6. Private Equity Flashcards
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
Leveraged Loans
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_ First or Early Capital Stage
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_ Business Risk
- senior debt: from banks, finance companies, insurance - mezzanine debt: mezzanine debt funds, institutional investors, investments banks - equity: provided by LBO firms and management.
Financing LBO
Purchase of nonfinancial firms by financial institutions; similar to LBO. -merchant bank always the general partner
Merchant Banking
The VC obtains capital commitments from investors. No funds invested during this period. Typically six months to a year
VC Stage_ Fundraising
Refers to the order in which claims are processed in bankruptcies. 1. Employees, Accounts Payable, Tax Justifications 2. Debt and Bond Holders (with senior secured debt holding priority) 3. Preferred and common shareholders
Absolute Priority
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
Private Investment in Public Equity (PIPE)
- 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.
Comparison of Mezzanine Debt to Other Financing Types
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_ Second or Late/Expansion Stage
Leveraged buyout when investors are the firm’s current management team.
Management Buyout
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.
Incurrence Covenant
Bankruptcy court freezes all default notices from lenders.
Bankruptcy Process _ Step 2
** 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
Terms to Qualify as Distressed Debt
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.
Registered Common Stock (use in PIPE)
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.
Historical Performance of Venture Capital
Investment strategies the invest in privately traded equity. Typically higher risk, long term strategies that require extensive due diligence.
Private Equity
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.
Haircut/Margin
- Active Investors Seeking Control - Active Investors Not Seeking Control - Passive Investors
Distressed Debt_ Investment Strategies
- When other opportunities are limited - In companies they have already invested in to get the firm through IPO
Mezzanine Debt Investors_ Traditional Venture Capital Firms
Three primary differences from publicly trades stocks and bonds: 1. Require activities investors that become controlling shareholders 2. Rely on substantial amount of leverage 3. Not public ally traded despite reliance on traditional investments to acquire financing
Leveraged Buyouts_ Differences from Traditional Investments
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.
Mezz Debt_ Takeout Provisions
- Larger capital pool - Investment restrictions - Pooled resources
Advantages of Club Deals
- 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 Seeking Control
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.
Structured PIPEs
- Management Buyout 2. Growth and/or Expansion 3. Acquisitions 4. Company recapitalization 5. Commercial Real Estate Financing 6. Leveraged Buyouts 7. Bridge Financing
Mezzanine Financing_ Types of 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
Goals of LBO Transactions
- 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_ Insurance Companies
Initial product testing and assessment by potential customers.
Beta Testing
- 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 Commitment
KKR bough RJR Nabisco
1989 KKR Buyout
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
Prudent Person Standard
-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
Venture Capital
The issuer agrees to sell a specific number of registered shares to the investor at regular invervals 9e.g. semiannually)
Equity Line of Credit (use in PIPE)
Grants the limited partners the ability to reclaim incentive fees at liquidation if they have experienced a loss of capital.
Clawback Provision
Focus on the firm’s business plan.
Venture Capital Portfolio Companies
Require debtor to take certain actions, such as paying interest, principal, taxes, complying with loan agreements, and maintaining properties.
Positive Covenants
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_ Refinancing
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 3
Refers to a fund adopting a more risky investment style that includes leverage.
Gearing
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.
Bankruptcy Process _ Step 9
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_ Seed Capital
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 Risk Premium_ Concentration Risk
In a Chapter 11 bankruptcy, the debtor firm is reorganized but remains a going concern (i.e., maintains daily operations).
The Bankruptcy Process
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.
Fulcrom Securities
- 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 Senior Lenders
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 6
- Fundraising 2. Sourcing Investments 3. Investment Commitment 4. Investment Management 5. Fund Liquidation
Life Cycle of VC Fund
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_ Acceleration
- 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
Benefits of LBO to Target Companies
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.
Private Equity Firms
- Management: 1-3% 2. Profit Sharing: 20-30% 3. Privatization: May charge fee to firms to take private. ~ 1% 4. Break-up: if LBO deal falls through, takeover firm may be charged 5. Director: general partners are often board members for portfolio companies and receive compensation 6. Divestiture: if LBO firm arranges sale of division
Leveraged Buyout Fund Fees
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 Escrow Agreement
Prohibit borrower from taking certain actions, usually requiring the borrower to maintain certain ratios at specific levels.
Negative Covenants