6. Private Equity Flashcards
Private Equity
Investment strategies the invest in privately traded equity. Typically higher risk, long term strategies that require extensive due diligence.
Private Equity Investment Types
- Venture Capital
- Leveraged Buyout
- Mezzanine Financing
- Distressed Debt Investing
Private Equity Firms
Intermediaries who both raise and manage the investments of these funds. PE firms act as general partner. Firms can be publicly traded, i.e. KKR or Blackstone.
Limited Partnership Agreement (LPA)
Defines legal framework. In general, life expectancy of firm is 7-10 years, possible extension of 3 years. Share of the fun NOT registered with the SEC, thus can not be traded on public exchanges.
Portfolio Companies
Private equity funds invest in PE portfolio companies, which are investments in underlying business enterprises.
Vintage Year
Calendar year that a private equity fund was established and the first drawdown of capital was made.
Venture Capital
- Equity investment in start up ventures
- often insufficient tangible assets
- generally negative cash flow for first few years
- strat: loss on many, windfall on few
- illiquid investment
- very active role in portfolio companies
- capital commitment 5-10 years
First Venture Capital Firm
American Research and Development
- formed in 1946
- publicly traded, closed end fund
First VC Limited Partnership
Draper, Gaither & Anderson
- 1958
Prudent Person Standard
1979
- defines the fiduciary responsibilities of trustees, was changed to allow venture capital investments if the investments are deemed to be prudent in the context of an entire portfolio of assets.
- called for investment suitability to be judged on pre-investment basis.
- **allowed for pension managers to invest
Leverage Buyout
Take a public company private by purchasing all outstanding stock using a large quantity of borrowed capital (as much as 90%),
- typically financed using firm’s assets and cash flows to secure debt financing.
- long term and illiquid
Management Buyout
Leveraged buyout when investors are the firm’s current management team.
Goals of LBO Transactions
- **unlock hidden value by:
- expand balance sheet capacity of firm (use more debt)
- actively manage firm
- replace management with professional managers
- use debt to realize tax advantages
- refocus the firms business plan towards value creation
- align management’s interests with shareholder’s interests
History of LBO
1960’s: year after WWII, first LBO created
1960: Bear Stearns conduct several LBOs
1976: KKK founded by formed Bear Stearns.
1980’s: Junk Bonds grew in popularity
1989: KKR bought RJR Nabisco for 31 billion
1990’s: LBO declined
2000’s: burst of tech, slowed LBO
03-07: low interest rates incr LBO, KKR buyout TXU for $ 32 billion.
2008: credit crisis
1976
KKK founded by formed Bear Stearns LBO team. Leading firm in 70’s and 80’s.
Micheal Milken
Powerful junk bond trader at his firm Drexel Burnham Lambert in mid-80’s.
1989 KKR Buyout
KKR bough RJR Nabisco
LBO Transaction in 1990’s
Decline in number of transactions
- US in recession 90-91
- 1998 Russian govern defaulted on treasury bonds
1998
Russian government defaulted on treasury bonds.
2006 KKR Buyout
TXU for $32 billion
Merchant Banking
Purchase of nonfinancial firms by financial institutions; similar to LBO.
-merchant bank always the general partner
Mezzanine Debt
- hybrid of debt & equity that falls btw senior secured debt and equity in cap structure
- typical form: intermediate term bond with equity kicker
- bond payment: may be cash or more debt
- form: senior subordinated debt, convertible subordinated stock, convertible preferred.
- falls btw junk bonds and story credits
- financing for middle market companies
- generally $5-$50 million
- customized & negotiated between counterparties
- ** used to bridge financial gaps as a firm grow and evolves.
Story Credits
Loans to a company with a good story and atypical situation, rather than a strong credit history.
Middle Market Companies
Firms with capitalization of $200 million to $2 billion.
Distressed Debt
-Debt securities issued by companies that are in financial hardship. DD investors sometimes called vultures DD investor goals: - profit on quick turnaround - cheaply gain equity stake Sources of risk: business & liquidity
Terms to Qualify as Distressed Debt
- no universal definition, but generally meets one or more of the following:
- low credit rating, below CCC, Caa
- mrk value of debt issue lower than 50% of principal
- yield to maturity at least 10% higher than risk free
Growth of Distressed Debt
- grew substantially between 2000-2009
1. new types of commercial loans
2. active portfolio management
3. increased debt levels
4. increase in M&A and buyouts
5. growth in covenant loans
Charge- off Loans
Bad debts that have been deems uncollectible by a creditor and are therefore written off as a loss.
Haircut/Margin
reduction in the value from a security’s purchased price to it’s current price.
Ex: bond bought at 1000, now worth 400, has experienced 60% haircut.
Positive Covenants
Require debtor to take certain actions, such as paying interest, principal, taxes, complying with loan agreements, and maintaining properties.
Negative Covenants
Prohibit borrower from taking certain actions, usually requiring the borrower to maintain certain ratios at specific levels.
Covenant-light Loans
Are debtor friendly leveraged loans with fewer covenant protections for the lender.
Incurrence Covenant
The company must meet any specific criteria (e.g., a debt to earnings ratio lower than 4.0) when a specific action is taken, such as issuing new debt.
-Can violate criteria, as long as not a result of the action being taken.
Maintenance Covenant
The company must meet certain criteria on a regular basis and failure to meet the specific criteria is a violation of the covenant regardless of the reason for the violation.
Leveraged Loans
Loans made to borrowers who do NOT carry an investment grade credit rating.
- considered absolute return prodcut
typically meets one or more of the following:
1. borrower’s debt below investment grade rating
2. loan carries greater spread than 125 basis points over LIBOR
3. loan is subordinated to other senior secured loans
Loan Syndication
Several lenders provide various parts of a large loan, which is administers by one or more commercial or investment banks.
Secondary Market for Leveraged Loans
Mid-1990s: institutional investors used bank loans
1995: Moody’s decided to give credit ratings to bank loans
Advantages of Secondary Markets
- Greater access to future PE funds
- More effective vintage year diversification
- Faster profit realization
- Opportunistic buying
Private Investment in Public Equity (PIPE)
An investor group deals directly with a public firm to acquire a private equity position. Public firms sell unregistered securities to institutional investors.
- Securities can’t be sold till registered with SEC
- stock often sold at sizable discount to market price
- often the case that sold with agreement shares will be registered within 6 months
Types of PIPEs
- Registered Common Stock
- Privately Placed Common Stock
- Convertible Preferred Stock or Convertible Debt
- Equity Line of Credit
Registered Common Stock (use in PIPE)
Issued privately to a limited set of investors under an existing registration with the SEC. Typically only sold at a small discount to the public shares.
Privately Placed Common Stock (use in PIPE)
Unregistered shares that are not tradable in the public markets. Sold at a significant discount to the public shares.
Convertible Preferred Stock or Convertible Debt (use in PIPE)
Unregistered private placement of convertible securities. Offers flexibility to the issuer and a significant discount to the investor, who also obtains seniority to common shareholders. The issuer normally agrees to register the securities within six months after the close of the offering.
Equity Line of Credit (use in PIPE)
The issuer agrees to sell a specific number of registered shares to the investor at regular invervals 9e.g. semiannually)
Reasons to Engage in PIPEs
Discount associated with PIPEs key reason for PE firms.
Public firms engage because PIPEs are less costly and can be done relatively quickly compared to a public offering.
Traditional PIPEs
Issuer privately sells convertible debt or convertible preferred stock with a FIXED common equity conversion ratio.
Structured PIPEs
Floating convertibles, reset convertibles, reset common equity, or reset convertible preferred stock are issued.
Number of shares received by PIPE investor increases as the price of the common stock decreases.
Toxic PIPEs
Occurs when a structured PIPE receives greater and greater amounts of common equity as the price of the issuer’s stock falls.
- creates a death spiral
Death Spiral (PIPE investing)
Investors short the stock, putting pressure and driving price down. The conversion ratio continues to grow, until finally investors either:
- Convert to common equity and cover shorts
- Effectively take control of the company
Deal Term Advantages for HF over PE Firms
- HF incentive fees based on changes in NAV vs. PE based on realized profits
- HF typically do not have clawback provisions, while PE do
- HF specify lower hurdle rates which makes them more aggressive in bidding process
- HF receive incentive fees earlier than PE managers do
- HF collect incentive fees ongoing basis, PE only upon exit
- HF receive incentive fees anytime, PE only when capital returned to investors
Venture Capital Portfolio Companies
Focus on the firm’s business plan.
Components of a Business Plan
- Market
- Product
- IP Rights
- Startup Management Team
- Operations
- Prior Operating History
- Financial Forecasts
- Financial Schedule
- Exit Plan
Venture Capital Financing
structure: limited partnership with VC as the general partner and other investors as limited partners
Three main protective covenants:
1. Cov regarding fund management
2. Cov regarding general partner activities
3. Cov regarding allowable investments
Gearing
Refers to a fund adopting a more risky investment style that includes leverage.
Fee Structure of Venture Capital
Typical Management Fee 1-3.5%
Typical Incentive Fee 20%
Management fee assessed on committed capital
VC paid percentage of profits or 0
Typical Covenants to prevent increased volatility:
1. Clawback provision
2. Escrow agreement
3. Prohibition on Distribution of Profit Sharing Fees
Clawback Provision
Grants the limited partners the ability to reclaim incentive fees at liquidation if they have experienced a loss of capital.
VC Escrow Agreement
Requires that a portion of the VC’s incentive fess be held in a separate account until all limited partners have earned a profit.
VC Prohibition on Distribution of Profit Sharing Fees
Ensures that the capital is returned to the limited partners before fees are paid to the venture capitalists.
Life Cycle of VC Fund
- Fundraising
- Sourcing Investments
- Investment Commitment
- Investment Management
- Fund Liquidation
VC Stage_ Fundraising
The VC obtains capital commitments from investors.
No funds invested during this period.
Typically six months to a year
VC Stage_ Sourcing Investments
- After fund is closed to new investors, VC begins reviewing potential opportunities.
- No funds invested
- Fund managers begin drawing management fees, fund decreases in value
- Stage can last up to 5 years
VC Stage_ Investment Commitment
- VC determines which funds to invest in and how much
- Capital calls and investments mad
- Management fees still drawn
- Investments yield no retuns
- This stage can overlap with stage 2 as it takes place in years 3-5
VC Stage_ Investment Management
- All capital has been invested
- VC begins to work with portfolio companies
- Investments will become profitable and offset earlier management fees
- Exit strategies may begin to form in this stage
VC Stage_ Fund Liquidation
- Fund s closed through selling of funds investments or bankruptcy liquidation.
- If fund profitable, distribution of profits, and general partners collect incentive fee.
J-Curve
Is the graphical plot of VC investment effect. Negative (2 &3), positive (4&5).
Stages of Financing for a Startup Company
- Angel Investors
- Seed Capital
- First or Early Capital Stage
- Second or Late/Expansion Stage
- Mezzanine Stage
Startup Financing Stage_ Angel Investors
Stage ONE
- friends, family and fools
- $50,000 - $500,000
- developing prototype & writing a business plan
Startup Financing Stage_ Seed Capital
Stage TWO
- management team and business plan
- finishing prottoype, alpha and beta testing
- first stage where VC invest
- $1- $5 million capital investment
- generally smaller VC firms are involved, as it has high risk
Startup Financing Stage_ First or Early Capital Stage
Stage THREE
- product that has successfully made it through beta testing
- product moves to second stage of customer testing with second generation prototypes
- other activities include: marketing product and establishing distribution channels
- business begins making sales
- generally $2million or more investment
Startup Financing Stage_ Second or Late/Expansion Stage
Stage FOUR
- product has penetrated the market
- business is either at profitability or break even
- most VC prefer to invest here, returns lower but risk lower & more rapid return of capital
- period of high growth
- generally $5- $25 million investment
- serves to get business through cash crunch and period of high growth
Startup Financing Stage_ Mezzanine Stage
Stage FIVE
- matured company
- final stage of investment where the firm is sold either through IPO or private investors
- bridge financing is needed to take the company to the point where is can be sold
- generally $5-25 million and may take form of convertible debt
- business may be able to obtain traditional loan as well at this point
Alpha Testing
Internal laboratory testing
Beta Testing
Initial product testing and assessment by potential customers.
Venture Capital as a Compound Option
At each stage of financing an investor may be given the option to invest additional money in the startup or let this option expire.
Venture Capital Expected Return
Expect to earn relative return equal to the return of the public stock market plus 4-8%.
Attributed to processing three risk premiums: business, liquidity, concentration risk.
VC Risk Premium_ Business Risk
VC capital firm has no track record and is pre- IPO. May firms will fail before IPO, and thus investors demand high returns.
VC Risk Premium_ Liquidity Risk
VC investments very hard to exit before IPO.
Investors who are forced to exit early will likely have to sell at severe discount.
VC Risk Premium_ Concentration Risk
Compared to other investments, VC much less diversified.
Fund managers rely on their own sector specific expertise, thus lack of diversification.
Departure from CAPM, VC funds must be compensated for both systematic and unsystematic risk.
VC Importance of Access and Diversification of Vintage Year
Access: VC fund managers exhibit performance persistence , is successful tend to be successful in follow- on funds. Key to get access to top managers.
Diversification: historically, a leading cause of poor performance has been a year diversification.
lack of vintage t
Historical Performance of Venture Capital
2000-2010 underperformed both private and public equity, as it has a negative return, substantial volatility, negative Sharpe ratio, and highest possible drawdown.
Return distribution had slight positive skewness and substantial correlation to equity.
Leveraged Buyouts_ Differences from Traditional Investments
Three primary differences from publicly trades stocks and bonds:
- Require activities investors that become controlling shareholders
- Rely on substantial amount of leverage
- Not public ally traded despite reliance on traditional investments to acquire financing
Leveraged Buyout Fund Structures
- limited partnerships
- rely in safe harbor provision of Investment Company Act of 1940 to avoid regulatory registrations
- funds generally structured to operate for ten years, with option to extend for two years
Leveraged Buyout Fund Fees
- Management: 1-3%
- Profit Sharing: 20-30%
- Privatization: May charge fee to firms to take private. ~ 1%
- Break-up: if LBO deal falls through, takeover firm may be charged
- Director: general partners are often board members for portfolio companies and receive compensation
- Divestiture: if LBO firm arranges sale of division
Types of Leveraged Buyout Deals
- Efficiency
- Entrepreneurship
- Conglomerates
- Buy &Build
- Turnaround
LBO_ Efficiency Buyouts
Improving operating efficiency. Management compensation is adjusted to focus on net profit margins and increasing the value of the company rather than the revenues in an attempt to reduce principal- agent conflicts.
LBO_ Entrepreneurship Buyout
Good way to create value is to free management to concentrate on innovations.
Another option is to freeing a division with full autonomy to implement a separate business plan.
LBO_ Conglomerates
Opportunity to sell of some assets to focus on the undervalued core business.
LBO_ Buy and Build Strategy
The goal is a strategic alignment and value creation through synergies. Also known as leveraged buildup.
LBO_ Turnaround Strategies
Which seek out underperforming firms with too much leverage and weak management. Primarily focus in two types of firms:
- Firms approaching bankruptcy
- Firms owned by other LBO funds but underperforming expectations
Portfolio Characteristics of LBO Funds
- depending in revenue of portfolio company (e.g. Small cap)
- most LBO fund portfolios consist of 10-30 companies
- fund employees take active role in helping firms, often focusing on reducing employees and cost.
Benefits of LBO to Target Companies
- highly leveraged structure of LBO results in substantial tax benefits
- regulatory requirements and investor communications is reduced so that management can focus in core business
- if LBO was previously part of larger company, Management can now clearly focus in product goals instead of alignment
- if warrants issued to management, managers receive direct benefit from increase in company’s value
- existing investors often in favor because of the premium that LBO is willing to pay for their equity holdings
Calculating LBO Returns
Add equation from pg. 102
Financing LBO
- senior debt: from banks, finance companies, insurance
- mezzanine debt: mezzanine debt funds, institutional investors, investments banks
- equity: provided by LBO firms and management.
LBO Exit Strategies
- sale to strategic buyer
- sale to financial buyer
- sale via IPO
- new LBO
- refinancing
- hybrid strategy
LBO Exit Strategy_ Sale to Strategic Buyer
*** primary exit type and involves the sale of portfolio company to competitor in the same industry.
LBO Exit Strategy_ Sale to Financial Buyer
LBO firm sells portfolio company to another LBO firm.
This is know as a buy-to-buy or secondary buyout.
Becoming more and more popular and now accounts for 33% of all private equity deals.
LBO Exit Strategy_ Sale via IPO
Once turnaround complete, portfolio company taken public via an initial public offering.
LBO Exit Strategy_ New LBO
Completely new LBO is created using additional debt financing.
New LBO the. Purchases the equity stake held by original LBO investors.
LBO Exit Strategy_ Refinancing
If company has had significant value appreciation since buyout, portfolio company may finance by taking additional debt in order to pay equity investors sizable dividend.
LBO Exit Strategy_ Hybrid Strategy
Two or more of the exit strategies combined to form a blended exit strategy.
Benefits of LBO Corporate Governance
- Strong corp giv often remain in place after company becomes public again.
- Managers are given a warning to act better or risk losing their positions.
- Management incentives and shareholder monitoring programs can provide roadmap for other managers and shareholders.
- Threat of LBO helps prevent the formation of inefficient conglomerates.
Advantages of Club Deals
- Larger capital pool
- Investment restrictions
- Pooled resources
Disadvantages of Club Deals
- Lack of market participation
- Lack of defined leadership for the business plan
Risks & Returns of LBOs
LBOs are significantly less risky than VC because:
- LBO target established companies
- LBOs are more diversified than VC
- IPO exit strategy much more realistic for LBO than VC
Mezzanine Debt
- is a hybrid of equity and debt
- extremely flexible structure
- investors expect return of 15-20%; debt return component tends to make up 10-15%, while equity kicker makes up 5-10%.
- debt covenants often contain a payment-in-kind (PIK) toggle
Mezzanine Debt to Lower WACC
- Essentially if the firm can replace a portion of the expensive equity component with less expensive mezzanine debt, its WACC will be lower.
- However, note that issuance of mezzanine debt typically results in equity investors requiring higher returns.
Comparison of Mezzanine Debt to Other Financing Types
- Max total mezzanine debt issued by a single firm tends to be around $400 million
- Mezz debt structure customized , making them much less liquid than high yield bonds and leveraged loans.
- Mezz deb covenants generally allow for max loan-to-EBITA multiple of 4.0 - 4.5, whereas bank and senior loans allow for max 2.0 - 2.5.
Mezzanine Financing_ Types of Transactions
- Management Buyout
- Growth and/or Expansion
- Acquisitions
- Company recapitalization
- Commercial Real Estate Financing
- Leveraged Buyouts
- Bridge Financing
Mezzanine Debt Investors
- Mezzanine Funds
- Insurance Companies
- Traditional Senior Lenders
- Traditional Venture Capital Firms
Mezzanine Debt Investors_ Mezzanine Funds
- Similar infrastructure to HF & VC
- 1-2% management fee, 20% incentive
- seek returns 15-20%
- tend to have staff with finance vs. tech background
- tend to be smaller than other PE funds due tot deal size
Mezzanine Debt Investors_ Insurance Companies
- Because their liabilities are long term in nature, illiquidity not a concern.
- However, bc nature of liabilities need stable source of income and therefore place higher value on fixed income component of mezzanine debt.
Mezzanine Debt Investors_ Traditional Senior Lenders
- Such as banks will partake after traditional limits are reached, lenders provide stretch financing, subject to higher interest rates and may include inclusion of equity kicker.
Mezzanine Debt Investors_ Traditional Venture Capital Firms
- When other opportunities are limited
- In companies they have already invested in to get the firm through IPO
Characteristic of Mezzanine Debt
- Board representation
- Restrictions on borrowers
- Flexibility
- Negotiations with senior creditors
- Subordination
- Acceleration
- Assignment
- Takeout provisions
Mezz Debt_ Acceleration
If there is a covenant violation, the lender may accelerate the senior debt making it due and payable immediately. A default would then occur and collateral would be seized.
Mezz Debt_ Assignment
The senior lenders do not generally allow permit the mezzanine investors to assign interest to a third party. If they do permit this, then a new inter-creditor agreement would be needed.
Mezz Debt_ Takeout Provisions
Once the senior debt has been repaid to a certain level, this important provisions allows the mezz debt holders to take out (buy) the senior debt, making the mezz investor the most senior level of financing for the firm.
If wanted mezz debt can take steps to take over company by converting debt to equity ownership.
Distressed Debt
- Usually the result of a company’s actual business plan slowly diverging from its optimal plan over time.
- Failed LBOs present the greatest opportunity for DD investors.
- Inefficient market due to not publicly traded and lack of uniformity.
- Can earn profit when investment grade downgraded to non-investment, bc many people have to sell off the books below intrinsic value.
- Diversification not primary objective, however since they tend to invest in multiple industries, moderate level of diversification.
Distressed Debt_ Investment Strategies
- Active Investors Seeking Control
- Active Investors Not Seeking Control
- Passive Investors
DD Investment Strat _ Active Investors Seeking Control
- Investors actively seek:
1. Blocking position to influence Chapt. 11
2. Equity-for -debt conversion for control of the company
3. Board of director or Chair position - Fulcrum Securities
- Active role in restruc and business plan
- May infuse additional equity after conversion
- Highest risk and longest holding period strategy
- expected returns: 20- 25%
DD Investment Strat _ Active Investors Not Seeking Control
- Have active role in restructuring and business plan
- May accept debt-for-debt conversion or equity-for debt and equity kicker
- expected returns: 15-20%
DD Investment Strat _ Passive Investors
- Goal to earn short turn returns, not gain equity stake
- Buy undervalued debt from risk averse investors
- may engage in credit arbitrage
- expected returns: 12-15%
The Bankruptcy Process
In a Chapter 11 bankruptcy, the debtor firm is reorganized but remains a going concern (i.e., maintains daily operations).
Bankruptcy Process _ Step 1
The firm files for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. Only the firm itself can file for protection.
Bankruptcy Process _ Step 2
Bankruptcy court freezes all default notices from lenders.
Bankruptcy Process _ Step 3
If firm has a pre-packaged (i.e. a reorganization plan approved by lenders in advance of filing), the firm will seek bankruptcy court approval.
If successful, this allows firm to move quickly through bankruptcy process.
Bankruptcy Process _ Step 4
If, no pre-packaged plan that is approved, then the debtor firm must create and file a plan or reorganization within 120 days.
Bankruptcy Process _ Step 5
After filing the reorganization plan, the firm has 60 days to convince creditors to accept plan.
Bankruptcy Process _ Step 6
For reorganization plan to be accepted, either:
1. creditor class must be paid in full
2. 50% in number or 2/3 in dollar amount of claims in class must vote in favor of specified plan.
Conversely to create BLOCKING Position:
- group must comprise either more than 1/2 of the claimants or more than 1/3 of the value of the class.
Bankruptcy Process _ Step 7
If the 120-day, plus 60 day period lapses without an approved plan, any party of interest can submit a plan.
Bankruptcy Process _ Step 8
If debtor accepts alternative plan, bankruptcy court approval is sought.
Bankruptcy Process _ Step 9
If debtor firm rejects the alternative plan, debtor firm submits a new plan and again begins the negotiation process with creditors, alternatively, the court can force a CRAMDOWN- in which. the court confirms a reorganization plan in spite of claimants objections- very infrequent.
Debtor- in- possession (DIP) financing
Occurs when secured lender extends additional credit to debtor to prevent the debtor from ceasing operations during a Chapter 11 bankruptcy.
Two reason why:
1. Allows borrower to continue operations
2. DIP loans have first priority in Chapter 11
Absolute Priority
Refers to the order in which claims are processed in bankruptcies.
- Employees, Accounts Payable, Tax Justifications
- Debt and Bond Holders (with senior secured debt holding priority)
- Preferred and common shareholders
Chapter 7 Bankruptcy
Occurs if plan of reorganization is not accepted by the creditors of the company and the company is forced to liquidate its assets.
Fulcrom Securities
When investors purchase more junior debt with high likelihood of equity conversion after a firm emerges from Chapter 11 bankruptcy. The debt issues are know as Fulcrom securities.
