Exam 2 Flashcards
What is private equity
Investment strategy that involves the purchase of equity or equity linked securities in a company
Investment is made thru a negotiated process. Hostile buyouts are rare
Sophisticated investors with financial and operating expertise
Goal is to acquire undervalued or promising assets and realize profits 3-5 years after the acquisition
Fund of funds
You make investments in PE shops that then invest in other PE shops. Allows you to enter the PE world if you don’t have money to do so.
Fund that invests in other funds
LBO
- Acquisition of a company where a PE firm uses cash, equity, and debt to fund the purchase price
- PE firm injects equity into a new shell company which borrows debt and simultaneously acquires the target
- PE firm contributes capital, operating and financial expertise, strategic insight, contacts and management talent
- Mgmt ownership increases, creating higher incentives to improve operations & deliver results
- Debt is repaid by the operating cash flows or by the sale of non-core assets of the acquired business
- LBO is similar to buying and renting out a house - the rent cash flows to pay down the mortgage debt
Power of leverage: allows for a higher return to the equity holder
PE Fund Structure
A PE Fund is a pool of raised capital committed by investors to be invested over the course of a number of years
Limited partners (LP): consist of pension funds, insurance companies, fund of funds, high net-worth investors, family offices, endowments, foundations, sovereign wealth funds, etc
They provide capital and a 2% fee to the private equity fund (the general partner (GP))
The GP then has a fund which uses the capital from the different LPs and invests in different deals
Generally about 10 investments in a fund and 5-7 year life for the fund
LP will only be required to invest capital once an investment occurs.
Three ways to generate returns for LBO
- Operational improvement and growth (grow EBITDA)
- Purchase/exit multiple expansion
- Use of leverage
Generally there is a hurdle rate of 8% - require at least an 8% return for the deal
More recently, deals have been getting value due to operational improvement. Used to be mainly from leverage in the 1980s and multiple expansion in the 1990s. Now is earnings growth
What does the GP do?
Exit opportunities
- Select investments: obtain access to high quality deal flow, sort and evaluate large amount of info
- Due diligence and structuring: business, accounting, and legal diligence. Structuring the transaction
- Monitoring investments: providing strategic, operational, and financial assistance to portfolio companies
- Exiting investments:
A. Sale: Financial (another PE firm) or strategic (someone in the industry, will pay a premium for the synergies. For financial, which is sponsor to sponsor (PE to PE), look at transaction comps and get rid of corporations who pay a premium. Low valuation.
For strategic, aka corporate, look at transaction comps, incorporate synergies, and high valuations
B. IPO: multi stage in that don’t dump all equity at the IPO but have multiple exit at IPO –> look at public/trading comps. Medium valuation
C. Dividend Recapitalization (partial exit). Process of borrowing money to issue a special dividend to owners or shareholders allowing them more recover of investment and allowing to increase IRR
Timeline of Fund Cash Flow for LPs and J-Curve Effect
- In the early years, PE funds tend to show low or negative returns due to management fees and early identification of underperforming assets and the subsequent write down
- Investment gains usually come in the later years, as the companies mature and with the help of the GP, increase in value
- The effect of this timing on the fund’s interim returns are drawn as the J-Curve effect. This plots time on X axis and returns on Y axis. see it starts at zero, goes down at first and then up higher than began to a positive return
Year 1: LP make the fund commitment
Years 1-6: capital is called from LPs as needed. Typically funds are invested over 4-6 years
Years 3-10: fund will make distributions to LPs as investments are realized. Expected hold period for an investment can typically be 3-7 years
What makes a good LBO candidate
- Predictable, steady cash flows to service debt
- History of (of potential to have) consistent profitability
- Availability of (or potential to produce) excess cash
- Easily separable assets or businesses
- Strong management team
- Strong brands and market position: good companies are expensive but if you pay and can grow company then it is worth it
- Industry with barriers to entry
- Little danger from disruptive changes (technology, regulatory, etc)
- Visible/feasible exit strategy (IPO or M&A)
- Scope for operational improvements
- Trading below intrinsic value
- Low capex needs bc high capex means more cash outflow
- Assets to secure debt as collateral
- Low cost of debt
–> Capital structure before isn’t important because you start fresh when you come in
Sources and Uses Table
Uses are the things that you will use after the transaction. This includes repaying the old debt, fees, any immediate investments, and how much you paid for the equity
Sources are how the money is raised. This comes from the new debt, as well as both management and sponsor equity.
Sources should = uses
Ex: Say we have a deal where there is an EBITDa of 20 and a multiple of 5. So purchase for 100 and have senior debt for 50, mezzanine debt for 20, equity for 35 (fees of 5%). Repaying old debt that was 20.
Total sources:
New senior debt: 50
New mezzanine: 20
New equity: 35
Total uses:
Repay old debt: 20
Acquiring equity: 80
Expenses: 5
Sources of Funds
- Equity:
New equity injection from PE fund (LPs)
Potential equity contribution from existing management (incentive alignment when CEO is a shareholder)
Potential continuing equity investment by existing shareholders (rollover)
Equity from a strategic partner
Co-investment by a limited partner (multiple funds, don’t pay fees)
2. Debt: Bank debt (senior debt) High yield debt (subordinated debt) Generally you prefer to pay down the high yield debt first since higher interest rate, but contract may require you to pay down senior debt. You borrow against the junior debt in case you need to raise more debt (need to pay senior debt and don't have enough cash to do so, so draw more of the subordinated debt)
- Mezzanine structures: can be structured to be more “debt-like” or more “equity-like” depending on the situation
Senior debt usually amortizes over the years while mezzanine debt doesn’t
Bank Debt
Aka leveraged loans
•Senior secured (most senior debt) (1st or 2nd lien)
•Matures before other debt classes, amortizing
•Structured at the operating company level
•Typically callable/prepayable at par
•Often floating rate (e.g., LIBOR+)*
•Quarterly interest payments
•Privately held: Do not need public disclosures
•Underwritten via syndication
•Significant financial covenants (unless “cov-lite”)
–> This includes interest coverage ratio, debt to ebitda ratio. Make sure can meet certain standards. Cov-lite lacks these covenants
•Process: Diligence, commitment, launch, syndicate, fund
•Revolving Credit Facilities vs. Term loans: security for ability to take out cash flows
Revolvers allow multiple drawings for working capital and general corporate needs (if need more debt, do so against the revolvers)
Term loans funded at closing
Term A: bank, 5 year term, 1st lien
Terms B,C,D: looser covenants. 5-8 year terms. More cov-lite with lower interest rate, debt lenders competing to give money. Less standards
High yield debt
Junk bonds
Generally credit rating BBB-or worse
•Usually subordinated and/or unsecured
•“Bullet” maturity after full bank debt amortization (maturity of 8-10 years)
•Structured at the operating company level
•Usually not callable at par in early years, typically the first 1-5years
•Interest rate is fixed: Semi-annual interest payments
•Greater leverage capacity
•Sometimes public: Public filing requirements
•Process: Diligence, document, road-show, price and fund
Investors in high-yield debt: pension bonds, insurance companies, mutual funds
Mezzanine debt
Subordinated to bank debt and high yield bonds
•Flexible, typically floating interest rate
•Often structured at the holding company level
•Typically matures after bonds
•Non-amortizing, “bullet” maturity typically after 10 years (no mandatory principle payments, interest is paid only)
•Cash & PIK coupon payment further enhanced with equity warrants “equity kicker”
•PIK component can “eat” into equity (PIK Toggle provides an option to pay interest either in kind or in cash)
•Fully private, no public reporting requirement
•Process: Private negotiation with single or small number of parties
Summary: Sources of funds
- Bank debt (30-60% of the sources): expected returns are 4-8%. Low financing costs, lowest default risk. Floating rate, callable instrument. Covenants
- Yield yield debt (0-15%): expected returns are 8-14%. Typically fixed rate loan, prepayable penalties for first few years, limited flexibility in raising additional debt
- Quassi Equity (0-15%): expected returns 15-20%. Downside protection like debt with upside potential like equity
- Common equity (20-50%): expected return 20-40%. Riskiest security in capital structure and no downside protection. Private market equity is financial sponsor and public market equity is common shareholder
- -> riskier has higher expected return
Anatomy of a deal
- Formal review (review every opportunity and screen possible companies)
- Initial due diligence & initial offer: explore the deal and develop detailed financial case. Assess competitive edge in the process and/or post-deal and identify partner
- Extensive due diligence: conduct thorough commercial and financial due diligence and evaluate management team.
How can PE firms generate value?
- Pre-acqusition:
Identify investment theses (why do you want to own the business); identify parts of the investment thesis that are in PE’s control; extensive company and industry due diligence; disciplined approach to purchase price focusing on below market multiples - Senior management. Compensation: individuals do what they are incentived to do
- Improve business operations. Trend: in house operations group
- Financial management. Managing working capital, managing expenses, managing the balance sheet (capital structure, timing of refinancing, dividends)
- Optimize exit. Understand industry M&A activity and trends, position company with strategic or market buyers, evaluate potential for an IPO, sale to a strategic or out of the box opportunities
Assets Under Management (AUM) and Dry Powder
Assets under management = dry powder + unrealized value of assets
Dry powder is uncalled capital commitments
Unrealized value of assets is the current estimated value of the portfolio
Trend is higher AUM recently but not really a problem since deal activity is higher as well so there is a place to put the AUM
Trends in PE
Sellers market now - high prices
Lot of capital being raised recently
Lot of AUM and increasing a lot
Dry powder up
This is all okay since global deal activity also up
Size of deals not as large as in 06 and 07 before recession
Holding period shifting more toward 3-5 years. Still is just slightly majority more than 5 years.
Multiples increasing
Exit values increasing. Most sales are to strategics who will pay premiums. Some to other GPs and others IPOs
Upper quartertile PE funds are consistently the best. Bottom quartile doing worse than S&P 500
Performance is therefore persistent in that the top funds outperform the rest on a consistent basis
More different types and more frequent investing in PE as LPs
