested in each stage can be viewed as the purchase of a call option on investing in the next stage of the project, which itself is a call option.
Value:
1) ability to defer decision until more certainty is available
2) At compound option expiration date the option is either bought (money invested) or abandoned (project sold/abandoned)
2 keys to successful VC investing?
- Identifying underpriced options by locating potentially valuable projects for which information about profitability can be obtained before committing large amounts of capital.
- Abandoning worthless out-of-the-money options when they are expiring by ignoring sunk costs, and assessing potential outcomes based on objectively analyzing new information.
What is GROWTH EQUITY investing?
- Final financing prior to exit via IPO
- limited involvement into the operations
Growth equity key characteristics?
- Securities - newly originated securities that have a minority position in terms of control, but a relatively high position in terms of priority during liquidation (e.g., convertible preferred equities or debt).
- Source of growth - value of growth equity increases primarily as the company’s revenues and profitability increase
- Cash flow - Growth equity companies have moderate cash inflow from revenues, but little or no free cash flow.
What are protective provisions in growth equity?
Investors have control on major issues (investor consent)
4 key elements of redemption rights in Growth Equity financing?
1) Redemption triggers - time (60-66m after issuance), performance, financial covenant violations
2) redemption value - if redemption is triggered the redemption value is determined as the max of either of the 3:
- original issuance price + preferred return
- multiple of the original issuance price
- fair market value of equity interest
3) source of funds to redeem the investor: (GROWTH EQUITY REDEMPTION SOURCES)
- all legally available funds
- forced sale
- promissory note
- all available means
4) Default remedies (Growth equity default remedies):
- springing board remedy: right to designate a majority of the board of directors
- forced sale remedy
What are redemption rights in Growth Equity financing?
Mechanism through which the investors can redeem positions in the company by specifying triggers and actions
=
force the company to buy back the shares of investor
Valuation of growth equity companies, formula
Value = (annual revenue x revenue multiple) / (1+IRR)^T
4 Types of PE Buyouts
1) management buyout (MBO) inside management team buys
2) management buy in (MBI) - outside management team buys
3) buy in management buyout - combination of management teams
4) secondary buyout - private company sells to another private company
Rescue capital (turnaround capital) strategy?
Provide capital to help established companies recover profitability after undergoing difficulties
Replacement capital (or secondary purchase capital) strategy
Acquires a company’s shares from another PE investment organization
Goals of buyout of private company?
1) To provide capital to optimize company’s efficiencies
2) optimize capital structure
3) exit using IPO
2 key value creation approaches in buyouts?
1) capital structure optimization
2) operational efficiency
Debt to equity rations in LBOs?
9 to 1 = 90% debt, 10% equity
Key periods of LBOs? Key transactions? Levels of leverage?
1) Started after WW2
2) popular in the 1970s, apparent in 1976 (KKR established)
3) 1980s - junk bonds, michael milken (drexel). KKR buys Nabisco - 1989, EFH - 2006 (bankruptcy 2014 due to debt load). 95% leverage
4) 1990s - slowing, increased credit spreads, 75% leverage
5) 2000s - max activity in 2003-2007. Max in 2006-2007 (4k transactions, 760b)
Buyout activity is driven by?
Economic activity & interest rates, credit spreads
3 economic and agency issues of buyouts?
1) segmentation and efficiency of buyout market
2) possible violation of fiduciary duties in case of MBOs
3) perverse incentives to management (want to receive max compensation in case of buyouts)
5 types of LBOs that can create value
1) efficiency buyouts - improve operational efficiencies
2) entrepreneurship stimulators
3) dismantling conglomerates
4) buy and build strategy (buy and combine several companies)
5) turnaround strategy - improve poorly management company
Benefits of LBOs to targets?
Shareholders: premium to market valuation
Management:
1) tax benefit for using leverage
2) less gov oversight
3) improving potential of a business unit/division or whole company
4) may become owners of the business
How are call options and LBOs similar?
Their payoff has large upside potential and relatively low downside risk
3 tranches of LBO financing?
1) senior debt - financing from banks, credit companies, insurance, public debt offerings
2) mezzanine debt - purchased by mezzanine debt funds/insurance companies, etc
3) equity of LBO firm
Benefits of good corporate governance to the public market?
- The governance principles established in the private companies (e.g., proper shareholder monitoring and manager incentives) should remain when the firms subsequently go public
. - LBOs serve as cautionary vehicles to firms with inferior corporate governance practices that they may become targets of takeover attempts.
- The incentive and monitoring schemes that LBO firms implement can serve as examples to managers and shareholders of other firms seeking to improve efficiency.
- LBOs may help to prevent inefficient diversification in conglomerates (for fear that they may be a target of an LBO).
What is Merchant banking?
Practice of financial institutions buying non financial companies.
What are the implications of a winner take all market for the investors?
Investors may increasingly seek:
1) smaller investments in more enterprises
2) investments only with the most talented PE managers.
Implication of longer time horizon to exits?
VCs now have to wait longer to exit investment, increasing ILLIQUIDITY
Potential REASONS FOR DECLINING number of public companies (7,000 in the mid-1990s to less than 5,000 in 2021). Economist:
1) Concerns over increasing regulations.
2) Pressure from shareholders of public companies regarding short-term stock price performance.
3) Decline in IPOs (from an average of 300 per year from 1980 to 2000 to about 100 per year after 2000), which result in fewer entrants to public listings.
6 Exit strategies for PE Investment
1) sale to strategic buyer (strategic merger)
2) IPO
3) another LBO or Leveraged Capitalization (companies stay public)
4) buyout to buyout (sell to another PE firm) - AKA secondary buyout/financial merger
5) direct listing (sell shares directly to the market)
6) Special Purpose Acquisition Corporation (SPAC)
strategic merger?
Sale of a private company to an operating company in the same or adjacent industry
What was the most common exit strategy for Buyout Funds in the 1980,1990,2010s?
1980: 80% exited via IPO,
1990: mostly IPO
2010: 10% via IPO, 90% via mergers
Median age of IPO company? 1996-2001; 2006-2016.
1996-2001 - 4.5yrs
2006-2016 - 6.2-7.8 yrs
When did number of VC backed IPOs peak? What was the median time to IPO in that year?
2021, 6 yrs
IPOs regulatory and annual compliance cost according to IPO Task Force?
2.5m - ipo
1.5m - annual
Underwriters fees
1-7% of of proceeds, the larger the proceeds the lower the %
Steps in the IPO process
1) Draft a prospectus (invest bank, attorneys, accountants)
2) After filing prospectus, quite period until prospectus is approved
3) roadshow (build book order)
4) IPO
Goal of a roadshow?
Oversubscribe the listing (have more demand than supply)
SPAC underwriters fees:
5.5% underwriting fee, including:
2% IPO proceeds
and
3.5% when purchase of business is made
What is a warrant?
A warrant is similar to an option, giving the holder the right but not the obligation to buy an underlying security at a certain price, quantity, and future time.
Issued by a company
Typical pricing of a SPAC
10$ per unit
+
A warrant with a strike price of 11.5$, 5 yr term and a mandatory conversion if the price exceeds 18$ in 30 days (most spacs have a fraction of a warrant)
2 stages of SPACs IPO
1) IPO
2) purchase the company
How much support does a SPAC need to purchase a company?
USA, Canada: simple majority
Malaysia: 75%
SPACs funds regulations
90% of IPO proceeds to be locked up in an interest baring escrow account
Potential skewness of a SPAC?
Potentially positively skewed
How are SPACs like default free convertible bonds?
If the SPAC does not find a company in 2 years, then the investors can just get their money back with interest.
If they do want to participate in the SPAC they can redeem shares and if the price increases convert their warrants to shares
Arbitrage investing with SPACs?
Warrants, unit and shares are traded separately allowing for arbitrage investing
SPACs default free return from 2010 to 2018?
Warrants return in the first year? Business underperforms the market by?
9.3% and 44%, 24%
Good and bad SPACs?
Good: stock prices trading above their redemption value after announcement of the business combination. If investors can sell their SPAC shares for more than they could from redeeming the shares, redemptions will be very low.
Bad SPACs: stock prices trading at or below their redemption value after announcement of the business combination. If
3 potential conflicts of interests in SPACs
1) Sponsors receive up to 20% of SPAC value as “promote” - compensation for sponsor’s services and costs
2) ability to redeem shares for cash while keeping the warrants results in non redeeming shareholders paying most costs
3) Most de-SPACs underperform the public market and traditional IPOs during the first year of trading due to the dilution from warrants and redeeming shareholders
Dilution of SPACs? Impact on returns? Which SPACs tend to under/over perform?
6.67$ in cash (from 10 per share). 50% dilution is common
Impact: less than one-third dilution is 12.7% and to companies with more than one-third dilution is around -21.2%.
Investor led SPACs - underperform, operator led - overperform
How to lower dilution?
1) lower “promote” and lock ups
2) lower redemption rights
3) decrease warrant ratio
How was Pershing Pershing Square Tontine Holdings, structured differently than most SPACs?
1) Each unit of this SPAC consisted of:
i) warrants on 1/9 of a share that can be kept by redeeming shareholders
ii) a warrant 2/9 of a share that can be held by shareholders who do not redeem the stock until after completion of the business combination
2) This SPAC had a tontine-like feature: the warrants forfeited by redeeming shareholders were reallocated to the shareholders who maintain in the SPAC after the de-SPAC transaction.
3) Very low promote of 6.21% held through purchased warrants and received only after shareholders have received a 20% return.
4) Non detachable majority of warrants
What are Tontines?
Tontines are annuities that pay a regular income to all surviving investors, and shares of investors who have died are given to the surviving investors.
Difference between De SPAC and IPO?
1) regulation (spacs allowed to project 3 years of financial info, regulated as a merger)
2) ease of raising capital (spacs are faster because no financial info is needed)
3) timing
Costs of going public via SPACs, IPOs, Direct listings.
Which is most expensive?
What justifies higher costs of going public via SPAC?
1) speed and certainty
2) price and time of closing certainty
3) management assistance
4) only option to go public (for a co which does not qualify to float an IPO)
What characteristic does venture capital and real estate development have in common?
Compound option (i.e., a string of real options), where the option holder delays committing additional capital until new information is received.
The value of the option comes from being able to defer decisions until there is less uncertainty about the investment.
Investment horizon and IRR of VC, Buyout and Growth equity
1) Venture capital has a 5-10 year investment horizon and a target IRR of 30%-60%.
2) Buyouts have a 3-5 year horizon and a target IRR of 20%-35%.
3) Growth equity has a 3-7 year horizon and a target IRR of 25%-40%.
Role of mezzanine financing?
One of the roles of mezzanine financing is to bridge a gap in a firm’s capital structure.
This is usually necessary hen a firm is unable to get full funding from
nior creditors due to a high debt-to-equity ratio or short operating history.
Mezzanine financing is also used to fill a gap in the supply of capital in the financial markets.
Merchant banking is most similar to?
LBOs
Gang, Ritter, and Zhang (2021) equate pre-merger SPACs to what?
Default free convertible bond with extra warrants
What are potential disadvantages of direct listings compared to initial public offerings (IPOs)?
1) They generally require a large existing customer base to guarantee sufficient interest in the offering.
2) They may not attract the desired investor attention due to not using an underwriter
Describe a virtually default-free SPAC arbitrage trade often employed by hedge funds?
Purchase SPAC IPO units for $10, redeem shares for $10 in cash, retain SPAC warrants for the upside
