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Private Equity Investing

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Title: Private Equity Investing


1
Private Equity Investing
  • Mehmet I. Budak

2
What is Private Equity?
  • Investment strategy that involves the purchase of
    equity or equity linked securities in a company
  • Investment is made through a negotiated process
  • By sophisticated investors with financial and
    operating expertise
  • The goal is to acquire undervalued or promising
    assets and realize profits in 3-5 years after the
    acquisition
  • Information asymmetry and inefficiencies are
    important factors

3
Alternative Investments
4
Private Equity Investment Strategies
  • Leveraged Buyouts
  • Venture Capital (early vs. late stage)
  • Special Situations (i.e. distressed)
  • Mezzanine
  • Secondary Purchases
  • Fund of Funds

5
Leveraged Buyouts
  • Established firms with track records, stable cash
    flows and stable growth rates
  • Annual revenues of 25 - 500 million
  • Typically in basic retail, transportation and
    manufacturing industries
  • Typically have assets to borrow against and
    access to bank loans
  • Seek private equity to effect a change in
    ownership, finance an expansion or restructure

6
Venture Capital - Early Stage
  • Firms with substantial risk of failure - business
    models and marketing approach are yet to be
    proved
  • Small and illiquid investments with size of 500k
    - 2 million
  • The smallest type is the entrepreneur who needs
    the financing to conduct initial research and
    development
  • The most mature type are those firms that are
    starting to turn profits but need capital for
    expansion
  • Angel capital is an important source of funding

7
Venture Capital - Late Stage
  • Firms with more certain business models
  • Proven technology and market
  • Profitable and need expansion capital
  • General size of 2 - 15 million
  • IPO or Sale expected/feasible in near term
  • Original investors may achieve some liquidity
  • Because the risk is generally lower and the
    liquidity higher, later-stage investments require
    lower returns than early-stage investments

8
Leveraged Buyouts vs. Venture Capital
  • Buyouts focus on mature companies with stable or
    sustainable growth profile
  • Buyouts rely heavily on debt financing to finance
    most of the purchase price
  • Venture Capital focus on high growth industries
    with riskier investment profile than buyouts
  • Venture Capital relies heavily on equity
    financing and has higher return targets than
    buyouts

9
Special Situations
  • Investment is supplied by specialized Turnaround
    Funds (TF) for target firms that have defaulted
    on their outstanding loans
  • TFs receive controlling interests, with former
    owners making up the minority interest
  • TFs renegotiates terms with existing lenders,
    offering to restructure or pay off loans at a
    discount
  • TFs also deliver expertise to find new markets or
    partners for the firms products, cut costs,
    change or improve the current management

10
Fund of Funds
  • Investing directly in PE funds can be difficult
    for individual investors and small institutions
  • Relatively high investment minimums may
    disqualify some of the small investors
  • Information on PE managers is difficult to locate
  • Gaining access to top PE funds can be difficult
    due to high investor demand
  • Fund of Funds co-mingles the investments of small
    investors into a single pool and then assembles a
    portfolio of PE funds

11
How are PE Funds Structured?
  • Private limited partnerships
  • Individual managers are the General Partner (GP)
  • Providers of capital (pensions, insurance
    companies, wealthy people) are Limited Partners
    (LPs)
  • Partnerships have 10-year life with 11
    extension
  • 4-6 year investment period
  • 1-2 annual management fee
  • Profits split 80-20, after reaching hurdle
    return level for LPs
  • LPs need to fund within 2-3 weeks of capital
    call
  • Penalties for failure to fund by LPs
  • IRRs depend on when money is transferred by LPs

12
General Partners Key Activities
  • Selecting investments
  • Obtaining access to high quality deal flow
  • Sorting and evaluating large amount of
    information
  • Structuring investments
  • Designing transactions
  • Monitoring investments
  • Providing strategic, operational and financial
    assistance to portfolio companies
  • Exiting investments
  • IPO, Sale or Recapitalization

13
Private Equity Partnerships and Fundraising
14
Private Equity Market - Investors
  • Public and corporate pension funds, endowments,
    foundations, wealthy families, insurance
    companies, foreign investors and others
  • Investors expect to receive higher risk-adjusted
    returns on private equity than other investments
  • Potential benefits of diversification
  • Advantage of economies of scope between private
    equity investing and investors other activities

15
Private Equity Market - Intermediaries
  • 80 of PE investments flow through specialized
    intermediaries, which are limited partnerships
  • Intermediaries provide expertise in selecting,
    structuring, and managing private equity
    investments
  • Intermediaries not organized as LPs play a less
    significant role today in the private equity
    market
  • SBICs owned by banks and VC subsidiaries of
    non-financial corporations mostly invest their
    corporate parents capital

16
Private Equity Market - Issuers
  • Vary in size and their reasons for raising
    capital
  • Young firms that are developing innovative
    technologies
  • Middle market companies that are stable,
    profitable and need private equity to expand or
    restructure
  • Going private transactions for public companies
  • PIPE (Private Investment in Public Equity)
    provides financing without registration costs/
    disclosures associated with public offerings

17
How are PE Funds Structured?
  • Limited Partners Investors with money
  • Insurance companies, pension funds, banks, and
    high net worth individuals
  • Investors commit a certain amount to the fund
  • They have no other active role in the fund and no
    liability beyond their commitments
  • One General Partner Managers of money
  • Manages the investments via a management company
  • Receives management fee (typically 2) on
    commitments
  • Receives carried interest in the profits

18
How are PE Funds Structured?
  • Contractually fixed lifetime (10-12 years)
  • Capital is invested during the first 4-6 years
  • Thereafter, investments are managed and
    liquidated
  • Distributions are made to the limited partners in
    the forms of cash or securities
  • General Partner typically raises a new fund when
    the investment phase for the existing fund has
    been completed (gt 80)
  • Each fund partnership is legally separate and is
    managed independently of other fund partnerships
    (i.e KKR I vs. KKR II)

19
Partnership Terms - Example
  • Target Fund Size 1 billion
  • Minimum Commitment 10 million
  • Gross Target Return 25
  • Management Fee 2
  • Carried Interest 80 - 20
  • Commitment Period 5 years
  • Fund Term 10 years 11

20
Relationship Between LPs and GPs
  • LPs delegate significant responsibilities to GPs
  • Resolution of potential conflict of interests
    lies in the structure of the partnership
    agreement
  • Partnerships have finite lives
  • To remain in business, GPs regularly raise new
    funds - easier for reputable firms with good
    record
  • GP compensation is closely linked to the fund
    returns

21
Partnership Covenants
  • The objective is to limit excessive risk taking
    by GPs
  • Covenants usually set limits on the of the
    partnerships capital that may be invested in a
    single firm
  • Covenants may preclude investments in publicly
    traded and foreign securities, derivatives and
    other private equity funds, etc
  • Covenants usually require that cash from sale of
    portfolio assets be immediately distributed to
    LPs
  • LPs usually limit such deal fees or require that
    deal fees be offset against management fees
  • Return hurdle rates for LPs

22
Evaluating General Partners
  • Track record, relevancy of past experience
  • Generation of adequate deal flow
  • Sound investment decision-making processes
  • Ability to achieve successful exits / liquidity
  • Advantages vs. similarly focused funds
  • Sufficiency of resources
  • Meaningful commitment of time
  • Cohesiveness and sustainability of team
  • Succession planning

23
Co-investment By LPs
  • Co-investments are direct investments in
    portfolio companies by LPs alongside private
    equity partnerships
  • Usually, LPs acquire the securities on the same
    terms as the partnership but pay no management
    fee or carried interest
  • Co-investment opportunities arise when GPs need
    additional equity financing to close a deal
  • Some institutional investors see co-investing as
    an opportunity to acquire expertise in private
    equity investing
  • For GPs, LPs that stand ready to co-invest
    represent a flexible source of funds for closing
    deals

24
Transaction Origination
25
Deal Flow
  • Deal flow, access to high quality investment
    opportunities, is absolutely crucial
  • GPs rely on relationships with third parties and
    industry contacts for deal flow generation
  • The greater the deal flow, the higher the
    likelihood of identifying an attractive
    opportunity
  • Proprietary deals are more attractive than
    deals brought by agents or intermediaries
  • Less competition means lower purchase price
  • Lower purchase price means higher IRRs

26
Origination
  • Investment banks, consultants, lawyers and
    industry contacts introduce potential
    opportunities
  • Preliminary opportunity analysis will be
    performed relatively quickly
  • Initial decision is quickly made whether a PE
    firm would be interested in the opportunity
  • PE firms have different investment strategies and
    views of the world
  • If interested, PE firms would sign
    Confidentiality Agreement to begin evaluating the
    opportunity

27
Screening of Deals
  • Deal screening is art and science
  • PE firms receive many investment proposals in a
    year
  • Proposals are first screened to eliminate those
    that are clearly fail to meet investment criteria
  • Specialization on a specific industry or
    geography reduces the number of investment
    opportunities considered
  • Initial review takes a 1 2 days and results in
    the rejection of 90 of proposals received by a
    PE firm
  • Surviving proposals then become subject to a
    secondary review after the signing of a
    Confidentiality Agreement
  • Proposals that survive the preliminary and
    secondary reviews become the subject of a
    comprehensive due diligence process

28
Non-Binding Indications of Interest
  • Commonly referred to as 1st round bid
  • Give sellers a perspective on the level of buyer
    interest and the valuation parameters buyers are
    likely to assume
  • Indication of interest subject to
  • Completion of business, legal, accounting and
    environmental due diligence
  • Negotiation and execution of documents
  • Receipt of necessary approvals
  • Negotiation of employment agreements with key
    management

29
Leveraged Buyouts
30
What is an 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
    (NewCo), which borrows debt and simultaneously
    acquires the target
  • PE firm contributes capital, operating and
    financial expertise, strategic insight, contacts
    and management talent
  • Management ownership increases, creating higher
    incentives to improve operations and 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

31
Typical LBO Structure
32
Typical LBO Structure
  • Varies over time with market conditions
  • Sources of financing
  • 40 50 senior bank debt (5-7 years)
  • 20 30 subordinated debt (8-12 years)
  • 20 40 common equity
  • Bank debt is secured from receivables, inventory
    and PPE

33
Good LBO Candidates
  • History of consistent profitability
  • Predictable cash flows to service debt
  • Availability of excess cash
  • Easily separable assets or businesses
  • Strong management team
  • Strong brands and market position
  • Industry with barriers to entry
  • Little danger from disruptive changes
    (technology, regulatory, etc.)
  • Visible/feasible exit strategy (IPO or MA)

34
Value Creation
  • Strategic
  • Vision, growth initiatives, add-on acquisitions,
    exit
  • Operational
  • Sales, costs, assets
  • Organizational
  • Processes, structure, systems, skills
  • Financial
  • Balance sheet, tax structure, capitalization
  • Expansion in valuation multiples
  • Advantages of being private

35
How Do PE Firms Create Value?
  • Minimize purchase price
  • Maximize leverage
  • Minimize liabilities purchased
  • Manage transaction costs
  • Improve business operations
  • Maximize tax efficiency
  • Optimize exit

36
Minimize Purchase Price
  • Avoid competition
  • Auction process vs. proprietary deal
  • Maintain price discipline
  • Avoid deal fever
  • Maximize deductions from headline price
  • Earn outs
  • Liabilities pension, legal, other

37
Maximize Leverage
  • Maintain competitive process among banks willing
    to fund the transaction
  • Choose right financing structure
  • Balance of risk, flexibility and interest cost
  • Seller notes and staple financing
  • Deeply subordinate and at attractive terms
  • Partner with co-investors

38
Minimize Liabilities Purchased
  • Detailed due diligence
  • Legal
  • Financial
  • Accounting
  • Environmental
  • Tough negotiations
  • Reps and Warranties

39
Transaction Costs and Taxation
  • Minimize transaction costs
  • Internal costs
  • Aborted deal costs
  • Maximize tax efficiency
  • Increase interest tax shield
  • Increase depreciation
  • Increase tax deductible amortization

40
Improve Business Operations
  • Top line growth
  • New markets, partners
  • Products
  • Margin improvement
  • COGS
  • SGA

41
Exit
  • Difficult to predict future business cycles and
    market conditions
  • Prepare an exit strategy and groom the business
    for that exit
  • Trade sale or MA clean cash exit
  • IPO long process, company needs to be above a
    certain size, lock-up restrictions
  • Leveraged recapitalization allows sponsor to
    remove invested capital prior to ultimate exit,
    increases IRR and hedges against poor exit
  • Secondary buyout selling to another sponsor

42
Sources and Uses of Funds
43
Sources of Funds
  • Equity
  • New equity injection from LBO sponsor
  • Potential equity contribution from existing
    management
  • Potential continuing equity investment by
    existing shareholders (rollover)
  • Equity from a strategic partner
  • Debt
  • Bank debt (senior debt)
  • High yield debt (subordinated debt)
  • Mezzanine securities
  • Can be structured to be more debt-like or more
    equity-like depending on the situation

44
Bank Debt
  • Senior secured (most senior debt)
  • Flexible, interest rate is floating
  • Matures before other debt classes, amortizing
  • Typically callable/prepayable at par
  • Quarterly interest payments
  • Maintenance covenants
  • Structured at the operating company level
  • Underwritten via syndication
  • Diligence, commitment, launch, syndicate, fund

45
Bank Debt
  • Revolving Credit Facilities vs. Term loans
  • Revolvers allow multiple drawings for working
    capital and general corporate needs
  • Term loans funded at closing
  • Pro Rata facilities
  • Revolver and Term Loan A held by commercial
    banks
  • Buy and hold mentality, shrinking segment
  • Institutional tranches
  • Consist of Term Loans B, C or D- held by
    insurance companies, CLOs and CDOs, growing
    segment
  • Purely transactional, liquidity in the secondary
    market
  • Minimal front-end amortization

46
High Yield Bond Debt
  • Usually subordinated and/or unsecured
  • Interest rate is fixed, maturity of 8-10 years
  • Bullet maturity after full bank debt
    amortization
  • Usually not callable at par in early years,
    typically 1-5 years
  • Structured at the operating company level
  • Publicly quoted security
  • Incurrence covenants
  • Diligence, document, roadshow, price and fund

47
Mezzanine Debt
  • Subordinated to bank debt and high yield bonds
  • Flexible, typically floating interest rate
  • Non-amortizing, bullet maturity typically after
    10 years
  • Cash PIK coupon payment further enhanced with
    equity warrants
  • PIK component can eat into equity
  • Structurally subordinated at the holding company
    level
  • Incurrence covenants

48
Due Diligence
49
Due Diligence
  • Objective
  • Validate business concept
  • Verify market
  • Appraise management
  • Validate forecasts
  • Valuation
  • Diligence establishes basis for valuation, price
    and negotiation
  • Diligence is expensive and time consuming
  • Diligence strategy
  • Preliminary evaluation to identify
    deal-breakers before spending time and money on
    detailed due diligence

50
Key Topics for Due Diligence
  • Business concept, opportunity
  • Market
  • Competition
  • Customers
  • Products
  • Management
  • Financials
  • Returns

51
Business Concept, Opportunity
  • What is the concept/opportunity?
  • Is the opportunity sustainable?
  • Potential size of the opportunity?
  • How can the target company capitalize on the
    opportunity?
  • Is the proposed plan/strategy realistic?
  • How does the target business fit to its markets
    and region?
  • Why are we so smart or lucky?

52
Market
  • Market characteristics, segments, size, growth,
    cyclicality, key metrics, demographics?
  • Projected market share and sales volume?
  • Low barriers to entry into the market?
  • Is targets business model sustainable?
  • How will the business be perceived by customers?
  • Regulatory issues?

53
Competition
  • Who are the direct competitors?
  • Relative size, scope, cost basis, brands and
    market share?
  • What are the key factors/levers of competition in
    the industry?
  • How is targets business strategy different than
    competitors?
  • What are targets competitive advantages?
  • What are the targets competitive disadvantages?
  • Threat from potential new entrants?

54
Customers
  • Who are the customers?
  • Current and future customer base?
  • What specific market and customer needs does the
    target business serve?
  • How do customers make their purchase decisions?
    Key criteria?
  • Customer satisfaction and retention?
  • Does the projected number of customers or sales
    make sense? Realistic?
  • How will the target acquire new customers?

55
Products
  • Product life cycle, penetration trends?
  • Product pricing?
  • Product profitability?
  • Productivity versus competition?
  • Maintain or jettison certain products?
  • Plant consolidation?
  • Inventory optimization?
  • CAPEX requirements?
  • Development plans?

56
Management
  • Competent?
  • Experienced?
  • Cohesive?
  • Strategic?
  • Flexible?
  • Incentivized?
  • Proactive?
  • Realistic?

57
Financials
  • What is the optimal capital structure?
  • Are revenue and cost projections comprehensive,
    realistic, reasonable?
  • What are the underlying business assumptions of
    the projections?
  • Impact of various business case scenarios?
  • How does cash flow in this business?
  • How much capital investment needed? When?
  • Correct accounting treatment?
  • What are the key sensitivities?

58
Confirming Value
  • Financial and accounting diligence is primarily
    focused on drilling into the basic components of
    valuation
  • Recurring EBITDA (adjust for extraordinary items)
  • CAPEX
  • Working Capital
  • Cash Flow
  • Multiple

59
Recurring EBITDA
  • General issues exclusions, accounting changes,
    pro forma adjustments
  • Revenue components, method of recognition,
    customers, customer arrangements, pricing/volume
  • Margins components of cost of sales, gross
    margin trends
  • Reserves under/over statement of profits
  • Compensation benefits, headcount needs,
    transition issues, bonus
  • SGA components, trends, discretionary costs,
    fixed vs. variable, cost savings
  • Other restructurings, acquisitions,
    contingencies

60
CAPEX
  • Determine normalized annual CAPEX
  • Maintenance or mandatory CAPEX
  • Determine expansion CAPEX
  • Discretionary CAPEX
  • CAPEX between signing and closing of transaction
    reduce net cash position
  • Important to have correct CAPEX assumptions in
    calculating exit value

61
Working Capital
  • Analyze working capital cycle
  • Components of B/S accounts
  • Needs and trends
  • Savings opportunities
  • Potential closing balance sheet issues
  • Important to have correct working capital
    assumptions in calculating exit value

62
Legal Due Diligence
  • Conducted in tandem with business, financial and
    accounting due diligence
  • Structure the transaction in the most tax
    efficient manner
  • Understand the legal aspects of targets business
    and assets being acquired
  • Identify and evaluate liabilities
  • Materials are typically made available for review
    in a data room

63
What Is a Bad Deal?
  • No real competitive advantage of PE firm
  • Long list of things that have to go right to make
    the deal work
  • Build it and they will come is not a good
    business strategy
  • Aggressive estimates of future growth
  • Employing the wrong management team
  • True downside case is not adequately evaluated

64
Transaction Structuring and Documentation
65
Term Sheets
  • Preliminary documents designed to provide a
    framework for negotiations between investors and
    the target company
  • Provides collective understanding of the proposed
    transaction, basic terms and conditions
  • Generally focuses on the targets valuation and
    the conditions under which investors agree to
    provide financing
  • Term sheet eventually transforms into a formal
    agreement known as the Purchase Agreement, which
    is a legal document that details
  • who is buying what
  • from whom
  • at what price
  • when

66
Key Sections of Term Sheets
  • Acquirer
  • Target
  • Valuation
  • Structure of acquisition
  • Management compensation
  • Debt financing
  • Board of directors
  • Rights
  • Transaction fees
  • Management fees

67
Purchase Agreement
  • Transaction terms and structure
  • Description of asset sold
  • Calculation of purchase price
  • Closing date
  • Reps and Warranties buyer and seller
  • Conditions to closing seller
  • Conditions to closing buyer
  • Conditions for termination

68
Purchase Agreement
  • Clarity regarding key financial and deal terms
  • Business/assets being acquired and the
    liabilities being assumed
  • Arrangements for asset sharing going forward
  • Protecting the acquirer from contingent or
    undisclosed liabilities
  • Locking up the target, no shopping of the deal
  • Representations and Warranties verification of
    factual matters covered during the due diligence
  • Pre-closing operations
  • Closing conditions fiduciary outs, break up fee
  • Purchase price adjustments post closing
    adjustment

69
Representations and Warranties
  • Statement of fact at a particular point in time
  • Purpose
  • Provides basis for refusal to close the
    transaction if untrue (pre-close)
  • Provides basis for post-closing indemnification
    for damages if untrue (post-close)
  • Mainly refers to areas covered in due diligence
  • Financial statements, liabilities, contracts,
    real estate, litigation, taxes
  • Both buyer and seller gives Reps Warranties
  • Buyers objective understand what I am buying
  • Sellers objective increase certainty of closing

70
Covenants
  • Agreements to act or refrain from acting in the
    future
  • Positive vs. Negative covenants
  • Necessary because signing and closing are not
    simultaneous
  • Pre-closing covenants
  • Largely to the benefit of buyer
  • Objective is to preserve the asset to be
    purchased and ensure closing occurs
  • Post-closing covenants
  • To the benefit of seller
  • Objective is to protect certain interests once
    seller no longer owns the business

71
Covenants
  • Pre-closing
  • Operations in the ordinary course of business
  • No solicitation of proposals from competing
    buyers
  • No dividends and distributions
  • No issuance of equity or incurrence of debt
  • No acquisitions and divestitures
  • No execution of significant contracts
  • No change in accounting practices
  • Post-closing
  • No changes to compensation
  • No hiring or firing of key management employees

72
Closing Conditions
  • Transaction will not close until all conditions
    are satisfied
  • Representations and warranties are true
  • Absence of material adverse change in the
    business
  • Excludes general economic or industry conditions,
    stock price movements, failure to meet forecasts,
    matters known to buyer
  • Receipt of required government approvals and
    major third party consents
  • Debt financing available on terms and conditions
    set forth in commitment letters
  • Termination is cessation of both parties
    obligations
  • Drop dead date financing and regulatory
  • Breaches - break up fee 5
  • Fiduciary out
  • Buyers objective to be able to walk away if
    anything major is wrong
  • Sellers objective to have some certainty that
    transaction will close if things are in
    reasonable order

73
Deal Process Inside the PE Firm
  • Initial screening of deals
  • Heads up memorandum
  • Non-binding indications / term sheets
  • Detailed due diligence and evaluation
  • Formal and detailed presentation to the
    investment committee
  • Final approval and funding

74
Heads Up Memo
  • Why is the company being sold?
  • What is the investment thesis?
  • How does the opportunity fit with the PE firms
    investment strategy and skill base?
  • What are the size, structure and timing of the
    investment?
  • What is the PE firms edge in the process?
  • What is the due diligence road map?
  • How will the PE firm exit the investment?
  • What are the expected returns and key assumptions
    driving the projections?

75
Formal Investment Committee Memo
  • Analysis of the deal opportunity, the business,
    the transaction, the process, industry trends,
    due diligence results
  • Detailed discussion of risks and opportunities
  • Detailed analysis of operating and financial
    projections
  • Detailed scenario analysis and projected returns
  • Key questions to answer
  • Why do we want to do this deal?
  • What is our edge?
  • What value do we bring to this deal?
  • Who is the competition?
  • How and when will we exit?
  • Impact of this deal on the rest of the portfolio?

76
Portfolio Company Monitoring
77
Portfolio Company Life
  • Year 1 Figure out what you just bought
  • Fix problems, focus on 2-3 key areas to improve
  • Assess and change out management
  • Years 2-3 Strategic Plan and Execution
  • Develop strategic business plan
  • Make investments, pursue acquisitions
  • Execute plan
  • Pay down debt
  • Year 4-5 Prepare for Exit
  • Windows dressing, clean up
  • Sell on good performance

78
Portfolio Monitoring
  • Takes place at least quarterly
  • Candid and open discussion on the status of each
    investment
  • Progress of investment thesis
  • Value already created
  • Problems experienced
  • Changes needed to the game plan
  • Basis for valuation
  • Exit planning and timing

79
Portfolio Monitoring
  • Information gathering is crucial
  • Board seats provide meaningful access
  • Monthly financial and operational statistics are
    provided to PE investors
  • Regular interaction (weekly/monthly conference
    calls) with management
  • Weekly PE firmwide meetings
  • Quarterly MDA write-ups from portfolio companies
  • Annual audit reports

80
Portfolio Company Assistance
  • Strategic and operational advice
  • Financial engineering expertise
  • Recruitment of top management and board members
  • Leveraging industry contacts for identifying
    future partners, markets
  • Revenue growth
  • Gross margin improvement
  • Operating expense reduction
  • Cash flow improvement
  • Crisis management
  • Corporate governance
  • Exit preparation
  • Degree of involvement varies with type of
    investment

81
Mechanisms of Control
  • Board Representation
  • GPs are extremely influential and effective
    outside directors
  • GPs have the resources and staff to monitor
    portfolio companies
  • Allocation of Voting Rights
  • GP investment is large enough to achieve majority
    ownership
  • In some situations, GPs may obtain voting control
    even if they are not majority shareholders
  • In general, a GPs voting rights do not depend on
    the type of stock issued. For example, holders of
    convertible preferred stock may be allowed to
    vote their shares on an as converted basis
  • Control of Access to Additional Financing
  • Venture Capital is provided in several rounds
  • Influence of original investor is high on new
    GPs willingness to participate in subsequent
    rounds

82
Best Practices
  • Interact regularly with the management and gather
    timely information
  • Focus on top 2-3 priorities and deliver strategic
    and operational assistance
  • Evaluate progress made vs. plan
  • Identify problems early
  • Adjust game plan as needed
  • Value portfolio companies conservatively
  • Prepare for exit at least one year in advance

83
Exit
84
Exit
  • Limited partnerships must be dissolved within a
    certain time as they need to return capital to
    LPs
  • Exit Monetization and realization of paper
    profits
  • Exit requires advanced planning and preparation
  • Sale
  • IPO
  • Recapitalization

85
Exit Planning
  • Need to forecast the evolution of the business
  • Closely follow macro trends in the industry
  • Who are the likely buyers?
  • Strategics vs. financial buyers
  • Foreigners vs. local buyers
  • Exit preparation takes time
  • Execute strategy and hit the budget forecasts
  • Develop and prepare the management team
  • Establish a clean track record (audits)
  • Establish a reputable and competent board

86
MA Exit
  • Advantages
  • Buyers usually pay a premium
  • Clean exit with greater certainty
  • Cheaper than IPO
  • Faster and simpler than IPO
  • Convince one buyer vs. the whole market
  • Disadvantages
  • May not be welcomed by the management sale or
    merger imply reduced independence
  • Buyer appetite can be unpredictable

87
MA Sellside Process
  • Investment bank (target advisor) due diligence
  • Investment bank (target advisor) writes selling
    memo
  • Narrow the universe of potential buyers and place
    initial calls into buyers
  • Send and negotiate confidentiality agreements
  • Send preliminary bid letters
  • Analyze preliminary bids
  • Create management presentations
  • Assemble data room
  • Buyer due diligence
  • Send final bid letter
  • Analyze final bids
  • Negotiate key terms
  • Contract negotiations and documentation
  • Transaction announcement

88
IPO Exit
  • Advantages
  • Prestige of becoming a publicly traded company
  • Currency for future MA activity
  • Increased visibility for the company
  • Preservers a companys independence and provides
    continued access to capital
  • Disadvantages
  • Not an immediate, clean liquidity event for
    investors
  • Long and time-consuming
  • Distraction for management
  • Expensive process
  • Information disclosure requirements
  • Lock ups

89
IPO Process
  • Due Diligence and Drafting
  • Meetings with senior management, iterative
    drafting of registration statement (Business
    Overview, Risk Factors, Financials, MDA)
  • Initial Filing with SEC
  • Generally accessible to the public and does not
    include the expected share price range for the
    offering
  • Structuring and Valuation
  • Selecting co-managers, setting the initial filing
    range that serves as a valuation guideline for
    investors during the marketing process
  • Prospectus Distribution
  • SEC gives comments on each draft of registration
    statement, the preliminary Prospectus is mailed
    broadly to potential investors
  • Salesforce Education
  • On the companys story before marketing to
    potential investing clients, management dry runs
  • Targeting Investors
  • Identification of best potential buyers,
    determine anchor buyers based on their current
    holdings of stock, one-on-one meetings

90
IPO Process
  • Syndication
  • The lead underwriter takes the primary
    responsibility for this, syndicate members
    underwrite a fixed amount of stock and may be
    given additional allotments
  • Roadshow and Bookbuilding
  • Schedule of meetings with investors in key cities
    around the world, lasts 2-3 weeks, roadshow team
    makes formal presentations to investors at these
    meetings, key investors are met in a one-on-one
    format, smaller investors are accommodated in a
    group
  • In tandem with the marketing effort, the
    bookbuilding process begins, investors submit
    indications of interest for shares in the IPO,
    the lead managers collect these orders and build
    a book of demand over the course of the marketing
    period, a critical component is the collection of
    qualitative feedback on the orders in the book
  • Pricing and Allocation
  • The quality of the book and aftermarket
    intentions of investors are critical, share
    performance in the aftermarket is important,
    allocations to institutional and retail investors
  • Aftermarket
  • Balance supply and demand in the aftermarket,
    over-allotment option, on-going research coverage
    (after 25 days) and trading support

91
Recapitalization
  • Usually, the acquired company is highly levered
    at the beginning
  • Over time, the company pays off debt with cash
    flows from its operations
  • This creates additional capacity to add more debt
    1-3 years after the acquisition
  • When additional debt is issued, excess cash is
    dividended out to the equity investors
  • Investors achieve partial monetization
  • Refinancing a mortgage is effectively a
    recapitalization

92
Capital Distribution to LPs
  • Once an investment is monetized, the profits
    will be divided between LPs and GPs according to
    the partnership agreement
  • 80 / 20 is usually the norm
  • 80 to the LPs
  • 20 to the GPs
  • A minimum return hurdle for LPs may have to be
    cleared before GPs can claim their share of
    profits (I.e. 8)
  • Clawback provision
  • High returns make a strong track record which in
    turn makes future fundraising easier

93
Other Topics
94
Business Plan
  • Identify a business need or niche and demonstrate
    its feasibility
  • Analyze a product within the context of market
    and customer
  • Evaluate the viability of a technology
  • Describe major goals, objectives, and vision for
    1 year, 3 years and 5 years
  • Assess ability of management to execute
  • Provide detailed financial projections

95
Business Plan Key Sections
  • Concept/Opportunity
  • Strategy
  • Operations
  • Markets
  • Customers
  • Products
  • Competition
  • Risks
  • Implementation

96
Concept/Opportunity
  • Always stated within the context of an existing
    or projected market
  • Translate concept into terms that investors can
    understand
  • Clearly highlight which market needs will be
    filled or issues will be addressed
  • Have comprehensive knowledge of the competitive
    environment and the potential reactions from
    competitors
  • Analyze the current and future customer base in
    detail

97
Raising Money
  • The process of raising money may have significant
    costs
  • Time
  • Opportunity cost of distraction
  • Significant amount of questions and information
    requests
  • Impact on the organization (I.e. uncertainty)
  • Direct expenses travel, legal and accounting
  • May be beneficial to hire reputable advisors with
    relevant past fundraising experience and track
    record

98
Presenting to Private Equity Firms
  • Identify relevant PE firms
  • May make sense to use advisors
  • Most effective if someone credible refers you to
    the PE firm
  • Do your research in advance
  • At the initial meeting, impress them and capture
    their interest
  • PE firms time is the biggest asset

99
Questions in PE Minds
  • Who are these people?
  • Do they fit the way we do business?
  • What is the value and appeal of this business?
  • Will there be enough customer demand for its
    products?
  • What can go wrong with this company?
  • What needs to be accomplished to justify this
    valuation?
  • What are the key trends in the industry and
    sector?
  • How dependent is the value of this company on the
    overall performance of the sector or industry?
  • What is the likely response from competition?
  • Do they have the right experience and skills to
    deliver?
  • Do they have a realistic, relevant and flexible
    strategy?
  • What are the exit implications?
  • IPO and MA market trends?
  • Can we/they win?

100
Developing Economies Need
  • Capital
  • Strategic vision
  • Growth
  • Credibility
  • Global best practices
  • Investor contacts
  • Management talent

101
Private Equity Provides.
  • Access to long-term financing
  • GPs and LPs with significant investing experience
    around the globe
  • Valuable strategic insights and operational
    expertise
  • Significant financial discipline
  • Substantial credibility and visibility to target
    company and the country
  • Best practices to pursue profitable growth

102
Positive Impact of Private Equity
  • A long-term support to those companies with the
    potential of success and sustainability
  • Builds and grows business faster than they
    otherwise would
  • Encourages entrepreneurial spirit, technological
    advancement and job creation
  • Crucial to the existence, feasibility and success
    of businesses in the seed/start-up and expansion
    stages
  • Teaches discipline of the buyside

103
Priorities for Private Equity
  • Promote entrepreneurial environment and increase
    incentives for entrepreneurial investments
  • Facilitate private equity fund formation
  • Develop long-term capital sources
  • Incorporate private equity needs and perspectives
    into policy-making

104
Entrepreneurial Environment
  • Minimum regulation and bureaucracy
  • Simplified requirements of company formation
  • Support for private equity and entrepreneurial
    education
  • Favorable tax regime capital gains
  • Equity and options ownership
  • Awareness of private equity as engine of growth
    and value creation

105
Long-Term Capital Sources
  • Access to long-term funding is essential for PE
    firms
  • Development of pension funds and relevant
    regulatory regime is a critical step
  • U.S. example
  • Pension funds should be allowed to invest in
    private equity
  • Unrestricted movement of capital is a must-have
    for private equity industry

106
Rules for Private Equity Investing
  1. Develop your own idea of what a business is worth
  2. Avoid auctions
  3. Pick your spots
  4. Approach each potential transaction with
    overwhelming force
  5. Follow the cash
  6. Get timely help from experts, advisors
  7. Keep your emotions in check (deal fever)
  8. Develop trust with your team and managers
  9. Make sure acquired company managers concentrate
    on the few vital objectives
  10. When management team is not working, change them
    as soon as possible
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