8.3 Investments in Private capital: Equity and Debt Flashcards
The largest source of returns for private equity investors
capital appreciation
–> which may take the form of price appreciation or free cash flows generated by portfolio companies’ operations.
The primary approaches to private equity investing
leveraged buyouts
venture capital,
growth capital.
Leveraged buyout (LBO) deals
structured to acquire publicly traded companies and operate them under private ownership
The intention of LBO investors is to add value by making changes to a company’s operations and capital structure.
These transactions are described as leveraged because they are financed with a high proportion of debt.
This debt becomes part of the newly private company’s capital structure and its assets are often pledged as collateral.
Because the companies that are targeted by PE firms typically have well-established operations, their cash flows are expected to be sufficient to support higher levels of debt.
management buyout (MBO)
used to describe a leveraged buyout in which the target company’s current management team participates in the acquisition
management buy-in (MBI)
a deal in which the company’s current leaders are replaced by management team that has been selected by the acquiring firm
Venture capital (VC) firms
seek to take equity positions in companies with high growth potential
These companies are generally young, ranging from the smallest of start-ups to companies that are approaching the initial public offering (IPO) stage.
All else equal, venture capital investors expect higher rates of return when providing funds to companies at earlier stages in their development due to the greater risk of failure.
Because portfolio companies have often not yet started generating sales or operating cash flows, most VC investments take the form of equity, although debt capital (usually convertible debt) may be provided as well.
describe the VC firms’ sources of capital. investors, and typical investment amounts at the Pre-seed stage
sources of capital: mostly individuals
Investors:
–> Founders
–> Family and friends
–> Angel investors
Typical investment: USD $5K - $500K
describe the VC firms’ sources of capital. investors, and typical investment amounts at the seed stage
sources of capital: funds
Investors:
–> Seed funds
–> Angel investors
Typical investment: USD $25K - $5M
describe the VC firms’ sources of capital. investors, and typical investment amounts at the early/later stage
sources of capital:
–> Institutional Investors
–> Family offices
–> Strategic Investors
Investors:
–> VC Funds
–> Coporate venture funds
–> Private equity investors
–> Strategic investors
Typical investment: USD $5M or more
Pre-seed capital, or angel investing
used to support activities such as the development of a business plan.
These investments are relatively small and typically come from angel investors (e.g., friends and family) rather than VC firms.
Seed-stage financing, or seed capital
supports pre-production activities such as product development and market research.
VC firms are generally unwilling to invest in companies before they have reached this stage.
Early-stage financing, also known as early-stage VC or start-up financing
typically funds the initial phase of commercial production and sales.
Later-stage financing, also known as expansion VC
provided after a company has started generating revenue, but before it is ready to go public through an IPO.
The funds provided at this stage are typically used to expand operations, improve products, and/or launch major marketing campaigns.
Because portfolio companies are generating sales, investors are more willing to provide debt capital at this stage. Indeed, the higher priority claims of debt securities (including convertible instruments) offer greater protection than common equity in the event of a subsequent bankruptcy.
It is at this point when founders and managers usually sell majority control of their company to VC investors.
Mezzanine-stage financing, also known as mezzanine VC
prepares a company for its IPO.
This type of capital is provided after a company has started commercial production and is used to bridge the gap in advance of an IPO.
The term mezzanine financing refers to the issuance of hybrid securities, such as convertible debt and convertible preferred shares.
While mezzanine financing instruments may be used at this stage, investors are more likely to provide equity or short-term debt.
Growth capital, also known as growth equity or minority equity investing
funds a company’s expansion during the period when it no longer requires VC investments but before it is mature enough to be considered as a potential LBO target.
Companies typically seek growth capital to expand or restructure their operations.
If a company has not yet gone public, its managers may initiate a round of growth financing to monetize some of their shares while retaining control.
private investments in public equities (PIPE)
A company that has already gone public through an IPO can raise growth capital by issuing a private investments in public equities (PIPE)
These securities may be sold to existing or new stockholders at an agreed fixed price but they may only be marketed to sophisticated investors, such as mutual funds or endowments.
Lower disclosure requirements reduce transaction costs and allow the firm to raise capital more quickly compared to issuing exchange-traded shares.
PIPE transactions are often used to raise capital during periods of market turmoil or company-specific distress, when a company’s share price is significantly below management’s valuation.
The disadvantage of PIPE issues, including convertible debt and convertible preferred stock
is that they are dilutive, which can lead to conflicts between new and existing shareholders.
The two main exit strategies used by private equity investors
trade sales and public listing
a trade sale
the portfolio company is sold to a strategic buyer, which is typically a competitor within the same industry.
Trade sales offer the following advantages:
Cash is received immediately
Strategic buyers typically offer higher valuations due to synergies
Execution is relatively fast and simple
Transaction costs and disclosure requirements are lower compared to an IPO
The disadvantage of a trade sale include:
The pool of potential buyers is limited
Managers may object out of concern for losing their jobs if the company is acquired by a competitor
Employees may prefer to monetize their shares through an IPO, which may produce a higher valuation
An initial public offering (IPO)
another exit strategy that a private equity firm can use to sell some (but not necessarily all) of its position in a portfolio company
main advantages of an IPO exit strategy:
The potential for a higher sale price than could be realized from other exit strategies
Managers will be supportive because they will retain their jobs
A successful IPO will generate good publicity for the private equity firm
Continued exposure to upside potential if some shares are retained
disadvantages of an IPO exit strategy:
Long lead times
High transaction costs
High disclosure requirements
Exposure to market volatility, including the tendency for investors to focus on short-term performance
A lockup period provision can require a private equity firm to hold its shares for a minimum amount of time after the IPO
IPOs are best suited for larger companies with high growth potential
a direct listing
results in a company’s shares being listed on a public exchange
However, an underwriter is not required to execute this strategy because no new capital is raised.
This is a faster, less costly alternative to an IPO for companies that are not in need of new capital and would like the benefits of having publicly-traded shares.
A special purpose acquisition company (SPAC)
a shell company that raises cash through an IPO with the intention of buying a private company and taking it public.
If a suitable target is not acquired within a specific period (typically 24 months), the shell company dissolves and the capital that was raised in the IPO gets returned to investors
The advantages of the SPAC exit strategy include:
The extended deal period can be used to build investor confidence through public disclosures
A fixed valuation and less volatile share pricing
Highly flexible transaction structure
Access to high profile sponsors and their networks of investors
The disadvantages of the SPAC exit strategy include:
The cost of capital can be increased by sponsor dilution, warrants, and other fees
Dilution will result in a spread between the announced price and the true equity valuation
Exposure to deal risk due to the possibility that the transaction will not be completed
Capital risk exposure from the prospect of investor redemptions
Shareholder overhang and churn may occur after the transaction closes
Three additional exit strategies
recapitalizations
secondary sales
liquidations.
recapitalizations
executed by having the portfolio company take on additional debt and redistributing part of the proceeds as dividend payments to shareholders.
In fact, this is not a true exit strategy because the private equity firm retains its shares and control over the company.
This is a complementary approach that is often used to monetize a position and improve the investment’s internal rate of return before selling shares at a later date through an IPO or a trade sale.
A secondary sale strategy
involves selling a position to another private equity firm or group of investors.
This exit strategy has become more common as the private equity market has grown.
A liquidation strategy, also known as a write-off
used when an investment does not work out as expected.
Underperforming companies, or some of their assets, are sold for the purpose of salvaging any value.
Private debt
refers to the various forms of lending to private entities.
The four main categories of private debt
direct lending
mezzanine loans
venture debts
distressed debt
direct private debt investment
the investor makes a loan directly to a specific operating company
indirect private debt investment
the investor takes an intermediated path, purchasing an interest in a fund that pools contributions typically on behalf of multiple participants to buy into the debt from a set of operating companie
Venture Debt
provides funding to complement the existing equity financing of start-up or early-stage companies.
It often takes the form of a line of credit or term loan. Venture debt allows shareholders to retain ownership and control of the company.
To compensate investors for the increased risk of default and the lack of collateral, venture debt includes features such as the right to purchase equity in the borrowing company under certain circumstances.
Direct Lending
Direct lending transactions involve a private debt firm providing capital directly to the borrower using funds raised that have been raised from investors looking for higher-yielding debt.
The loan is typically senior and secured, with covenants in place to protect investors.
It differs from traditional debt instruments as the loan is provided by a small number of investors and cannot be publicly traded.
Leveraged loans
commonly used in direct lending to enhance the return on the loan portfolio of a private debt firm.
This form of private debt investing carries additional risk because loans are made with borrowed funds.
Mezzanine debt
subordinate to senior secured debt but senior to equity.
To compensate for its junior ranking and the fact that it is usually unsecured, mezzanine debt offers higher yields and usually comes with warrants or conversion rights.
The capital provided by mezzanine debt is often used to finance LBOs, recapitalization, and corporate acquisitions.
Distressed debt
financing provided to mature companies that are facing financial distress
Debt issued by firms in these circumstances is often priced closed to the expected recovery rate.
Turnaround investors buy debt at a fraction of its par value and seek to directly increase its value by becoming involved in the management of the reorganized company.
This type of investing requires specialist knowledge of the bankruptcy process, which can be complex, lengthy, and capital intensive.
Unitranche debt
a combination of different tranches of secured and unsecured debt into a single loan
Its priority ranking falls between those of senior and subordinated debt.
The interest rate on this type of debt will fall between the rates of return that investors require on secured and unsecured debt.
Specialty loans
debt extended to borrowers in specific situations, such as to finance the legal fees and expenses in a litigation.
Real estate debt
loans provided for real estate financing collateralized by a specified real estate asset or property.
Infrastructure debt
used to finance the construction, operation, and maintenance of infrastructure assets.
Collateralized loan obligations (CLOs)
created by pooling loans offered to multiple corporations in various industries and dividing the pool into tranches of debt and equity that differ in seniority and security.
More senior tranches of the CLO are sold to investors who are more risk-averse.
Vintage year effects
especially important to consider when comparing different investments in private equity and venture capital
rank the different types of debt/investments based on the most risk averse to riskiest (proportional with eexpected returns)
- infrastructure debt
- Senior real Estate Debt
- Senior Direct Lending
- Unitranche Debt
- Debt Mezzanine
- Pivate equity / Co-investments
