Session 9 Flashcards
What are the key differences between private equity and public equity?
Private Equity:
- Illiquid, ownership is concentrated
- Valuation is difficult
- Finance includes control and mentoring
- Includes buy-outs, later stage financing, secondaries (later stage)
- Includes venture capital, early stage financing
Public Equity:
- Liquid, ownership is dispersed
- Valuation is relatively easy
- Finance is often divorced from control and mentoring
- Includes stock market-listed companies
What are the key stages of private equity and hedge fund investments, and their characteristics?
- “Angel” (Seed): 0 years, idea stage, private, $0.2-0.5M, 70%+ returns
- “Venture Capital” (1st, 2nd & 3rd Rounds): 0-3 years, prototype to 1st gen product, private, $1-5M, 50-60% returns
- “Growth” (Emerging Growth): 3-10 years, 2nd/3rd gen product, private/public, $5-20M, 40-50% returns
- “Buyouts” (Leveraged Buyouts & Mezzanine Debt): 10-50 years, established/slow growth, private/public, $10-250M, 20-40% returns
- “Distressed Investing” (Equity & Debt): 10-50 years, stressed companies, private/public, $10-250M, 30-50% returns
- “Hedge Funds”: 5+ years, public, N/A investment requirement, 20% returns
What are the key differences between Venture Capital and Buyouts in terms of focus, characteristics, risks, and investment strategy?
Venture Capital (Bottom Left Quadrant)
- Focus: New and unproven companies/industries
- Characteristics: High growth potential but negative cash flows
- Risks: High operational risk due to uncertain business models and market acceptance
- Investment Strategy: Investors bet on technology and industry trends, expecting high future margins
Buyouts (Top Right Quadrant)
- Focus: Established, mature companies with proven industries
- Characteristics: Low to moderate growth but positive cash flows
- Opportunities: Companies with outdated ownership structures, declining margins, or inefficiencies that can be optimized
- Investment Strategy: Buyout firms use leverage (debt) to acquire businesses, optimize efficiency, and benefit from tax shields
What are the key components and investment flow in private equity and venture capital?
Key Components
Investors (Sources of Capital):
- Pension funds, endowments, foundations, banks, high-net-worth individuals, insurance companies, investment banks, corporations, etc.
Intermediaries (Facilitate Investments):
- Private Equity Funds: Invest directly in companies.
- Fund of Funds: Invests in multiple private equity funds, offering diversification.
Issuers (Investment Targets):
- Venture Capital: Early-stage financing (seed, start-ups, expansion).
- Private Equity & Buyouts: Later-stage financing (replacement capital, special situations, buyouts).
Investment Flow
- Investors provide capital.
- Intermediaries (funds) allocate capital.
- Issuers (companies) receive funding based on their stage and needs.
What are the roles and responsibilities of Limited Partners (LPs) and General Partners (GPs) in Private Equity?
Limited Partners (LPs)
- Who they are: Institutional investors (pension funds, insurance companies, high-net-worth individuals, endowments).
- Liability: Limited to their committed investment (cannot lose more than they invest).
- Role: Provide capital but do not participate in daily management.
- Risk: Protected from further financial obligations beyond investment.
General Partners (GPs)
- Who they are: Private equity firm or “PE house” managing the fund.
- Liability: Unlimited liability (responsible for fund management and potential losses).
- Role: Actively manage investments, make strategic decisions, and ensure portfolio growth.
- Structure: Often set up as a limited company to mitigate personal liability.
- Additional Support: May seek guidance from Fund Advisers for regulatory, fiscal, or governance expertise.
Key Takeaway: This structure allows LPs to benefit from PE returns while minimizing risk, while GPs earn management and performance fees for their expertise.
What is the Private Equity Fee Structure?
1. Annual Fees
- ~2% of committed capital (ranges from 1-3%).
- Covers operational costs of the General Partner (GP) managing the fund.
2. Carried Interest (“Carry”)
- Performance-based fee, usually 20% of profits.
- Profits calculated for the entire fund (losses offset against profits).
- Hurdle rate (typically 8% IRR) must be met before GPs earn carry.
- Taxed as capital gains, leading to political/media scrutiny.
What are the key benefits of Private Equity?
1. Financing for Early-Stage & Restructuring Firms
- Helps companies transform and restructure.
- Provides capital where public equity or debt financing may not be available.
2. Superior Governance
- Focus on value-creating governance, not just compliance.
- Emphasis on operational improvements over regulatory avoidance.
3. Strong Incentives for Success
- Managers & PE firms have aligned interests (performance-based compensation).
- Maximizes efficiency & profitability.
4. Attracts Talent & Innovation
* PE-backed firms attract top-tier professionals & innovative business strategies.
Key Takeaway: PE offers hands-on management, strong incentives, and governance improvements, making it superior to public equity in some situations.
What are the key stages of the Private Equity Fund Lifecycle (10-12 years)?
- Private Equity Fund Lifecycle (10-12 Years)
- Fundraising (Year 1) – Investors commit capital.
- Investment Phase (Years 1-5) – Fund deploys capital into companies.
- Growth & Management (Years 5-10) – Companies are optimized for value creation.
- Exit & Returns (Years 8-10) – Investments are sold, cash flows return to investors.
- Extension (Years 10-12) – Extra time for final exits if needed.
- Follow-On Fund – New fund raised while the old one matures.
Most private equity is invested via partnerships of limited duration, with cash flows back to investors as indicators of fund performance.
What are the key components of Venture Capital?
1. Early-Stage Funding
- Initial capital often comes from family, friends, and fools (FFF).
- As startups grow, they need external funding for expansion.
2. Angel Investors
- Wealthy individuals investing in small private firms in exchange for equity.
3. Venture Capital Firms
- Limited partnerships that raise funds to invest in high-growth startups.
- Venture Capitalists (VCs) are General Partners managing these investments.
Venture capital provides funding, expertise, and networks to help startups scale.
What are the key stages of a Leveraged Buyout (LBO)?
1. Acquisition Using Debt & Equity
- The buyer (sponsor) finances the purchase mostly with debt (leverage).
- A small equity investment is made by the buyer.
2. Company Growth & Debt Repayment
- Buyer improves operations and uses company cash flow to repay debt.
- May sell assets or make add-on acquisitions for expansion.
3. Exit Strategy (3-5 Years)
- The buyer sells the company or takes it public via IPO to realize returns.
LBOs maximize returns through financial leverage and operational improvements.
What are the three main strategies LBOs use to increase value?
1. Operational Improvements (Higher Profits)
- Increase revenues and/or reduce costs, leading to higher EBITDA growth.
- Even if the valuation multiple remains the same, higher earnings increase company value.
2. Multiple Expansion (“Buy Low, Sell High”)
- Purchase at a low valuation multiple (e.g., 6x EBITDA) and sell at a higher multiple (e.g., 8x EBITDA).
- Achieved through stronger growth, better management, or industry trends.
3. Debt Reduction (Deleveraging)
- Use company cash flow to repay debt over time.
- As debt decreases, equity value increases (equity value = enterprise value – net debt).
LBOs create value by growing profits, improving efficiency, and reducing debt, leading to maximized returns upon exit (sale or IPO in 3-5 years).
What types of firms are suitable for Leveraged Buyouts (LBOs)?
1. Cash Flows
- Strong, stable, and cash-generating business.
- Potential for cost-cutting and efficiency improvements.
- Low capital intensity (not requiring heavy reinvestment).
2. Business Model
- Market leader with competitive advantages.
- Stable industry with growth potential.
3. Financial Structure
- Low existing leverage, allowing for additional debt financing.
- Clear exit strategy through a sale or IPO.
LBO firms prefer profitable, stable, and scalable businesses.
How do LBOs mitigate agency conflicts?
1. Monitoring
- Regular check-ups and board representation to oversee management.
2. Staging
- Capital infused in phases, ensuring company performance meets expectations.
3. Management Compensation
- Stock or options-based pay to align incentives.
- Vesting periods to prevent short-term gaming by executives.
Governance strategies ensure management stays aligned with investor interests.
Why do Private Equity (PE) firms use leverage in Leveraged Buyouts (LBOs), and when is it feasible?
1. Why Use Leverage?
Leverage (debt) is a key tool in LBOs because it enhances returns while reducing the amount of equity investment needed.
Key Reasons:
- Tax Benefits → Interest payments on debt are tax-deductible, reducing the tax burden.
- Incentivizing Efficiency → Debt repayment forces management discipline and operational efficiency.
- Lower Equity Commitment → PE firms can acquire larger companies with limited equity.
- Higher Returns (but Higher Risk) → Leverage amplifies returns but increases financial risk.
2. When is Leverage Feasible?
- Used mainly in later-stage buyouts, where companies have strong, predictable cash flows to support debt repayment.
- PE firms do not borrow directly → Instead, the target company takes on the debt, using its assets and cash flows as collateral.
LBOs use leverage to maximize returns while managing risk through financial discipline and efficient operations.
What is the financing structure of a Leveraged Buyout (LBO)?
- Most of the capital in an LBO comes from debt, while the PE firm invests a smaller portion as equity.
- Debt is structured in different layers, with varying levels of risk, cost, and repayment priority.
- LBOs use a combination of debt and equity, with debt forming the majority of the capital structure.
What are the key features and structure of Senior Debt in an LBO?
Senior Debt (Lowest Risk, Lowest Cost)
- Provided by: Banks & institutional lenders.
- Typical Proportion: ~45% of total financing.
- Risk Level: Lowest (secured by company assets).
- Interest Rate: LIBOR + 225-325 basis points (bp).
- Repayment Period: 7-9 years.
Key Features of Senior Debt
- First priority repayment → Lenders get paid first in case of default.
- Collateral-backed → The company’s assets serve as security.
- Lower interest rates → Due to lower risk.
- Includes Covenants → Rules ensuring financial discipline.
- Syndicated Loan → A “lead bank” arranges financing & distributes it among multiple lenders.
Structure of Senior Debt – “ABC Revolver”
- Tranche A (Amortizing Loan): Principal repaid gradually over time.
- Tranche B & C (Bullet Loans): No payments until maturity, then full payment.
- Cash Flow Must Support It: Company must generate enough cash flow to cover interest & principal repayments.
Senior debt provides cheap financing, reducing the overall cost of capital while ensuring financial discipline.
What is subordinated debt in an LBO, and what are its types?
Subordinated Debt (Higher Risk, Higher Cost)
- Provided by: Banks, mezzanine lenders, institutional investors.
- Typical Proportion: ~25% of total financing.
- Risk Level: Higher than senior debt (lower repayment priority).
- Interest Rate: LIBOR + 500-1000 basis points (bp).
- Repayment: ~10 years (often bullet repayment).
Types of Subordinated Debt
- Second Lien Debt → Secured but ranks below senior debt.
- Repayment after senior debt.
- Interest rate: LIBOR + 500 bp.
- Mezzanine Debt → Unsecured, highest risk.
- No collateral; lenders rely on company growth.
- Interest rate: LIBOR + up to 1000 bp.
- May include warrants (equity kicker) → Lenders get a small share in the company.
- Often includes PIK (Pay-In-Kind) interest → Instead of paying interest in cash, it’s added to the loan principal.
Used when more debt is needed beyond what senior lenders will provide. Higher risk = higher return for lenders.
What is High-Yield Debt (Junk Bonds) in an LBO, and what are its key features?
High-Yield Debt (Junk Bonds)
- Provided by: Bond investors (institutions & hedge funds).
- Typical Proportion: Variable (~10-20%).
- Risk Level: Very high (unsecured, last repayment priority).
- Interest Rate: Highest among debt types (~10-15%).
- Repayment: 8-10 years (bullet repayment).
Key Features
- No collateral → Lenders take the most risk.
- Used when companies need extra financing beyond other debt sources.
- Very expensive → Higher risk means higher interest rates.
- Last option for financing if other sources are not enough.
High-yield debt is a risky, expensive financing option used as a last resort when other funding sources are insufficient.
What is the role of equity in an LBO, and what are its key features?
Equity (Last in Repayment Priority, Highest Potential Return)
- Provided by: Private Equity (PE) firm & management.
- Typical Proportion: ~30% of total financing.
- Risk Level: Highest (only repaid after all debts are settled).
- Potential Returns: 100%+ if the investment is successful.
Key Features of Equity
- PE firms invest their own money to align interests.
- Management may also invest via “sweet equity”, which incentivizes performance.
- If the company performs well, equity holders receive the majority of profits.
- If the company fails, equity holders lose everything (debt gets paid first).
Equity ensures the PE firm has skin in the game, while maximizing returns for investors.
How do different layers of financing work together in an LBO?
- LBOs use multiple debt layers to minimize equity investment while maximizing returns.
- Senior debt is the cheapest & safest but requires stable cash flows.
- Subordinated debt (Second Lien, Mezzanine, High-Yield) fills gaps but has higher risk & cost.
- Equity provides the highest upside but is the riskiest investment.
LBO debt structure balances risk, cost, and repayment schedules, ensuring efficiency and high returns for investors.
What is Deal Origination in Private Equity, and how do PE firms source deals efficiently?
What is Deal Origination?
- The process of sourcing and identifying potential investment opportunities for a private equity (PE) firm.
- A core function of PE managers to maintain a pipeline of attractive deals.
Challenges in Deal Origination
1. High Competition
- More PE funds & available capital → More buyers competing for fewer deals.
- Many acquisitions are secondary buyouts (PE firms buying from other PE firms).
2. Auction-Based Deals - ~70% of PE deals happen through auctions, increasing bidding competition.
- Less profitable for buyers due to high purchase prices.
How PE Firms Source Deals Efficiently
- Exclusive Access to Vendors → Build personal networks to secure deals before auctions.
- Sector Focus & Expertise → Deep knowledge in a specific industry attracts opportunities.
- Deal Origination as a Core Competence → Invest in research, relationships, and sourcing strategies.
The ability to find and secure attractive deals before auctions is a critical skill for successful PE firms.
What is IPO underpricing, and how is the first-day return calculated?
IPO Underpricing
* Underpricing happens when an IPO price is set lower than the market price on its first trading day.
* Investors who buy at the IPO price see large initial gains when the stock jumps in value.
What are some key examples and trends of IPO underpricing?
Why does IPO underpricing happen?
Reasons for IPO Underpricing
- Investor Attraction → Ensures demand and a successful market debut.
- Risk Reduction → Helps avoid IPO failure due to weak demand.
- Underwriters’ Strategy → Banks benefit by giving institutional investors early gains.
Underpricing benefits IPO investors with instant gains, but the company raises less money than it potentially could.
What are the key stages in the IPO process?
1. Bookbuilding (Allocating Shares)
- Issuing firm & underwriter set a price range.
- Roadshow (Marketing Phase) → Company presented to institutional investors.
- Investors give nonbinding indications of interest.
- After bookbuilding (when offers become binding), final price is set & shares allocated.
2. IPO Timeline
- Pre-Marketing Phase → Initial discussions with investors.
- Marketing Phase → Roadshows, order-taking period.
- Setting Offer Price & Allocation → Final pricing & share distribution.
- First Listing Day → Shares start trading.
- Stabilization Phase → Price support to avoid volatility.
3. Price Support (Stabilization)
- Underwriters might help keep stock price stable but aren’t required to.
- They can buy back shares (Green Shoe Option) to prevent price drops.
- Stock prices stay close to IPO price, requiring significant selling to push them down.
- Underwriters try to avoid sudden price drops, but no official promise exists.
The IPO process involves pricing, allocation, and post-listing price support to ensure a smooth market debut.
What is the Green Shoe option in an IPO, and why does it matter?
Green Shoe Option (IPO Price Stabilization Tool)
- Used in Initial Public Offerings (IPOs) to help keep the stock price stable.
- Underwriters sell more shares than originally offered (overallotment), creating a temporary short position.
- If the stock price rises, underwriters buy extra shares (up to 15% limit in US & Germany) from the company to cover the short.
- If the stock price drops, underwriters buy back shares from the market at a lower price to stabilize the price.
Why It Matters?
✅ Prevents excessive stock price drops after an IPO.
✅ Increases investor confidence in the new stock.
What are the key costs associated with IPOs, and why are US IPO fees surprising?
1. High IPO Costs in the US
- Companies pay ~7% of the IPO volume as a fee.
- This spread is the difference between the investor price and what the investment bank gives to the company.
2. Lower Costs in Other Countries
- In other countries, IPO fees are typically 3.5%—about half of US IPO costs.
3. Why is This Surprising?
- Normally, economies of scale should reduce costs as IPO size increases.
- But medium-sized IPOs still face high fees, showing no cost advantage for bigger deals.
- Investment banks charge high & fixed IPO fees, especially in the US, making IPOs expensive.
- The lack of economies of scale suggests strong pricing power by investment banks.
What are the key costs associated with IPOs, and why are US IPO fees surprising?
1. High IPO Costs in the US
- Companies pay ~7% of the IPO volume as a fee.
- This spread is the difference between the investor price and what the investment bank gives to the company.
2. Lower Costs in Other Countries
- In other countries, IPO fees are typically 3.5%—about half of US IPO costs.
3. Why is This Surprising?
- Normally, economies of scale should reduce costs as IPO size increases.
- But medium-sized IPOs still face high fees, showing no cost advantage for bigger deals.
Key Takeaway:
* Investment banks charge high & fixed IPO fees, especially in the US, making IPOs expensive.
* The lack of economies of scale suggests strong pricing power by investment banks.
