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My Blackbook Private Equity Project Most Important.
My Blackbook Private Equity Project Most Important.
My Blackbook Private Equity Project Most Important.
HISTORY
The early history of private equity relates to one of the major periods in the history
of private equity. Within the broader private equity industry, two distinct sub-
J.H. Whitney & Company was founded by John Hay Whitney and his partner
Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer
Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his
cousin Cornelius Vanderbilt Whitney. By far, Whitney's most famous investment
was in Florida Foods Corporation. The company, having developed an innovative
method for delivering nutrition to American soldiers, later came to be known as
Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H.
Whitney & Company continues to make investments in leveraged buyout
transactions and raised $750 million for its sixth institutional private equity fund in
2005.
PRIVATE EQUITY IN 1980S
The development of the private equity and venture capital asset classes has
occurred through a series of boom and bust cycles since the middle of the 20th
century. The 1980s saw the first major boom and bust cycle in private equity. The
cycle which is typically marked by the 1982 acquisition of Gibson Greetings and
ending just over a decade later was characterized by a dramatic surge in leveraged
buyout (LBO) activity financed by junk bonds. The period culminated in the
massive buyout of RJR Nabisco before the near collapse of the leveraged buyout
industry in the late 1980s and early 1990s marked by the collapse of Drexel
Burnham Lambert and the high-yield debt market.
BEGINNING OF THE LBO BOOM
The beginning of the first boom period in private equity would be marked by the
well-publicized success of the Gibson Greetings acquisition in 1982 and would
roar ahead through 1983 and 1984 with the soaring stock market driving profitable
exits for private equity investors.
months after the original deal, Gibson completed a $290 million IPO and Simon
made approximately $66 million.[1] Simon and Wesray would later complete the
$71.6 million acquisition of Atlas Van Lines. The success of the Gibson Greetings
investment attracted the attention of the wider media to the nascent boom in
leveraged buyouts.
LBO BUST (1990-1992)
By the end of the 1980s the excesses of the buyout market were beginning to show,
with the bankruptcy of several large buyouts including Robert Campeau's 1988
buyout of Federated Department Stores, the 1986 buyout of the Revco drug stores,
Walter Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR
Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that
involved the contribution of $1.7 billion of new equity from KKR.[44]
Additionally, in response to the threat of unwelcome LBOs, certain companies
adopted a number of techniques, such as the poison pill, to protect them against
hostile takeovers by effectively self-destructing the company if it were to be taken
over.
PRIVATE EQUITY IN 1990S
Private equity emerged in the 1990s out of the ashes of the savings and loan crisis,
the insider trading scandals, the real estate market collapse and the recession of the
early 1990s which had culminated in the collapse of Drexel Burnham Lambert and
had caused the shutdown of the high-yield debt market. This period saw the
emergence of more institutionalized private equity firms, ultimately culminating in
the massive Dot-com bubble in 1999 and 2000.
THE VENTURE CAPITAL BOOM AND THE INTERNET BUBBLE (1995-200)
In the 1980s, FedEx and Apple Inc. were able to grow because of private equity or
venture funding, as were Cisco, Genentech, Microsoft and Avis.[29] However, by
the end of the 1980s, venture capital returns were relatively low, particularly in
comparison with their emerging leveraged buyout cousins, due in part to the
competition for hot startups, excess supply of IPOs and the inexperience of many
venture capital fund managers. Unlike the leveraged buyout industry, after total
capital raised increased to $3 billion in 1983, growth in the venture capital industry
remained limited through the 1980s and the first half of the 1990s increasing to just
over $4 billion more than a decade later in 1994.
After a shakeout of venture capital managers, the more successful firms retrenched,
focusing increasingly on improving operations at their portfolio companies rather
than continuously making new investments. Results would begin to turn very
attractive, successful and would ultimately generate the venture capital boom of
the 1990s. Former Wharton Professor Andrew Metrick refers to these first 15 years
of the modern venture capital industry beginning in 1980 as the "pre-boom period"
in anticipation of the boom that would begin in 1995 and last through the bursting
of the Internet bubble in 2000.[30]
THE BURSTING OF THE INTERNET BUBBLE AND THE PRIVATE EQUITY
CRASH (2000-2003)
The Nasdaq crash and technology slump that started in March 2000 shook virtually
the entire venture capital industry as valuations for startup technology companies
collapsed. Over the next two years, many venture firms had been forced to writeoff their large proportions of their investments and many funds were significantly
"under water" (the values of the fund's investments were below the amount of
capital invested). Venture capital investors sought to reduce size of commitments
they had made to venture capital funds and in numerous instances, investors sought
to unload existing commitments for cents on the dollar in the secondary market. By
mid-2003, the venture capital industry had shriveled to about half its 2001
capacity. Nevertheless, PricewaterhouseCoopers' MoneyTree Survey shows that
total venture capital investments held steady at 2003 levels through the second
quarter of 2005.
Although the post-boom years represent just a small fraction of the peak levels of
venture investment reached in 2000, they still represent an increase over the levels
of investment from 1980 through 1995. As a percentage of GDP, venture
investment was 0.058% percent in 1994, peaked at 1.087% (nearly 19 times the
1994 level) in 2000 and ranged from 0.164% to 0.182% in 2003 and 2004. The
Limited liquidity and investment term: Private equity investments have very
low liquidity as these investments are made with the long term intention to
gain profit. The investment term for private equity is typically 3 to 7 years.
HOW PRIVATE EQUITY FUNDS WORK?
Private equity funds are set up as a limited partnership by a private equity firm.
The firm then reaches out to large investors like university endowments, union
pension plans, charities, insurance companies, and extremely wealthy individuals
to raise capital. Once invested, the limited partners capital is locked up for a
predetermined number of years before the fund is liquidated and the principle (and
hopefully profits) are returned to shareholders.
The investors are limited partners in the newly established fund. The private equity
firm managing the fund is the general partner enabled to make all investment
decisions after raising capital.
The name private equity explains much of what these funds do. Private equity
firms use their raised funds to take companies private from public stock markets,
or to invest in companies that are already private.
Investing in a private equity fund is different from investing in a mutual fund or
exchange-traded fund. PE funds are typically closed-end funds that operate for a
limited term, typically lasting ten years. They start by raising money from investors
and generally spend anywhere from 1-10 years investing in a portfolio of
companies, which is known as the investment period. The next chapter is known
as the harvesting period, which is when funds reap the rewards of their
investments. Ultimately, harvesting means selling the fund's stakes in companies
and liquidating the fund, but these transactions can happen gradually, one portfolio
company at a time. You can expect to receive cash proceeds as these events occur
as well as smaller interim cash flows if and when special dividends are declared.
Assuming the fund has met its objectives, over the course of the harvesting period
you receive your money back, plus profits.
The way your investment is initiated is also very different from what you may be
used to with open-ended funds like mutual funds. Instead of paying money directly
into the fund, you make a commitment of a certain amount of capital, and the fund
gradually draws on that money by issuing capital calls each time it finds a
suitable company to invest in. If the fund cant find enough good opportunities,
you may end up investing less money than you had committed.
Also, its generally not possible to redeem your money until the end of the funds
specified term. Investing in a private equity fund is a long-term commitment, and
although it is possible to sell your stake on the secondary market, its more
complicated than selling publicly-listed securities, and you may have to sell at a
discount.
LIQUIDITY
Hedge funds have higher liquidity as compared to private equity.
Private equity is less liquid as the funds have to be committed for a specific
period that is usually more than 3 years and around 5-7 years.
RISK MANAGEMENT
Hedge funds minimize risk by hedging high risk investments with safe
ones.
Private equity is sometimes confused with venture capital because they both refer
to firms that invest in companies and exit through selling their investments in
equity financing, such as initial public offerings (IPOs). However, there are major
differences in the way firms involved in the two types of funding do things. They
buy different types and sizes of companies, they invest different amounts of money
and they claim different percentages of equity in the companies in which they
invest.
MEANING:
Technically, the term private equity refers to money invested in private
companies, or companies that become private through the investment.
Startup companies with a high growth potential need a certain amount of
investment. Wealthy investors like to invest their capital in such businesses
with a long term growth perspective. This capital is known as venture
capital.
COMPANY TYPE:
Private equity firms mostly buy mature companies that are already
established. The companies may be deteriorating or not making the profits
they should be due to inefficiency. Private equity firms buy these companies
and streamline operations to increase revenues.
Venture capital firms, on the other hand, mostly invest in start-ups with high
growth potential.
% ACQUIRED:
Private equity firms mostly buy 100% ownership of the companies in which
they invest. As a result, the companies are in total control of the firm after
the buyout.
Venture capital firms invest in 50% or less of the equity of the companies.
Most venture capital firms prefer to spread out their risk and invest in many
different companies. If one start-up fails, the entire fund in the venture
capital firm is not affected substantially.
INVESTMENT SIZE:
Private equity firms invest $100 million and up in a single company. These
firms prefer to concentrate all their effort in a single company, since they
invest in already established and mature companies. The chances of absolute
losses from such an investment are minimal.
Venture capitalists spend $10 million or less in each company, since they
mostly deal with start-ups with unpredictable chances of failure or success.
STRUCTURE:
PE firms use a combination of equity and debt.
VC firms use only equity.
STAGE:
PE firms buy mature companies
VCs invest in early stage companies.
on where the company is in its life cycle. Each stage of a companys life cycle
exhibits a certain risk profile and requires a specific set of skills from the general
partner
Growth capital
Growth Capital refers to equity investments, most often minority investments, in
relatively mature companies that are looking for capital to expand or restructure
operations, enter new markets or finance a major acquisition without a change of
control of the business.
mature than venture capital funded companies, able to generate revenue and
operating profits but unable to generate sufficient cash to fund major expansions,
acquisitions or other investments. Because of this lack of scale these companies
generally can find few alternative conduits to secure capital for growth, so access
to growth equity can be critical to pursue necessary facility expansion, sales and
marketing initiatives, equipment purchases, and new product development. The
primary owner of the company may not be willing to take the financial risk alone.
By selling part of the company to private equity, the owner can take out some
value and share the risk of growth with partners. Capital can also be used to effect
a restructuring of a company's balance sheet, particularly to reduce the amount of
leverage (or debt) the company has on its balance sheet.
Mezzanine Financing
While some companies might take on growth capital to finance their expansions,
mezzanine financing is an alternate way. Mezzanine financing consists of both debt
and equity financing used to finance a companys expansion. With mezzanine
financing, companies take on debt capital that gives the lender the right to convert
to an ownership or equity interest in the company if the loan isnt repaid in a timely
manner and in full. Companies that take on mezzanine financing must have an
established product and reputation in the industry, a history of profitability, and a
viable expansion plan.
A key reason why a company may prefer mezzanine financing is that it allows it to
receive the capital injection needed for business without having to give up a lot of
equity ownership (as long as its able to pay back its debt on time and in full).
Another advantage of taking on mezzanine financing is that it may be easier to
receive traditional bank financing since its treated like equity on a companys
balance sheet.
On the flip side, there are some disadvantages to companies that take on mezzanine
financing. Since mezzanine financing is not collateralized, the lender takes on
greater risk. Therefore, mezzanine financing is typically conducted by
Venture capital
Venture capital is a broad subcategory of private equity that refers to equity
investments made, typically in less mature companies, for the launch of a
seed or start-up company, early stage development, or expansion of a
business. Venture investment is most often found in the application of new
technology, new marketing concepts and new products that do not have a
proven track record or stable revenue streams.
Venture capital is often sub-divided by the stage of development of the
company ranging from early stage capital used for the launch of start-up
companies to late stage and growth capital that is often used to fund
expansion of existing business that are generating revenue but may not yet
be profitable or generating cash flow to fund future growth.
Entrepreneurs often develop products and ideas that require substantial
capital during the formative stages of their companies' life cycles. Many
entrepreneurs do not have sufficient funds to finance projects themselves,
and they must therefore seek outside financing. The venture capitalist's need
to deliver high returns to compensate for the risk of these investments makes
venture funding an expensive capital source for companies. Being able to
secure financing is critical to any business, whether it is a start-up seeking
venture capital or a mid-sized firm that needs more cash to grow. Venture
capital is most suitable for businesses with large up-front capital
requirements which cannot be financed by cheaper alternatives such as debt.
Although venture capital is often most closely associated with fast-growing
technology, healthcare and biotechnology fields, venture funding has been
used for other more traditional businesses.
Investors generally commit to venture capital funds as part of a wider
diversied private equity portfolio, but also to pursue the larger returns the
strategy has the potential to offer. However, venture capital funds have
produced lower returns for investors over recent years compared to other
private equity fund types, particularly buyout.
Private equity real estate involves pooling together investor capital to invest in
ownership of various real estate properties. Four common strategies used by
private equity real estate funds are:
There are four basic things private equity investors do to earn money.
Raise money from Limited Partners (LPs) like pension and retirement funds,
endowments, insurance companies, and wealthy individuals
Source, diligence, and close deals to acquire companies
Improve operations, cut costs, and tighten management in their portfolio
companies
Sell portfolio companies (i.e., exit them) at a profit
Raising Money
Private equity firms raise funds by getting capital commitments from external
financial institutions (LPs). They also put up some of the their own capital to
contribute into the fund (commonly 1-5% but it can be higher). The partners of the
firm (the GP) might go on a roadshow themselves to raise the money (as did the
partners at the firm I worked at) or they might use a placement agent (an outside
fundraising team) to help them do a lot of the legwork.
LPs are usually required to commit a significant amount of capital in order to be
allowed to participate in the fund, since the last thing the partners want is to be
fielding support calls and communications to a long tail of many little
investors who only commit a small amount but require a lot of hand-holding to
service. The ideal fund to a PE firm would be comprised of a handful of LPs that
each commit tens or hundreds of millions of dollars, or even billions of dollars,
each. Huntsman Gay, the Bain Capital spinout that I worked at, had less than 10
LPs that each committed more than $100M.
If youre a high net worth individual, the commitment thresholds might be a little
lower than a normal LP, but they will likely still be in the millions in order to
comply with federal securities laws that basically say you can only sell PE
investments to rich people because they are the ones who actually probably know
what they are doing.
But even though LPs make a capital commitment, they dont give all the money to
the GP all upfront. Instead, the GP begins to source and close deals, and as those
deals need to be funded, they call capital from the LPs. LPs then have a very
limited window (e.g., 2 weeks) to write a check to the GP so that the GP can fund
and close the deal. So committed funds are called committed capital while
disbursed funds are called contributed capital.
Many PE funds have something called first close vs. final close. First close
basically means that when a certain threshold of money has been raised, the PE
firm can begin making investments and actually closing deals and new LPs can
still join in by committing capital for a limited time (e.g., 1 year from first close).
Final close means that when a second threshold has been reach, new LPs can no
longer join in on that particular fund.
Gay, there were a few proprietary deals we looked at and closed, and those were
definitely the ones we tried to move more quickly on, that didnt tend to get
dragged out in a process, and that were more pleasant to close. To get good
proprietary deal flow, the partners of the fund have to build and maintain strong
relationships with key people in industry, advisers, and even bankers.
Once a potential deal has been sourced, then the investment team will conduct
heavy due diligence to assess the companys strategy, business model, management
team, the industry and market, the financials, the risk factors, and the exit potential.
Diligence is typically conducted in stages that correspond to phases of the bidding
process, where financial and operational information is progressively revealed to
PE firms based on bidders that are still in the running at each phase. If the deal
looks promising and no dealbreaker red flags are found, then the investment
professionals will present to the investment committee (comprised of partners) for
funding approval.
Final terms of the deal with be negotiated with lawyers on both sides, and the deal
will transact, with funds being released and equity being traded.
updates, and LPs may use that information to mark their own portfolios to market
when they report their results to their own investors.
Trade sale:
Another commonly used exit route is the trade sale in which the private
equity investor sells all of its shares held in a company to a trade buyer, i.e. a
third party often operating in the same industry as the company itself. This
method is preferred by private equity providers mainly because it provides a
complete and immediate exit from the investment. Another advantage of the
trade sale is that in this case, the negotiations take place with a single buyer
which allows for a quicker and more efficient process which is not subject to
the regulatory restrictions applicable to IPO transactions. In a trade sale
transaction, the investor can also exercise more control over the whole
process, and in certain cases might even end up obtaining a higher value for
the company compared to other exit methods. On the other hand, trade sale
is not free from potential problems and risks either. The management of the
company may be resistant such a transaction as the change of control often
results in the replacement of the companys management as well. A trade
sale might also entail serious business risks as the buyer is oftentimes a
competitor of the company, which will inevitably obtain confidential
business information during the negotiation process.
Secondary buyout:
In the case of a secondary buyout, the company is sold by a private equity
investor to another private equity firm. In other words, the particular nature
of a secondary buyout lies in that private equity houses appear on both sides
of the deal, while in the average transaction private equity investors would
only be involved either as seller or purchaser. There are a number of possible
reasons why an investor may choose this method as the exit route. It can be a
means of shortening the life-time of a transaction which has become a
priority for private equity houses in the recent economic climate, and
therefore secondary buyouts have become increasingly popular. Sometimes,
the investor which carried out the original acquisition is not willing to (or
cannot) finance a business anymore, even though the company might not yet
be ready for a trade sale or IPO. In that case, selling the company to another
private equity firm which sees potential in further developing the company
Liquidation:
This is the least favorable option but sometimes will have to be used if the
promoters of the company and the investors have not been able to
successfully run the business.
an investor in private equity can run a liquidity risk. Lastly, an investor does not
pay in all of their capital on the first day; rather, the money is drawn from the fund
over time. This represents a specific risk for investors, which is of course a result
of the typical fund structure discussed in the previous paragraph; i.e. funding risk.
If the investor is not able to pay the capital call in accordance with the terms of the
partnership agreement, they default on their payment. In such a case, the investor
might lose the entire investment and all the capital which they already paid into the
fund. Many fund managers have strict rules in their Limited Partnership
Agreements in the case of a defaulting investor. Typically, the investor will lose
their entire investment; in some cases they still hold the liabilities. This strict
mechanism is important for the fund manager as they need to have the highest
possible security to fund the investments they would like to acquire. In addition to
the risk of not being able to fulfill their own undrawn commitment; each investor
can be adversely impacted as a result of other investors defaulting. Hence, liquidity
and funding risks arising through unfunded commitments are an important element
and need to be reflected in sophisticated risk management systems.
Following risks can be identified in private equity:
1. Funding risk: The unpredictable timing of cash flows poses funding risks to
investors. Commitments are contractually binding and defaulting on
payments results in the loss of private equity partnership interests. This risk
is also commonly referred to as default risk.
If this risk materialises, an investor can lose their full investment including
all paid-in capital, which is why it is of paramount importance for investors
to manage their cash flows to meet their funding obligations effectively.
The financial crisis in 2008 highlighted the importance of managing funding
risk. Since then, regulators have focused more on funding risk and have
issued principles for sound funding & liquidity risk management. But how
does funding risk occur when managing a private equity portfolio? In
general, there are two reasons: (i) over-commitment and (ii) market
distortion in capital calls and distributions.
How can funding risk be measured and which solutions are possible?
would see in even the most illiquid of listed markets. Moreover, the
secondary market was shut down during the financial crisis in 2009
with very low trading volumes. As such, the liquidity risk for
investors in private equity seems to be high due to inefficient
secondary markets.
How can liquidity risk be reduced?
Liquidity risk in private equity is difficult to reduce, although it is
simpler to handle for investors in an overall asset allocation model. If
an investor is solely focused on private equity assets and they need to
sell in difficult market times, they cannot circumvent the liquidity
risk. However, if private equity is only a small part of a welldiversified asset allocation, as is the case for many insurance
companies, pension funds and banks, many other assets are more
liquid and can be traded. In reality, the experience is that banks or
insurance companies use the secondary market in years of high prices
to sell their assets and do not use it frequently in distressed markets.
3. Market risk: The fluctuation of the market has an impact on the value of the
investments held in the portfolio.
How can market risk be measured and which solutions are possible?
As the NAVs are available on a quarterly basis, statistics that are
applied to continuously traded securities can also be used for private
equity investments, such as the volatility of the NAV-based return
time series on a quarterly basis. However, as mentioned above, such
unadjusted time series would unfairly favour private equity
investments over the stock market and therefore should not be used.
To still allow for a simple comparison with other asset classes, there
are approaches to de-smooth those NAVs before running risk
analyses. Other analyses focus on the time-lag of reporting.18
However, it is debatable how well such adjustments work for private
equity returns. Furthermore, results based on such market risk
measures are centered on the implicit assumption that the quarterly
NAVs are actual market values which an investor could buy and sell.
This is not true for private equity investments and as such the results
can give an investor a misleading view on their investment. Rather,
they should focus on the long-term properties of private equity as it is
inherently a long-term asset class.
How can market risk be reduced?
Market risk as the quarterly change of the net asset value is a shortterm risk measure and, therefore, also depends on the short-term
movement of public and FX risks. As such, if the portfolio is largely
diversified over various geographies, markets and industries, this
volatility can be minimised.
4. Capital risk: Closely related to market risk is capital risk for the investor.
Capital risk for the investor is defined as the probability of losing capital
with a private equity portfolio over its entire lifetime.19 As a consequence,
the investor would have a realised loss in their portfolio, while market risk is
based on unrealised values. Similarly to market risk, capital risk is driven
both by internal and external factors.
In the long-term, the development of the underlying companies in a fund
portfolio affects the performance and the capital risk of the investments. The
positive operational development of the companies and their financial
situation is a substantial source of value creation for investors. As such, the
fund manager spends a significant amount of time working with the
management analysing and improving the companies strategies during their
holding periods in order to exit the company to a value above the investment
cost. The conditions of the exit market, method and timing of the exit can
also be a route through which the fund manager can create value for
investors.
How can capital risk be measured and which solutions are possible?
For liquidated or mature funds, the ratio between distributions and
paid-in capital can be used as a measure for capital risk (DPI). If this
ratio is below one for a specific investment, an investor has lost
money. This measure can be calculated on the portfolio level of the
investor, on the fund level and on the portfolio company level. For
funds that are still active, the residual NAV should be added to the