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What is Private Equity?
S 1 - Introduction to Private
Equity and Venture Capital
B B Chakrabarti
Professor of Finance
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Business Life Cycle
3 4
Corporate Funding Life Cycle
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• Private equity is capital that is not noted on a public
exchange.
• Private equity is composed of funds and investors
that directly invest in private companies, or that
engage in buyouts of public companies, resulting in
the delisting of public equity.
• Institutional and retail investors provide the capital
for private equity, and the capital can be utilized to
fund new technology, make acquisitions, expand
working capital, and to bolster and solidify a balance
sheet.
Business Life Cycle
• Launch: A company begins its operations by launching new
products or services. During the launch phase, sales are low,
but slowly increasing, initial startup costs are high, with losses
in this phase and negative cash flows.
• Growth: Companies experience rapid sales growth with
profits beyond break-even point and positive cash flows.
• Shake-out: Sales continue to increase, but at a slower rate,
usually due to either approaching market saturation or the
entry of competitors with profits starting to decrease.
• Maturity: Sales slowly decrease. Profit margins get thinner
with stagnant cash flows. Many businesses extend their
business life cycle during this phase by reinventing themselves
and investing in new technologies and emerging markets.
• Decline: Sales, profit, and cash flow all decline.
PE – Four Different Forms of
Investment
• Venture capital – equity investments in less
mature non-public companies to fund the
launch, early development, or expansion of
business.
• Growth capital – minority equity investments
in mature companies for expansion,
restructuring of operations, financing an
acquisition or entering a new market, without
a change of control of the company.
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PE – Four Different Forms of Investment PE – Four Different Forms of Investment

• Mezzanine capital – investment in subordinated debt or • While additional liquidity can be obtained from equity
preferred stock of a company without taking voting control investors, equity is the most expensive source of capital.
of the company. Further, equity capital, by its nature, dilutes existing
• The gap in funding between senior debt and equity is shareholders.
common for the following reasons: • As a result, mezzanine debt can be an attractive
1) accounts receivable, inventories and fixed assets are alternative way to obtain much needed capital.
being discounted at greater rates than in the past for fear
that their values will not be realized in the future;
2) many balance sheets now contain significant intangible
assets,
3) as a result of defaults and regulatory pressure, banks
have placed ceilings on the amount of total debt a company
can obtain.
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PE – Four Different Forms of Investment PE – Four Different Forms of Investment

• Leveraged buyout (LBO) – purchase of all or most of a
company or a business unit by using equity from a small
group of investors in combination with a significant amount
of debt. LBO targets are mature companies generating
strong operating cash flows.
• Ex. In 2007, Blackstone Group bought Hilton Hotels for $26
billion through LBO. Blackstone put up $5.7 billion in cash
(and $0.8 bn later)and financed $20.5 billion in debt from a
group of 26 big banks, hedge funds, and real estate debt
investors. Before the financial crisis of 2009, Hilton had
issues with declining cash flows and revenues. Hilton later
refinanced at lower interest rates and improved operations.
• BS bought back some debt at deep discount and by issuing
shares. Hilton again became public in Dec 2013 with second
IPO of $2.3 bn. With 76 percent of the equity, Blackstone’s
stake in Hilton was worth at least $15 bn. That is a profit,
on paper at least, of more than $8.5 billion.
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Private Equity AUM (2017) - $2.8 tn Some PE/VC Terminology

General partner (GP):
An entity that raises capital from limited partners for a fund
and determines which assets the fund should invest in.
Limited partner (LP):
An entity that commits capital to a general partner’s fund.
Limited Partnership
A legal entity composed of a general partner and various
limited partners. The GP manages the investments and is
liable for the actions of the partnership while the LPs are
generally protected from legal actions and any losses
beyond their original investment. The GP receives a
management fee and a percentage of profits (Carried
interest), while the LPs receive income and capital gains.
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Some PE/VC Terminology
Portfolio company:
A company that has received an investment from a venture
capital or private equity firm.
Lead investor:
The investor that makes the largest investment in a venture
capital round. As the primary financier of the round, the
lead investor determines the valuation of the company.
Investment bank:
A financial institution that serves as an agent or
underwriter for security issuances. Some investment banks
also act as brokers/dealers and provide advisory services
for mergers, acquisitions, restructurings and other
transactions.
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Some PE/VC Terminology
Venture capital:
A type of private equity investing that focuses on startups and
early-stage companies with long-term, high-growth potential.
Vintage year:
When a fund closes and starts investing.
Angel:
A high-net-worth individual who makes direct investments
into early-stage companies.
Bootstrap
To bootstrap a company means to develop it without the
assistance of professional Venture Capital. Instead, the
founders make do with their own assets, capital from angel
investors and any cash flows which they can generate from
the company’s own business activities or assets.
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Some PE/VC Terminology
Fund
The investment vehicle, often a limited partnership, to
which the limited partners commit capital.
Syndicate
A group of investors that agree to participate in a round of
funding for a company.
Dry Powder
Unused capital which is, as yet, still available for drawdown
and investment.
Go shop
A contractually agreed period during which the owner of a
business can solicit offers for its sale at a price in excess of
that already agreed with a vendor, in default of which the
sale to the vendor will proceed. Should the owner be
successful in soliciting a higher offer, then a walkaway fee
will usually be payable.
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Some PE/VC Terminology
Accelerator:
A program startups can apply to that provides funds and
mentorship to help companies grow, usually in exchange for
equity. Most accelerators focus on helping early-stage
companies.
Incubator:
An organization that gives early-stage companies office space,
resources, advice and networking opportunities (usually in
exchange for equity).
Stage
The period in a VC’s life at which investment is made. Stage is
one of the two main ways of classifying and distinguishing
Venture transactions (the other being by sector) and is
divided into seed, early, mid and late.
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Some PE/VC Terminology
Unicorn
A VC-backed company with a valuation of $1B or more.
A round
Successive rounds of funding for a Venture company are given
successive letters, like A,B etc. New VC investors can be
introduced in each round. An A round is usually defined as the
first round but it may be preceded by one or more angel
rounds or by a seed round.
Anti Dilution
Provisions commonly found in the funding agreements
governing rounds of investment in Venture companies under
which the shareholdings of certain shareholders (typically
early-stage investors and entrepreneurs) cannot fall below a
specified percentage of the whole.
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Fund of Funds
• A private equity fund of funds consolidates
investments from many individual and institutional
investors to make investments in a number of different
private equity funds.
• This enables investors to access certain private equity
fund managers that they otherwise may not be able to
invest with, diversifies their private equity investment
portfolio, and augments their due diligence process in
an effort to invest in high-quality funds that have a high
probability of achieving their investment objectives.
• Private equity funds of funds represent about 15% of
committed capital in the private equity market.
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Secondary Markets for Private Equity
• A secondary market has developed for private equity
as banks and other financial institutions attempt to
sell their PE investments to reduce the volatility of
earnings and rebalance portfolios.
• In addition, individuals and institutional investors are
also sellers of LP interests in PE funds.
• Secondary market sales fall into one of two
categories: a) the seller transfers a LP interest in an
existing partnership that continues its existence
undisturbed by the transfer, b) the seller transfers a
portfolio of PE investments in operating companies.
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Private Investment in Public Equities (PIPE)
• Many PE firms are making private investments in
public equities (PIPEs). These are minority
investments in 5 to 30% of the stock of a publicly
traded company and the investments are made
without using debt financing.
• The return potential of these investments depends
on the actions of the management of the company,
who are not controlled by the PE fund.
• Ex. - Blackstone’s acquisition of a 4.5% equity stake in
Deutsche Telekom for $3.3 billion, KKR’s purchase of
a $700 million convertible bond from Sun
Microsystems.
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Private Equity vs Hedge Funds
• The investment strategies of PE firms differ to those of
hedge funds.
• Typically, PE investment is geared towards long-hold,
multiple-year investment strategies in illiquid assets
(whole companies, large-scale real estate projects, or
other tangibles not easily converted to cash) where
they have more control and influence over operations
or asset management to influence their long-term
returns.
• Hedge funds usually focus on short or medium term
liquid securities which are more quickly convertible to
cash, and they do not have direct control over the
business or asset in which they are investing.
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Secondary Markets for Private Equity
• Sellers of PE investments sell both their investments
in a fund and their remaining unfunded
commitments to the fund.
• Buyers of secondary interests include large pooled
investment funds and institutional investors,
including hedge funds.
• In addition, the private equity fund that originally
invested in a company will sometimes purchase
secondary market offerings.
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PE Club Transactions
• When the size of a potential acquisition by a private
equity firm exceeds around 10 to 15% of the capital
in a fund, the possibility of a “club transaction” is
considered.
• In a club deal, two to five different private equity
firms coordinate to co-invest in a target company.
• The benefits include spreading economic risk,
sharing expertise, pooling of relationships with
financing sources, reduction of costs per firm, and
reduction in competition.
• The challenges include increasing exposure to a
single large transaction for limited partners who have
capital invested in more than one of Club
Transactions.
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Private Equity vs Hedge Funds
• Both PE firms and hedge funds often
specialize in specific types of investments and
transactions. PE specialization is usually in
specific industry sector asset management
while hedge fund specialization is in industry
sector risk capital management.
• Finally, PE firms only take long positions, for
short positions is not possible in this asset
class.
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Portfolio Company Capitalization Some Large PE Firms

• Debt (50–70% of overall cap structure) PE Firm Year of Establishment AUM (2017) in $ billion
- Senior bank debt, two types: Revolving credit The Blackstone Group 1985 434
facility, which can be paid down and reborrowed
as needed and Term debt (senior and Kohlberg Kravis Roberts 1976 148

subordinated) The Carlyle Group 1987 201

- Junior debt, two types: High-yield (typically TPG Capital 1992 75

public markets) and Mezzanine (subordinated Warburg Pincus 1966 40
notes, typically sold to banks, institutions, and
Advent International 1984 31
hedge funds)
Apollo Global Management 1990 248
• Equity (30–50% of overall cap structure)
CVC Capital Partners 1981 70
- Preferred stock
Bain Capital 1984 75
- Common stock
Apax Partners 1969 51
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History of Venture Capital History of LBO

• VC in US developed in the late 19th. and early 20th. Century.
• When Alexander Graham Bell needed money in 1874 to
complete his experiments on telephone, Boston Attorney,
Hubbard and Salem leather merchant, Sanders helped out
and later put up the capital to start Bell Telephone Co. in
Boston.
• The first modern VC was formed in 1946 when MIT
President Karl Compton and others set up American
Research and Development (ARD) to finance commercial
applications of technologies. ARD is the “father of venture
capital”.
• With its support developed High Voltage Engineering
Company (X-Ray, 1947), Digital Equipment Company
(computers, now with HP, 1957) and others.
• The first LBO transaction was completed in 1955, using a
publicly traded holding company as an investment vehicle
to borrow money and then acquire a portfolio of
investments in corporate assets.
• This activity gained momentum during the 1960s when
Warren Buffet (through Berkshire Hathaway) and Nelson
Peltz (through Triarc) made leveraged investments.
• During the 1970s a group of bankers at Bear Stearns,
including Jerome Kohlberg and Henry Kravis, completed a
number of leveraged investments, but in 1976 these
bankers left Bear Stearns to organize their own firm, which
was called Kohlberg Kravis & Roberts (KKR).

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Private Equity Business Model

S 2 - Organization of PE Funds

B B Chakrabarti
Professor of Finance

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Structure of a PE Fund
• A PE fund is usually structured as a limited
partnership that is owned jointly by a PE firm
(General Partner or GP) and other investors such
as pension funds, insurance companies, high-net-
worth individuals, family offices, endowments,
foundations, funds of funds, and sovereign
wealth funds (all of which are Limited Partners or
LPs). Large PE firms may have 20 to 40 GPs. The
GP manages and controls the PE fund.
• The organizational structure of a PE fund is
developed with a view to maximizing incentive
compensation for the GP.
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Structure of a PE Fund
• PE fund GPs receive carry when their investment is
monetized, which often is after a 3-7 year holding
period.
• Partnership agreements between the GPs and LPs
are signed at the inception of each fund, and these
agreements define the expected payments to GPs.
• Successful PE firms stay in business by raising a new
fund every 3-5 years. Each fund is expected to be
fully invested within 5 years and is designed to
realize an exit within 3-7 years of the original
investment.
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Fund Raising and Closing Timelines
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Structure of a PE Fund
• The GP earns compensation based on their management
of the fund receiving management fees that usually
equal about 1 to 3% of the AUM and an interest in the
profits of the investment activity, referred to as “carried
Interest”. The average carried interest is about 20% of
profits. The balance of profits is paid out to LPs. However,
GPs and LPs must negotiate how the carried interest will
be applied.
• Finally, the companies that the fund invests in (portfolio
companies) sometimes pay transaction fees to the fund
in relation to various services rendered, such as
investment banking and consulting services, which are
typically calculated as a percentage of the value of the
transaction, and sometimes pay “monitoring fees.”
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Closed End Fund
• Most PE funds are “closed-end” funds, meaning that LPs
commit to provide cash for investments in companies and pay
for certain fees and expenses, but they cannot withdraw their
funds until the fund is terminated.
• The GP in a PE fund usually commits at least 1% of the total
capital and the balance is committed by LPs.
• These funds are normally invested over a 4 to 5-year period
and then there is a 5 to 8-year period during which the fund
will exit investments and return capital and profits to all
partners.
• During the period of time that capital is invested, LPs have
very limited influence on how the capital is spent as long as
the fund adheres to the basic covenants of the fund
agreement.
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Fund Raising and Closing Timelines
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PE Exits
• PE investors usually have an investment horizon of 5-7
years and plan to exit after making a substantial profit on
their investment. Some of the exit strategies are:
• Initial Public Offer (IPO)
Portfolio company’s shares get listed on the stock market
for the first time, so the PE investor will be able to sell its
shares to the public.
• Trade sale / Strategic sale
PE 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.
• Secondary Sale
The portfolio company is sold to another PE firm.
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Compensation for GP and LP
• There are four sets of fees and expenses in a typical PE
agreement between GPs and LPs:
1. Management Fee: Usually 2% of total capital
commitments until the end of a 4 to 5-year investment
horizon, and then 2% of unreturned funded capital
thereafter (declining as investments are sold or realized).
This fee is payable generally semiannually in advance. In
addition, LPs bear all organizational expenses incurred in
the formation of the fund (often subject to a cap).
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Compensation for GP and LP
3. Portfolio Company Fees and Expenses: These fees and
expenses are paid directly by portfolio companies to the
PE firm. Potential fees and expenses include
(1) transaction fees when purchasing and (sometimes)
when selling companies, (2) expenses related to
proposed but unconsummated investments, (3) tax and
accounting, litigation, general legal, and annual meeting
expenses, (4) advisory and monitoring fees and (5)
director fees.
4. Additional Costs: In some cases, a number of additional
costs can be imposed. For example cash proceeds can be
retained by the GP for some months before being
distributed to LPs. Finally, LPs may have to pay penalties
for selling their stakes or for defaults on a capital call.
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PE Exits
• Leveraged Recapitalization
The portfolio company raises money by borrowing from a
bank or by issuing bonds, which amount is then used to
repurchase the company’s own shares from the PE
investor.
• Repurchase by the Promoters
The management or the promoters of the portfolio
company buy back the equity stake from the PE investor.
• 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.
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Compensation for GP and LP
2. Carried Interest: This is an incentive payment that will be
paid only after a certain rate of return (preferred return)
is obtained by LPs. The purpose of this payment is to
create an approximate 80/20 split in profits above the
return of capital plus preferred returns between LPs and
GPs. For GPs to receive carried interest, PE funds must
sell their portfolio companies, realizing gains at the time
of sale.
We discuss preferred return issue in a later slide.
Alternatively, carried interest may be paid following
interim dividends, distributions, partial sales, or
recapitalizations before an ultimate sale. Profits or losses
are generally recognized at the time of any of these
corporate events.
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Preferred Returns for LPs
• Most compensation arrangements include preferred
returns, which must be paid to LPs (after return of
capital) before carried interest is paid to GPs. Since LPs
invest in PE funds based on an expectation of higher
returns and somewhat higher risk, a preferred return
helps to align interests between all partners by linking
carried interest to superior returns.
• There are two different ways to apply preferred returns:
pure preferred returns and hurdle rates.
• A pure preferred returns approach provides that the
carried interest percentage is applied only to profits in
excess of a specified return. The effect of this is to reduce
carried interest as a percentage of total profits.
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Preferred Returns for LPs
• In hurdle rates approach, a “catch-up” provision
eliminates this negative outcome for the General
Partner if total fund returns are not enough. This
approach usually provides that a carried interest
percentage is applied after returns exceed a
predetermined hurdle rate, such as the yield on one-
year U.S. treasuries, LIBOR, or a market index such as
the S&P 500.
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Fund Raising – PPM
• The main sections of a PPM typically include:
1. Executive summary
2. Firm and Fund investment philosophy
3. Investment Professionals and Advisory
Committee
4. Summary of GP/LP terms and agreements
5. Investment track record and prior fund
performance
6. Legal and tax matters
7. Inherent related investment risks
8. Accounting and reporting standards
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Global PE capital raised, by fund type
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Fund Raising – PPM
• A Private Placement Memorandum (PPM) is a
document that explains the details of an
investment to potential investors. A PPM is also
known as an “Offering Memorandum.” A PE firm
will issue a PPM to prospective LPs when it is
attempting to raise capital through a fund
offering.
• A PPM provides a broad range of information to
help LPs learn about the firm and its investment
strategy, as well as the proposed summary terms
and conditions of the investment opportunity.
The PPM serves as an outline of the fund
offering.
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Key PPM Criteria For Limited Partners
1) Management team
2) Performance track record
3) Investment strategy and market opportunity
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S 3 - SEBI AIF Regulations, 2012
B B Chakrabarti
Professor of Finance
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Introduction
• Following the introduction of the SEBI (Venture Capital
Funds) Regulations in 1996, the VCPE industry
successfully filled the gap between capital
requirements of fast-growing companies and funding
available from traditional sources such as banks, IPOs,
etc.
• SEBI in 2012 overhauled the regulatory framework for
domestic funds in India and introduced the SEBI
(Alternative Investment Funds) Regulations, 2012. The
main reasons cited by SEBI was to recognize AIFs as a
distinct asset class, to promote start-ups and early
stage companies and to tie concessions and incentives
to investment restrictions.
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Choice of Pooling Vehicle
• Pl read the attached document.
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Classification of AIFs
• SEBI AIF Regulations define different
categories of funds with the intent to
distinguish the investment criteria and
relevant regulatory concessions that may be
allowed to them.
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AIF
• An AIF means any fund established or
incorporated in India in the form of a trust or
a company or an LLP (limited liability
partnership) or a body corporate which is a
privately pooled investment vehicle which
collects funds from investors, whether Indian
or foreign, for investing it in accordance with a
defined investment policy for the benefit of its
investors.
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AIF Set Up as a Trust
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Investment Conditions and
Restrictions of AIFs
a) Only a specific percentage of the investible funds (25% for
Category I and II AIFs and 10% for Category III AIFs) can be
invested in a single investee company.
b) AIFs should not invest in associates except with the approval
of 75% of investors by value of their investments in the AIF.
c) The un-invested portion of the investible funds may be
invested in liquid mutual funds or bank deposits or other liquid
assets of higher quality such as Treasury Bills, Collateralized
Borrowing and Lending Obligations (“CBLOs”), commercial
papers, certificates of deposits, etc. till deployment of funds as
per the investment objective.
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Key Themes under the AIF Regulations
A. Continuing Interest
• The AIF Regulations require the sponsor or the manager of
an AIF to contribute a certain amount of capital to the fund.
This portion is known as the continuing interest and will
remain locked-in the fund until distributions have been
made to all the other investors in the fund.
• For a Category I or Category II AIF, the sponsor or the
manager is required to have a continuing interest of 2.5% of
the corpus of the fund or INR 50 million whichever is lower
and in the case of a Category – III AIF, a continuing interest
of 5% of the corpus or INR 100 million whichever is lower.
• For the newly introduced angel investment funds, the AIF
Regulations require the sponsor or the manager to have a
continuing interest of 2.5% of the corpus of the fund or INR
5 million whichever is lower.
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Key Themes under the AIF Regulations
C. Minimum Investment
• The AIF Regulations do not permit an AIF to accept an
investment of less than INR 1crore (“Minimum Investment
Amount”) from any investor unless such investor is an
employee or a director of the AIF or an employee or
director of the manager of the AIF in which case the AIF can
accept investments of a minimum value of INR 25 lakh.
• In case of an open-ended AIF, the first lump-sum
investment received from an investor should not be less
than the Minimum Investment Amount. Further, in case of
partial redemption of units by an investor in an open-ended
AIF, the amount of investment retained by the investor
should not fall below the Minimum Investment Amount.
D. Qualified Investors
• The AIF Regulations permit an AIF to raise funds from any
investor whether Indian, foreign or non-resident through
the issue of units of the AIF. 57
Key Themes under the AIF Regulations
H. Overseas investments by AIFs
• An AIF may invest in equity and equity-linked instruments of off-
shore VCUs, subject to an overall aggregate limit of USD 500
million for all AIFs and VCFs.
• Investments would be made only in those companies which have
an Indian connection (i.e. company which has a front office
overseas, while back office operations are in India) and such
investments would be up to 25% of the investible funds of the AIF.
• An offshore VCU means a foreign company whose shares are not
listed on any of the recognized stock exchange in India or abroad.
• Such an investment by an AIF requires prior approval from SEBI.
The allocation of investment limits would be done on a ‘first
come-first serve’ basis depending on availability in the overall limit
of USD 500 million, and in case an AIF fails to make the allocated
investment within a period of 6 months from date of approval,
SEBI may allocate such unutilized limit to another applicant.
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Key Themes under the AIF Regulations
B. Minimum Corpus
• The AIF Regulations prescribe that the minimum
corpus for any AIF shall be INR 20 crores for each
scheme and Rs. 10 Crores for angel funds. Corpus is the
total amount of funds committed by investors to the
fund by way of written contract or any such document
as on a particular date.
• By its circular dated on June 19, 2014, SEBI requires
that where the corpus of an open-ended scheme falls
below the Minimum Corpus (post redemption(s) by
investors or exits), the Fund Manager is given a period
of 3 months to restore the Minimum Corpus, failing
which, all the interests of the investors will need to be
mandatorily redeemed.
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Key Themes under the AIF Regulations
E. Maximum Number of Investors
• The AIF Regulations cap the max. no. of investors at 1,000.
F. Foreign investment in AIFs
• Foreign investments into an AIF are allowed under the
automatic route and the downstream investment by an AIF is
foreign investment only if the sponsor and/or the investment
manager are not Indian “owned and controlled”.
• Investments by NRIs will be deemed to be domestic inv
G. Private Placement
• The AIF Regulations prohibit solicitation or collection of funds
except by way of private placement.
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Key Themes under the AIF Regulations
I. Tenure
• While Category I and Category II AIFs can only be closed-end
funds, Category III AIFs can be open- ended. The AIF
Regulations prescribe the minimum tenure of 3 years for
Category I and Category II AIFs.
• The tenure of any scheme of the AIF shall be calculated from
the date of the final closing of the scheme. Further, the tenure
of any AIF can be extended only with the approval of 2/3rd of
the unit-holders by value of their investment in the AIF.
• Pl read SEBI AIF Regulations, 2012.
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Life Cycle of a Company

S 4 - Venture Capital: Financing
Company Creation

B B Chakrabarti
Professor of Finance

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Examples of VC Funding Examples of VC Funding

• JBF Industries , Mumbai
• KKR has entered into a definitive agreement to invest
USD150 million (Rs 962crore) in Mumbai-based listed
polyester maker JBF Industries Ltd.
• The firm will acquire 20% stake in JBF Industries and
will also invest in zero-coupon compulsorily
convertible preference shares with 14.5% voting
rights in its Singapore-based wholly owned
subsidiary JBF Global Pte Ltd.
• The funding provided by KKR will help JBF complete
the ongoing projects.
• Pepperfry.com
• India’s largest furniture e-marketplace, has raised USD100
million in a fresh round of funding led by Goldman Sachs
and Zodius Technology Fund.
• Pepperfry will use the funds to expand its footprint in Tier
III and Tier IV cities by adding to its growing fleet of delivery
vehicles.
• It will also open new distribution centres and expand its
carpenter and assembly service network.
• This is the largest quantum of investment raised by a sector
focused e-commerce player in India.

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VC Funding Process Seed Capital Financing

• Seed capital is the initial capital used when starting a
business, often coming from the founders' personal
assets, friends or family, for covering initial operating
expenses and attracting VCs.
• This type of funding is often obtained in exchange for
an equity stake in the enterprise.
• VC investors view seed capital as an "at risk"
investment by the promoters of a new venture.
• Capital providers may wait until a business is more
established before making larger investments.

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Seed Capital Financing
• Ex. In April 2016, Google provided seed money to
the Centre for Resource Solutions for setting up
renewable energy certification programmes in Asia.
• Professional angel investors actively work with
entrepreneurs in pooling resources and growing
startups. These investors enjoy hands-on
interaction while helping develop a company’s daily
operations. Professional angel investors typically
provide seed money through either providing a
loan or by buying equity in the company.
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Start-up – Need for Funding
• Activities for which financing is needed:
- Launching the production and presentation of the
product /service to the market
- Intensive marketing activities
- Creation of an initial organizational structure
• Funding Issues:
- The need for significant funding
- Unproven business model – acceptance or
rejection of the project by the market
- High level of risk of project financing
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Why Start-ups Fail – Top 20 Reasons
based on analysis of 101 start-up post-mortems
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Start-up Financing
• Start-ups are firms which have been already
registered and operate on a small scale for some
time before sales grow to a larger scale. The most
frequently this is a micro or small enterprise. In
other words, they are certainly young companies
in the early stage of their development.
• It may also be understood as a project that has a
product ready for the market, and therefore this
phase of development lasts until acceptance of
the company by the market, which usually
expresses a clear recovery in sales, understood as
a phase of early expansion.
68
Risks of Start-up Funding
• Risks in the development of the product and
implementation phase
• Risk in the production phase, i.e. whether it is
possible to manufacture
• Risk in the sales phase – marketing, i.e. whether
the product finds a buyer
• Risk of profitability, i.e. whether the product can
be sold with profit
• Risk of rising: will it be possible to increase the
production and development of the project
70
Convertible Notes for Seed Financing
• A convertible note is a form of short-
term debt that converts into equity, typically in
conjunction with a future financing round.
• In effect, the investor would be loaning money to
a startup and instead of a return in the form of
principal plus interest, the investor would receive
equity in the company.
• Ex. A VC provides INR 2 mn to a start-up at 10%
interest. Both principal and interest will be paid
back after say 3 years when a second round of
equity financing will take place by allotting equity
at say 25% discount.
72
12

Convertible Notes for Seed Financing
• Convertible notes are unpriced security. The
difference with a security in the priced round is
that no valuation is assigned to the start-up in
convertible notes while in a priced round, a
valuation is assigned.
• The advantage for investors is that they can invest
now and defer the complex issue of pricing to a
later date
• The advantage for an entrepreneur is that he can
raise money faster and at a lower price than
traditional financing.
73
Ex. SAFE, Cap and Discount
• Investor has purchased a SAFE for $100,000. The
Valuation Cap is $8,000,000 and the Discount Rate is
85%.
• The company has negotiated with investors to sell
$1,000,000 worth of Series A Preferred Stock at a
$10,000,000 pre-money valuation.
• Suppose, the company will issue and sell 1,100,110
shares of Series A Preferred at $0.909 (value - $1 mn).
• The company will issue Series A-1 Preferred to the SAFE
holder, based on the valuation Cap or the discount Rate,
whichever results in a lower price per share.
75
VC Investment Targets
(Early Development Phase)
• Companies with:
- Strong technological risks
- High R&D expenses
- Investments in equipments and fixed assets
- Investment in intellectual property rights
• Industry sector:
- Life sciences
- Information technologies
- Clean technologies
77
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SAFE for Seed Financing
• A SAFE is a Simple Agreement for Future Equity. An investor
makes a cash investment in a company, but gets company
stock at a later date, in connection with a specific event.
• A SAFE is not a debt instrument, but is intended to be an
alternative to convertible notes that is beneficial for both
companies and investors.
• The SAFE comes in a variety of forms, but the most popular is
the SAFE with a cap and no discount. About 75% of all SAFEs
are a cap with no discount, and the other 25% have some
form of discount.
• The SAFE has all of the advantages of convertible notes but
not the disadvantages.
74
Ex. SAFE, Cap and Discount
• The 15% discount applied to the per share price of the
Series A Preferred is $0.77265. The Valuation Cap results
in a price per share of $0.72727 (=0.909*8mn/10mn).
• Accordingly, the company will issue 137,500 shares of
Series A-1 Preferred to the safe holder, at $0.72727 per
share (value = $100,000).
• The discount rate does not apply in this case.
76
Survey Findings about Innovation
Entrepreneurs (2011)
• Not all entrepreneurs are young. Median age 40. Twice
as many were older than 50 as were younger than 25.
43.5% had 2 or more children.
• 52% entrepreneurs were the first in their families to start
a business.
• Founders of engineering and technology firms were well
educated. Studied in elite university is not a significant
advantage.
• Less than 5% of VC money goes to early stage companies.
VCs do not like to take the risk of developing innovative
products. VCs follow innovation.
78
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Sources of Equity Capital Stage wise Financing (Typical IT Firm)

Venture Amount Type of Ownership Post-money Ownership Founder
Source Start-up stage Growth stage
Milestone Invested Investor of New Valuation of Founder Value
Founder Yes May be ($000) Investor ($000) ($000)
Family and Friends Yes Yes Initial 25 Founder 100% 25 100% 25
Angels (Wealthy Yes May be seed
individuals) Product 75 Family 35% 215 65% 140
VC Investors Yes Yes R&D
Corporations No May be Product 150 Friends 15% 1 000 55% 550
Public Equity Offers No Yes Testing
Commercial Banks (debt) No Yes Shipping 300 Angel 10% 3 000 50% 1 500
Life Insurance Companies No May be Product
(debt) Expansion 2 000 VC Firm 33% 6 000 33% 2 000
Leasing Companies (debt) May be Yes Round
Govt. R&D Programs May be May be Late Stage 5 000 VC 25% 20 000 25% 4 000
Round Firms
Foundations May be May be
Supplier Financing May be May be Go Public 10 000 Public 20% 50 000 20% 10 000
(IPO)
79 80
Assuming no further investment by the Founder.

Financing Sources Financing Sources

• Bootstrapping: • Crowd funding:
- Self-financing by entrepreneur - It is the practice of funding a project or venture by raising
- Retains control and ownership monetary contributions from a large number of people. In
- Limited investment 2015, it was estimated that worldwide over US$34
- Need to fall back on others for money in lieu of equity stake for billion was raised this way.
future growth - This modern crowd funding model is generally based on
• Family and Friends: three types of actors: the project initiator who proposes
- Entrepreneurs can fall back on willing to support relations and the idea and/or project to be funded, individuals or groups
friends. Usually the next source. who support the idea, and a moderating organization (the
• Business Angels: "platform") that brings the parties together to launch the
- Key elements in seed financing idea.
- They are former entrepreneurs or executives who turned out to be - Crowd funding has been used to fund a wide range for-
HNI profit entrepreneurial ventures such as artistic and creative
- They can act as a catalyst to structure the ideas, develop them projects, medical expenses, travel, or community-oriented
professionally, gather initial capital and key human resources and social entrepreneurship projects.
identify early business partners.
- Ex. Impactguru in India
81 82

Financing Sources Global VC Deals

• VC Funds:
- Seed-stage financings are often comparatively
modest amounts of capital provided to
entrepreneurs to finance the early development
of a new product or service.
- Start-up financing provides funds to companies
for product development and initial marketing.
This type of financing is usually provided to
companies just organized or to those that have
been in business just a short time but have not
yet sold their product in the marketplace.

83 84

14
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Growth Equity / Capital

• By definition, growth equity or growth capital or expansion
S 5 - Growth Capital: Financing capital rounds consist of investments into relatively mature
(usually five years or older) companies that are revenue-
generating, growing and often profitable or nearing
Companies’ Expansion profitability.
• Companies utilizing growth equity funding are usually doing
so in order to fast-track an expansion of operations through
M&A and/or to make other internal investments to
accelerate growth. In addition, growth equity deals many
B B Chakrabarti times involve companies taking on their first institutional
investment.
Professor of Finance • Because of the nature of the companies being technology-
based and also being more mature and stable, growth
equity financing is often said to have characteristics of both
venture capital and private equity.

85 86

Growth Equity / Capital Growth Stage

• Growth capital is focused on growth financing,
helping companies which are not able to get
loans either because of their size, their
financial record or because banks still consider
them too risky.
• Today, a wide range of investor types
participate in growth equity deals from
venture capital firms and hedge funds to
private equity investors and pure-play growth
equity firms.
87
• The growth stage of a new business or venture generally
begins late in the “Early Stage” and proceeds well into the
stages requiring mezzanine / VC financing. Late in the early
stage, aspects of the company begin to become more
complete and there is clear evidence of progress in the
company’s development.
• Typically, the management team is more complete and the
product or service has gone to market on a commercialized
basis. Enough revenues are being generated such that the
company is beginning to obtain market validation for their
product. Patents filed for proprietary technology have been
or are close to being issued and their product and websites
are offered on a commercial basis.
• It is late in the early stage that this growth stage begins and
the entrepreneurs typically seek larger higher funding from
angels groups and VCs. These growth stage companies are
typically only two to four years old.
88

Sources of Equity Capital Convertible Debt vs Preferred Stock

Source Start-up stage Growth stage Convertible Debt Preferred Stock
Founder Yes May be
A convertible bond pays interest like a A preferred stock pays a fixed
Family and Friends Yes Yes normal bond, but also allows to profit dividend with priority over any
Angels (Wealthy Yes May be from an upturn in the value of a dividend payments made on common
individuals) company, by converting the bond to stock. This comes in addition to any
VC Investors Yes Yes common shares. potential increase in the price of the
Corporations No May be preferred shares.
Public Equity Offers No Yes Exists in callable version. Exists in callable version.
Commercial Banks (debt) No Yes Bond has priority over common and Preferred stock has priority over
Life Insurance Companies No May be preferred stock for any payments due. common stock for any payments due.
(debt) At the end of the day, convertible At the end of the day, preferred stock
Leasing Companies (debt) May be Yes bonds are still debt. Legal recourse is still equity, so may not get dividend.
Govt. R&D Programs May be May be available for breach of contract.
Foundations May be May be Bond interest provides tax shield. More costly as paid after tax.
Supplier Financing May be May be Less accessible to investors due to More accessible to investors due to
89 higher face value. lower face value. 90

15

How PE/VC Companies Add Value?
• There are three main areas where private equity
investments may bring value to corporations:
- Financial engineering, operational engineering, and
governance engineering.
a) Financial engineering refers to efforts to add value by
improving a company’s capital structure. Improvement
means making the capital structure more efficient by
reducing the cost of capital. This is achieved by adding
leverage from new outside sources.
b) Operational engineering refers to efforts by private equity
firms to improve their portfolio companies through formal
and informal consulting services. This consulting may help
improve production processes, marketing, and product
mix decisions and, ultimately, increase working capital.
91
How PE/VC Companies Add Value?
• Some portfolio companies respond well to
these three forms of engineering, creating
significantly more value for a PE firm than
they had previously produced as a public
company with a distributed shareholder
ownership model.
• Some other portfolio companies have done
poorly.
93
Active PE/VC Funds in India
95
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How PE/VC Companies Add Value?
c) Governance engineering refers to initiatives
by private equity firms to create value in
portfolio companies by improving incentives
and creating monitoring processes that focus
on improvements in cash flow through cost
reductions and increases in revenues. Many
other areas are monitored as well to
determine results against expectations.
Managers are directly compensated based on
performance in achieving targeted results.
92
Risks in Funding the Growth Stage
• Growth capital investments are probably the least
risky in the PE sector, as the companies are
mostly profitable or are soon to be and growing.
• The return is also theoretically less attractive, as
these companies are already valued with the
inclusion of their growth perspective.
• They are still an attractive investment as they
offer relative security to the investor compared to
LBO and start-up or seed stage VC, and the return
is still higher than on public equity traded on the
stock exchange.
94
India Focused Dry powder ($B)
96
16

India – Average Deal Size
97
Venture Debt Funding
• Venture Debt is better suited for startups having a
high degree of visibility into revenue forecasts and a
proven product-market fit. Such companies usually
have positive economics and a clear path to breaking
even. Startups having recurring or subscription-based
revenue model (e.g. SaaS companies) and Enterprise
consumer base with high lifetime value are more
attractive to lenders.
• The best time to raise venture debt is in conjunction
with or just following an equity round when it is most
accessible, all diligence materials are fresh, and the
business has momentum. It enables Venture debt
lender to leverage due diligence done by equity
investor which reduces processing time.
99
PE Funding of NBFCs
• NBFCs have emerged as key financiers to businesses,
especially the high-potential, credit-hungry
MSME sector.
• RBI data shows that, in FY17, NBFCs and housing
finance companies cumulatively extended Rs 2.59 lakh
crore in credit to commercial enterprises, meeting 18%
of their total credit needs. This marked a year-on-year
increase of 28% in NBFC lending from FY16 – a sharp
contrast to the banking system, which has
been grappling with a mountain of bad loans.
• NBFCs have registered multi-fold growth to double
their market share in SME and wholesale loan
categories, in addition to making significant inroads
into other consumer loan categories.
101
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Venture Debt Funding
• Venture debt is the perfect tool for raising growth
capital while avoiding dilution and maximizing
equity returns for startups. It is also a very timely
tool to finance acquisitions or bolster balance
sheet before an IPO, strategic partnership or an
M&A possibility.
• While VC’s are comfortable taking concept bets,
venture debt providers invest in the company’s
ability to execute. In developed markets like the
US and Europe, the Innovation Economy has
accessed debt for more than 35 years. However,
it is important to use venture debt in the right
situations and for the right kinds of startups.
98
Venture Debt Funding
• How much debt?
• Raising too little may not be worth the cost of having
additional conversations and juggling another investor
relationship. Raising too much can cause a company to
become over-leveraged.
• Startups must, therefore, balance the amount of debt
required with their business plan. Typically, companies
raise 20% to 30% of last equity round as Venture Debt. As
a thumb rule, monthly debt payments shouldn’t exceed
25% of a company’s total operating expenses.
• Also, the amount of Debt should be less than 10% of the
company’s Enterprise Value. Crossing these limits can
cause a startup to become over-leveraged which
discourages future equity investors.
100
PE Funding of NBFCs
• NBFCs are able to expand their lending activities faster
than banks due to higher availability of capital.
• PE investment into the NBFC sector in the past few
years has changed the way these firms progress and
grow. PE firms provide not only financial muscle to
NBFCs for growth, but also enable the creation of
world-class financial organizations with a focus on
industry developments around the world.
• The value-add of PE firms does not stop at just financial
support. Corporate governance requirements of PE
firms future-proofs investee NBFCs from regulatory
risks, fraud, and other losses. PE firms’ history and
experience can also provide early visibility to sector
headwinds, affording an opportunity to NBFCs to
course-correct in a timely manner.
102
17

PE Funding of BFSI in 2018
103
Financing of Flipkart
• 2007: Begins with Rs. 4 lakh or $6,000 as initial capital.
• 2008: Ashish Gupta, founder of Junglee and Helion Venture
Partners funds Flipkart initially.
• 2009: Accel India, the VC firm, provides the first
institutional round of fund of $1 million. Flipkart also
received $10 million from Tiger Global Management. The
valuation of the company was reported to be a bit lower
than $50 million.
• 2010-11: Flipkart raised $20 million from Tiger Global and
begins talks with private equity funds like General Atlantic.
The valuation of the company then was $1 billion.
• 2012: Flipkart became a unicorn startup. It announced
$150 million round led by South African tech major
Naspers. The valuation of Flipkart back then was $1 billion
105
Financing of Flipkart
• 2015: Flipkart reached the highest valuation at $15.5
billion. It also raised $700 million from all the existing
investors.
• 2016: This was a bad year for Flipkart. The company
received the first big markdown by a Morgan Stanley
Mutual Fund. This time the valuation stood at $11billion.
• 2016: The markdowns kept continuing by various mutual
fund investors like Vanguard, T Rowe Price and Fidelity.
• 2016: This time Valic, the US fund, marked up the valuation
of its shares in Flipkart by 10 percent. Now, the valuation of
the company was $11.5 billion.
• 2016: A Morgan Stanley Mutual Fund made another
considerable cut to the value of its Flipkart shares. The
valuation was now a mere, $5.6 billion.
107
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Financing of Flipkart
• Flipkart was started in 2007 by two IIT Delhi graduates,
Sachin Bansal and Binny Bansal, who had quit Amazon with
entrepreneurial dreams. Ten years later it is competing
hard and thriving in the presence of the global giant,
Amazon.
• Opened as just an online bookstore, Flipkart, India’s largest
e-commerce portal, now employs thousands of people and
sells the widest range of products.
• The company’s investors include Tiger Global Management,
Naspers, Accel Partners, Dragoneer Investment Group,
Sofina, ICONIQ Capital, DST Global, GIC and Morgan Stanley
Investment Management.
• Here is a timeline of the finances (funding and valuations)
that Flipkart has received through the years:
104
Financing of Flipkart
• 2013: Flipkart raised $200 million from existing investors in
mid-2013. The company also raised $160 million more from
Morgan Stanley, Sofina, Vulcan Capital and Dragoneer. The
valuation fo Flipkart was reported to be $1.6 billion.
• 2014: Following the acquisition of Myntra in that year,
Flipkart raised $210 million from DST Global. The valuation
then stood at $2.6 billion.
• 2014: This was a piece of history as Flipkart witnessed a
whopping $1B funding round from GIC Singapore and
existing backers like Naspers, DST Global and Tiger Global.
Even the valuation shot up 1.5 times and stood at $7 billion,
within the span of less than quarter of a year.
• 2014: Flipkart raised a $700 million fund from hedge funds
like Greenoaks, Steadview Capital, sovereign wealth fund
Qatar Investment Authority, mutual fund T Rowe Price.
Flipkart’s valuation again increased to more than $11
billion.
106
Financing of Flipkart
• 2017: SoftBank Vision Fund has bought stake worth at least
$2.6 billion in Flipkart Ltd, in a deal that provides a part exit
to some of the e-commerce company’s investors, boosts
the ability of India’s largest internet firm to take on arch-
rival Amazon India, and gives SoftBank a piece of India’s
most valuable start-up.
• The latest round of funding takes Flipkart’s cash reserves to
more than $4 billion.
• SoftBank will also buy Flipkart shares worth $1.2-1.4 billion
from Tiger Global Management, Accel Partners, IDG
Ventures and Flipkart co-founders Sachin and Binny Bansal,
among others.
• Flipkart’s largest investor, Tiger Global—whose
representative Kalyan Krishnamurthy is the company’s
CEO—will get a majority of the $1.2-1.4 billion from
SoftBank.
108
18

Financing of Flipkart
• The investment will likely make SoftBank the largest
investor in Flipkart along with Tiger Global, whose influence
on the firm’s board will diminish. Both SoftBank and Tiger
will end up owning 20-25% in Flipkart after the deal.
• The SoftBank-Flipkart deal may see the return of Sachin and
Binny Bansal to more prominent positions at Flipkart. While
the company’s official position all along has been that the
Bansals were always involved at the company, it has been
clear to most people that starting January 2017, when
Krishnamurthy was named CEO of Flipkart, he and Tiger
Global have been in charge.
• Flipkart will also end up with five strong voices on its board:
SoftBank, Naspers-Tencent, Tiger Global, Accel and the
Bansals. This is a break from the past when Tiger Global’s
Lee Fixel, Flipkart’s godfather, was by far the most powerful
voice on the company’s board since he first invested in
Flipkart in November 2009.
109
S 6- LBO: Financing Companies’
Transmissions
B B Chakrabarti
Professor of Finance
111
The Concept of LBO
• PE investments are often channeled through a
new company (called “portfolio companies”-
NewCo) that receives equity investments from
a PE fund and manages the target company.
• NewCo also obtains debt financing from
lenders. The proceeds of the debt and equity
capital received by NewCo are then used to
acquire the shares (or assets) of the target
company for cash.
• The cash flow from NewCo and the target
company is used to service debt payments.
113
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Financing of Flipkart
• 2018: On 9 May 2018, Walmart officially
announced its intent to acquire a 77% controlling
stake in Flipkart for US$16 billion.
• Following the proposed purchase, Flipkart
founder Sachin Bansal will leave the company,
while the remaining management will report to
Marc Lore, CEO of Walmart eCommerce US.
• Walmart president Doug McMillon cited the
"attractiveness" of the market, explaining that
their purchase "is an opportunity to partner with
the company that is leading transformation of
eCommerce in the Indian market”.
• Walmart expects the acquisition to be completed
by the end of 2018.
110
The Concept of LBO
• In a Leverage buyout (LBO), you acquire a company or
part of a company and the entire process is majorly
funded by debt.
• The parties involved are a Buyer and the Target company.
The Buyer, mostly is a PE fund who invests a small
amount of equity and majorly uses leverage or debt to
fund the remainder of the consideration.
• The PE firm uses debt to lift its returns. Using more debt
means that the PE firm will earn a higher return on its
investment.
• The purpose of leverage buyouts is to allow PE firms to
make large acquisitions without having to commit a lot of
capital.
112
Ownership of a Buyout Fund
114
19

NewCo Funding and Investing
How does LBO analysis work?
• LBO analysis is similar to a DCF analysis. The common
calculation includes the use of cash flows, terminal value,
present value and discount rate.
• However the difference is that in DCF analysis we look at the
present value of the company (enterprise value), whereas in
LBO analysis we are actually looking for the IRR.
• LBO analysis also focuses whether there is enough projected
cash flow to operate the company and also pay debt principal
and interest payments.
• The concept of a LBO is: Buy a company –> Fix it up –> Sell it
• Usually the entire plan is, a PE firm targets a company, buys it
with majorly debt, fixes it up, pays down the debt, and then
sells it for large profits.
KKR Buyout of RJR Nabisco
• RJR Nabisco was an American conglomerate, selling tobacco
and food products.
• In 1988 RJR Nabisco was purchased by KKR for $25 billion.
• KKR put only a little more than $15 million of its own money.
• This deal is credited with spawning the boom of LBOs in USA.
• After the KKR buyout
• RJR Nabisco divested the following divisions:
• Nabisco's UK operations (including Smith's and Walkers), Belin
of France, and Saiwa of Italy were sold to BSN. Smith's and
Walkers were swiftly resold to PepsiCo.
• Chun King was sold to Yeo Hiap Seng.
• Associated Biscuits International (consisting of 38% of India's
Britannia and 40% of Pakistan's English Biscuit Manufacturers)
to Britannia Industries.
10/11/19
LBO Example
• In 2007, Blackstone Group bought Hilton Hotels for $26
billion through LBO. Blackstone put up $5.7 billion in cash
(and $0.8 bn later)and financed $20.5 billion in debt from a
group of 26 big banks, hedge funds, and real estate debt
investors. Before the financial crisis of 2009, Hilton had
issues with declining cash flows and revenues. Hilton later
refinanced at lower interest rates and improved operations.
• BS bought back some debt at deep discount and by issuing
shares. Hilton again became public in Dec 2013 with second
IPO of $2.3 bn. With 76 percent of the equity, Blackstone’s
stake in Hilton was worth at least $15 bn. That is a profit,
on paper at least, of more than $8.5 billion.
• Pl read http://blogs.reuters.com/ben-
walsh/2013/12/16/how-blackstone-made-8-5-billion-from-
hiltons-6-billion-increase-in-value/
115 116
How does LBO analysis work?
117 118
KKR Buyout of RJR Nabisco
• Fresh Del Monte Produce was sold to Polly Peck.
• Del Monte Foods was sold to Merrill Lynch, Citicorp Venture
Capitol, and Kikkoman. Del Monte's Asia operations (outside
the Philippines) were separately sold to Kikkoman.
• The company's 20% stake in ESPN Inc. was sold to Hearst
Communications.
• The Financial Burden
• RJR was going downhill from the 1970s. Philip Morris became
the market leader by capturing young smokers with Marlboro,
while RJR contented itself with selling smokes to baby-
boomers' dads with Camel and Salem brands.
• What the LBO did was accelerate the decline. KKR had a $30
billion debt burden.
119 120
20

KKR Buyout of RJR Nabisco
• Philip Morris had a golden opportunity. While RJR used its
tobacco cash to pay off junk bonds, its rival plowed profits
right back into the business. By 1991, Philip Morris had grown
its market-share lead to 44% vs. RJR's 28%.
• RJR didn't retire its LBO debt until 1999--by selling overseas
operations--and in the meantime Philip Morris toyed with its
competitor, like a cat with a wounded mouse. In 1993, Philip
Morris cut cigarette prices by 20%, knowing that RJR would
have to do so too, and that it was far less able to take the
profit hit.
• From 1991, when KKR took 60% of the company public, to
1995, when the firm swapped the last of its shares for Borden
stock, RJR's market value shriveled about 50%.
• KKR badly lost in this buyout.
121
Sources of Funds in a LBO
• The following are the sources of funds to finance the
transaction.
• REVOLVING CREDIT FACILITY
- A revolving credit facility is a form of senior bank debt. It acts
like a credit card for companies. A revolving credit facility is
used to help fund a company’s working capital needs.
- A company in need generally will “draw down” the facility up
to the credit limit when it needs cash, and repays when excess
cash is available.
• BANK DEBT
- Bank debt is a low interest rates security than subordinated
debt. But it has more heavy covenants and limitations. Bank
debt typically requires full payback over a 5- to 8-year period.
123
Sources of Funds in a LBO
• SUBORDINATED OR HIGH-YIELD NOTES
- They are commonly referred to as junk bonds. These are
usually sold to the public and command the highest interest
rates to compensate holders for their increased risk exposure.
- Subordinated debt may be raised in the public bond market or
the private institutional market and usually has a maturity of 8
to 10 years. It may have different maturities and repayment
terms.
• SELLER NOTES / FINANCING
- Seller notes can be used to finance a portion of the purchase
price in an LBO. In case of seller notes a buyer issues a
promissory note to the seller wherein he agrees to repay over
a fixed period of time.
125
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India’s Buyout Market
• Safecorp Holdings Pvt Ltd, a consortium of WestBridge AIF,
Rakesh Jhunjhunwala and Madison Capital, decided to buyout
Star Health and Insurance for $880 million in 2019-20.
• Kedaara Capital and Partners Group decided to buyout Vishal
Mega Mart for $735 million in 2019-20.
• Control deals in India
• Strategic and PE investors have begun to lay emphasis on
control as a key component in the performance of their
investments.
• Buyout deals have witnessed nearly 25% increase in value in
2018 compared to 2017, underlining the growing appetite for
control deals in India.
• Promoters are now open to ceding control in an effort to
boost the growth of the company.
122
Sources of Funds in a LBO
- Bank debt generally is of two types:
- Term Loan A : Here the debt amount is evenly paid back
over a period of 5 to 7 years.
- Term Loan B: This layer of debt usually involves minimal
repayment over 5 to 8 years, with a large payment in the
last year.
• MEZZANINE DEBT
- It is a form of hybrid debt issue. The reason behind that
is, it generally has equity instruments (usually warrants)
attached with it. It increases the value of the
subordinated debt and allow for greater flexibility when
dealing with bondholders.
124
Sources of Funds in a LBO
- Seller notes are attractive sources of finance because it is
generally cheaper than other forms of junior debt. Also at the
same time it is easier to negotiate terms with the seller than a
bank or other investors.
• COMMON EQUITY
- Equity capital is contributed through a PE fund. The fund
pools the capital which is raised from various sources. These
sources include pensions, endowments, insurance companies,
and HNI’s.
126
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LBO – Sources of Revenue Key Features of a Target Company

• CARRIED INTEREST
- Carried interest is a share of the profit that is generated by
the acquisitions made by the fund. Once all the partners have
received an amount equal to their contributed capital, the
remaining profit is split between the GP and LPs. Typically, the
GP’s carried interest is 20% of any profits remaining.
• MANAGEMENT FEES
- LBO firms charge a management fee associated with
identifying, evaluating and executing acquisitions by the fund.
Management fees typically ranges from 0.75% to 3% of
committed capital, although 2% is common.
• RETURNS ON CO-INVESTMENT
- Executives and employees of the leveraged buyout firm may
co-invest along with the partnership, provided the terms of
the investment are equal to those afforded to the partnership.
• Company from a Mature industry
• Clean balance sheet with no or low amount of
outstanding debt
• Strong management team and potential cost-cutting
measures
• Low working capital requirement and steady cash flows
• Low future capital expenditure requirements
• Feasible exit options
• Strong competitive advantages and market position
• Possibility of selling some underperforming or non-core
assets

127 128

Exit Strategies and Exit Multiples LBO in a nut shell

• Exit strategy helps buyout fund to realize gains on Parameters Range
investments. It includes an outright sale of the
company to a strategic buyer or another financial Returns Between 20%-30% generally
sponsor/PE firm or an IPO.
Exit Time Horizon 3-5 years
• PE firms typically expect to realize returns within 3 to
7 years. Capital Structure Mixture of Debt (High) and Equity

• EV/EBITDA multiples are largely used. Higher Debt Payment Bank debt paid usually in 6-8 yrs.
multiples will boost the IRR. Higher yield debt paid in 10-12 yrs.

EXIT Multiples PE, EV/EBITDA

Potential exits Sale, IPO, Recapitalization

129 130

Value and No. of Global Buyout Deals Performance of Buyout Funds

131 132

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History of Venture Capital in India

• The Indian tradition of venture capital for industry goes back more
than 150 years when many of the managing agency houses acted as
capitalists providing both finance and management skill to risky
S 7 - PE Industry in India projects.
• After the abolition of managing agency system, the public sector
term-lending institutions met a part of venture capital requirements
through seed capital and risk capital for hi-tech industries, which
were not able to meet promoter’s contribution. However, all these
institutions supported only proven and sound technology.
• In 1975 venture capital financing was introduced in India by the all-
India financial institutions with the inauguration of Risk Capital
B B Chakrabarti Foundation (RCF) sponsored by Industrial Finance Corporation of
India (IFCI) to supplement ‘promoters’ equity with a view to
Professor of Finance encouraging technologists and professionals to promote new
industries. In 1976 the seed capital scheme was introduced by
Industrial Development Bank of India (IDBI).

133 134

History of Venture Capital in India History of Venture Capital in India

• In 1984, ICICI decided to allocate funds for providing • Banks were allowed to invest up to 5 % of
assistance in the form of venture capital to economic
activities involving both risk and high profit potential. their new funds annually in venture capital in
• To popularize VC financing, GOI announced the 1999.
creation of a Venture Capital Fund (VCF) in 1986. • At present, several VC firms are incorporated
• In 1988, the first organization to identify itself as a VC in India, promoted by State level financial
operator was Technology Development & Information
Company of India Ltd. (TDICI) in Bangalore. institutions, Public Sector banks, foreign
• The formalization of the Indian venture capital banks, private sector or financial institutions.
community began in 1993
• with the establishment of the Indian Venture Capital
Association (IVCA) headquartered in Bangalore.

135 136

Annual PE and VC Investments in India Annual PE / VC Exits in India

137 138

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Fund Raising India Focused Dry Powder

139 140

Growth of AIFs in India PE / VC Investments by Sector in India

141 142

Top 15 Deals in 2018 (40% of Total) PE / VC Deals in India by Stage

143 144

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Top 15 Deals in 2018 (70% of Total) PE / VC Exits in India

145 146

Case Discussion

HBS case no. W 15463

S 8 - Valuation of PE Investments
Fairfax and Thomas Cook India –
Private Equity, Permanent Capital and Public Markets

B B Chakrabarti
Professor of Finance

147 148

Valuation Methods Comparables

1) Using Comparables • Comparables used –
2) NPV method 1) P/E ratio
3) APV method 2) P/B ratio
4) Venture Capital method
3) P/Revenue ratio
5) Option valuation
4) Others like value based on no. of
subscribers for internet companies or no. of
Pl read: HBS Note on Valuation in PE Settings patents for biotech firms
(9-297-050)

149 150

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Comparables – Example Comparables – Example

(App. 1 of HBS Note) (App. 1 of HBS Note)
Happy Community Average Private Health
• Major shareholder of Private Health (PH) wants Healthcare Health Implied Value
to sell his stake. ($mn)

• Comparable companies are Happy Healthcare P/E ratio 21.0 14.5 17.8 533

and Community Health. P/B ratio 3.52 6.21 4.86 389

• Figures for PH are: Enterprise

value/EBITDA
9.49 8.35 8.92 397

a) Earnings = Net Income = $30 mn Enterprise 1.24 1.28 1.26 436

b) EBITDA = $45 mn value/Revenue
Enterprise 870 987 929 459
c) Revenue = $350 mn Value/No. of
d) Book Value of Equity = Net Worth = $80 mn Members

e) No. of members = 0.5 mn Equity value = Enterprise value – Long term debt of $5 mn
Valuation = $389 - 459 million
151 152

NPV NPV – Example (App. 2 of HBS Note)

• Calculate free cash flow during the planning
horizon and terminal cash flow.
• Calculate cost of equity using CAPM and beta
of comparable public companies after
unlevering and relevering.
• Calculate WACC using target capital structure.
• Calculate enterprise value by NPV method.
• Equity value = Enterprise value – Long-term
debt
153
• NPV of Hi-Tech to be calculated.
• NOL = $100 mn to be offset against future
income.
• Rf= 6%, EMRP = 7.5%, Unlevered Beta of
comparable cos = 1.2, no debt in Hi-Tech, Ke =
15% = WACC
• Terminal growth rate = 3%
• Tax computed using NOLs carried forward.
• NPV = $525 mn
154

APV APV – Example (App. 3 of HBS Note)

• APV preferred with changing capital structure,
and NOLs resulting in varying tax rate.
• 3 steps:
- value cash flows under all equity capital
structure
- calculate the NPV of tax shields using
discount rate = pre-tax rate of return on debt
- calculate the NPV of NOLs using discount
rate = pre-tax rate of return on debt
155
• Turnaround to be valued.
• $220 mn NOLs, $75 mn of 8% debt at beg yr 1
to be repaid in 3 equal installments
• Tax rate 40%, unlevered beta 0.8, Rf = 7%,
EMRP = 7.5%, Cost of unlevered equity = 13%
• Terminal growth rate = 3%
• APV = PV (FCF) + PV (Terminal CF) + PV
(Interest Tax Shield) + PV (NOL Tax Shield)
= $ 673 million
156

26

Venture Capital Method
• The company is valued using a multiple at a time
in the future.
• This “terminal value” is then discounted back by
using a high discount rate between 40 and 75%.
• VC achieves desired ownership interest with the
investment made without future rounds of
financing.
• VC will calculate retention ratio of his initial
ownership percentage in case of future rounds of
financing.
157
Venture Capital Method (App. 4 of HBS Note)
• VC intends to hire senior staff with 10% stock
options and issue additional 30% shares in
IPO.
• Retention ratio = 1/(1.1*1.3) = 70%
• Required current % ownership = 0.285/0.7 =
40.7%
• No. of new shares to be issued now =
500,000/0.407-500,000 = 343,373
• Price per share = $5 mn / 343,373 = $14.56
per share
159
Option Pricing – Example (App. 5 of HBS Note)
• Whether to invest in ThinkTank, who are
developing a new product for manufacturing
and selling in the market with $120 mn
investment.
• NPV = -$11.55 mn with discount rate of 25%
and terminal growth rate of 3%.
• The project can be in 2 stages a) $20 mn for
R&D and b) $100 mn for commercial
production. So, option to expand.
• The expansion project is a European call.
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Venture Capital Method (App. 4 of HBS Note)
• VC wants to decide the percent ownership
with his $5 mn investment in a start-up.
• Current shares o/s = 500,000, Net income
after 7 years = $20 mn, P/E ratio = 15,
Terminal value = $300 mn, Target return =
50%, PV = $17.5 mn.
• % ownership = 5/17.5 = 28.5%, No. of new
shares to be issued = 500,000/(1-0.285)-
500,000 = 200,000, Price per new share = $25
158
Option Pricing
• NPV / APV cannot adequately value firms with
“flexibilities” (options) for managers /
investors. VCs may have options like ability to
make follow-on investments.
• Such options change cash flows that cannot
be captured by NPV / APV.
• Value of equity is a European call on the value
of the firm.
• Black-Scholes formula can be used for such
valuation.
160
Option Pricing – Example (App. 5 of HBS Note)
• The parameters of the call option are T= 2
years, Rf = 7%, X = $100 mn, S0 = PV of the
project = (120-11.55) = $108.45 mn, σ = 0.5 to
0.6 (estimated).
• Value of call option = $38.8 - $43.7 mn.
• Value of the 2-stage opportunity = (38.8-20) –
(43.7-20) = $18.8 - $23.7 million.
162
27

Comparison of Various Valuation Methods
163
Key Elements to a Successful
Fundraising Plan
• Establish the team - A first time fund needs to
establish a key core team that is openly committed to
the fund.
• Review your strategy - The strategy should be a living
document that is periodically discussed and modified
as market conditions and business needs change. The
entire team must speak with one voice while
fundraising.
• Seek fund formation legal advice - If this is the first
fund or if the firm has not been in fundraising mode for
the past five years or so, seek the advice of a fund
formation attorney (FFA) to ensure compliance with
current formation requirements.
165
Fund Raising Challenges in Emerging
Markets
• Typical PE investors (LPs) are looking for low risk investments
with above average potential. From a LP’s perspective, risk can
be reduced by building trust with teams of GPs as well as looking
at the consistency of the GPs’ track record. Traditionally, PE firms
frequently raise capital with blind-pool structures, meaning LPs
contribute capital without knowing which assets will be
acquired. A private placement memorandum will shed some
light on the investment strategy, but in the end LPs have no
control where their capital will be deployed.
• In developed markets, PE firms can run consecutive funds with a
very similar structure, investment strategy and ultimately
outcome, reducing the risk for investors. The homogenous
market environment of developed countries enables them to
specialize in certain types of deals or industries.
167
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S 9 - Fund raising challenges for
PE firms
B B Chakrabarti
Professor of Finance
164
Key Elements to a Successful
Fundraising Plan
• Consider the advice of placement agents - These
professionals have their finger on the pulse of the
market and are invaluable in learning about the
competitive landscape, investor preferences and
other keys to successful fundraising.
• Seek early, informal feedback from your largest
LPs - This is a critical step in refining the strategy
and also in preventing surprises.
• Revisit your pitch - If this is your first fund, take
time to craft your pitch to truly address your
investors’ needs and questions.
166
Fund Raising Challenges in Emerging
Markets
• By contrast, emerging markets are fast moving
and very diverse, making it difficult for GPs to
establish a pattern and thus ultimately
building up trust with LPs. New markets like
Iran have no history of buy-outs whatsoever.
Fundraising therefore also entails a good
amount of educating LPs about the country
itself, before even getting the opportunity to
talk about the investment strategy.
168
28

Role of Placement Agents
• The basic role of a placement agent is to raise capital for
its fund manager clients as expeditiously as possible.
• Roles:
- All placement agents introduce fund managers to
investors.
- The best placement agents are interactive databases,
tracking the shifts of personnel at institutional investors,
as well as changes in sector appetite, investment
processes and private equity allocations of the investors
they cover.
- Most placement agents assist fund managers with their
marketing material in order to present a consistent
message as part of a coordinated marketing strategy.
169
Role of Placement Agents
- Experienced placement agents often will advise a
fund manager on fund terms and conditions before
the fund goes to market, to help ensure that the
terms are within market – or close enough not to
cause investors to reject a fund on first receipt of a
PPM.
171
Types of Placement Agents
• Niche independents: These smaller firms – sometimes as
small as a single individual – often focus on a small circle
of relationships, often geographically focused but in
other instances focused on expertise with a certain type
of fund, such as venture capital or funds of funds.
Especially in difficult fundraising markets like the Middle
East or Japan, some of these agents have a competitive
advantage because of their specific strong relationships.
• A placement agent cannot be of much help on a ‘friends
and- family’ fundraise that is dependent for its success
on relationships that a fund manager already has.
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Role of Placement Agents
- Successful agents are repositories of a tremendous
amount of experience; they know specifically what has
worked, and perhaps more importantly what has not
worked, in the past for other managers and can help
refine how a story is told. If engaged early in the process,
an experienced placement agent can act as a strategic
adviser, especially to a new or emerging manager.
- An agent can provide key insight on such issues as the
target fund size, investor expectations of the staffing
levels and professional backgrounds needed at the fund
at its launch, the process of negotiating track record
attribution issues.
170
Types of Placement Agents
• Investment bank agents: Operating as divisions of
large investment banks which offer a range of
products, these firms – such as Credit Suisse, Lazard
and UBS – are global players operating from multiple
offices with large dedicated staffs. Many of the first
placement agents were founded in this manner,
growing and expanding as the PE market grew.
• Global independent firms: There are also a number
of large, global independent firms – such as Atlantic
Pacific, MVision and Probitas Partners – that focus
solely on alternative investment placement and
advisory services.
172
HBS Case
Abraaj Capital
HBS case no. 9-809-008
174
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