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.