Private Equity

Course Objectives – Regarding Leveraged Buyouts:

¾ A broad overview of Private Equity from a Leveraged Buyout perspective

¾ Not all the details; a framework for key issues, drivers and dynamics

¾ Some practical exposure to assessing Private Equity opportunities and issues

London Business School 1/28/2007 Dwight Poler 1

Private Equity
Class One: Francisco Partners and Fund Formation

Agenda:

¾ The Private Equity “Eco-System”

¾ The “Deal Process”

¾ The Fundraising Environment and Key Dynamics

¾ Francisco Partners: Establishing a New Fund

¾ Wrap-up of Issues

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Private Equity
Investment Alternatives for investors/LPs

Lower Risk Spectrum of Investments Higher Risk

Lower Return Higher Return

Other Fixed
Cash Debt Income Public Equity Private Equity Other Esoteric
Inv Grade Real Estate Blue Chip LBOs Derivatives

Junk Project Finance [Hedge Funds] Venture Capital Commodities

Growth Stocks Other specialist

risks

Consider sources of “Risk”: Volatility Illiquidity Uncertainty

Market Underlying Asset Information availability

Company Deal Structure Lack of experience

Capital Structure Security

Note : Private Equity deals can involve all forms of investments above, and incorporate all forms of risk mentioned

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 Private Equity
Private Equity “Eco-System”
The € Flows The Players

$£€ Investors: Individuals (as investors, pensioners); Institutions (Endowments, Foundations)

Limited Partners: Investment Mangers (Pension Managers, Funds of Funds, Family Offices)
Fund Manager (“LPs”) – Pension/ endowment Mangers: Typically salary-based, some bonus

– Fund of Funds: Typically management fee (%of AuM) and often carry

– Family Offices: Mix both payment models

[“Gate Keepers”]: [Advisors to Investors or Limited Partners; typically on fee basis]

Advisor

Fund Manager General Partners: Fund Mangers

(“GPs”) LBO Funds VC Funds Hedge Funds

Company “Target” Companies: Mature Early Stage Public

(“Portfolio” Companies) Companies Companies Companies

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Private Equity
The Deal Process

Fund Sourcing Deal Post-Acquisition

Team Exit/Liquidity
Raising Selection Execution Value Creation

Capabilities Team Relationships Diligence Earnings growth IPO

Experience Track record Criteria Financing CF liberation Trade Sale

Judgment/Trust Strategy/ Resources/ Negotiation Multiple Expansion Recapitalization

Resources Oppty Cost

Energy Documentation

Investment Returns Cost+[80%] of profits

Carry to GP [20%] of profits

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Private Equity
Private Equity “Eco-System”
Summary

¾ Who:

¾ Investors - > LPs - > GP - > Companies - > Investors

¾Consider objectives and incentives for each party?

¾ How:

¾ Raise Fund > Source > Screen > DD/Execution > Post-Acquisition >
Liquidity Event
¾Which stages are most important?

¾ Caveats:

¾ theory v reality; art v science

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Private Equity
Significant Growth in Funds Raised

Estimated Available Capital for Investment

$160

$140 135

$120

$100 95 95
90
80
$80
70

$60

$40

$20 15
10

$0
1998 1999 2000 2001 2002 2003 2004 YTD 9/05

Source : Private Equity News

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Private Equity
Key Drivers of Growth in PE Funds Raised:

Consider Asset Allocation Model for Investors/LPs …

Key Drivers of the increase in PE fundraising:

1. High public and private equity returns created a higher base

against which to apply asset allocation % (a bigger “pie” to
allocate)
2. Existing LPs increasing weighting of alt assets in model (a bigger
“slice of the pie”)
3. New LPs using alt assets class as part of asset allocation model
(more “pies”)
4. Need to deploy large gains/dividends received

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Private Equity
Key Drivers of Growth in PE Funds Raised:

BUT: Consider impact of these changes on deal economics

¾ Number and size of funds

¾ Supply and demand of deals to invest money

¾ Types of LBOs pursued (sectors, geographies, sizes)

¾ Deals are getting larger and opening up new markets

8 out of the 10 largest buyouts ever were done in 2005

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Private Equity
Key Drivers of Growth in PE Funds Raised:

2001-03: Equity gains and cash receipts have declined last few years …
¾ LPs rushed for “Top Quartile” funds

¾ Weak performers, even big names suffered

¾ Very high barriers to change in the industry?

2005: … LPs coming back strongly now

¾ GPs returning significant capital to LPs in drive to raise new funds

¾ LPs interest is increasing PE exposure

¾ Funds are getting much larger to expand buying market

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Private Equity
Key Drivers of Growth in PE Funds Raised

Current LP Issues/Initiatives:

¾ Disclosure and standardization of information: transparency to compare; potential to

commoditize the returns

¾ Alignment of incentives with LPs: management (fund size and fees) and
performance (coinvest and carry)

¾ Flight to quality: dogs lose funding; stars ever more over-subscribed

¾ Growth of “Secondary Funds”:

¾ buy existing interests/commitments in GPs from Sellers
¾ provide liquidity (getting IN and getting OUT) that did not formerly exist for LPs

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Private Equity
Francisco Partners
Case: Setting up a New Fund

Why did Stanton leave TPG?

¾ Personal reasons/opportunities

¾ Market opportunity

¾ Was it a smart move or not?

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Private Equity
Does a Tech LBO fund make sense?

No Yes

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Private Equity
Does a Tech LBO fund make sense?

No Yes

Underlying assets too volatile Some Tech companies are less volatile
Address volatility with capital structure
(or are some less volatile?)

Has never been done … Expanded applications of Private Equity

to meet risk/return spectrum

Public markets provide cheaper capital Sometime public markets unavailable;

for growth companies … or situation too complex

¾ Future of PE involves addressing “untapped” risks (sector, geography) where degrees of risk can
be isolate

¾ Technology LBOs must alleviate another risk of “charge” an incremental premium

¾ Lenders (getting low return) will only lend if some truly low risk cash flows/assets can be isolated

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Private Equity
IF the fund makes sense, will Francisco succeed?

¾ How clear is the market opportunity: How big a market? What growth?

¾ Competitive environment: Who else is competing for each deal?

¾ What is their strategy? How will they compete with others:

¾ What scope: Europe as well as US?

¾ FP competitive advantage? How valuable Sandy R; Sequoia?

¾ Specialist vs Generalist Fund: What are the pros and cons?

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Private Equity
Key Issues for LPs to focus on …

How will the potential LPs look at the opportunity?

¾ All same issues Francisco considered as to how to succeed

¾ Market opportunity; strategy/focus; competitive advantage

Plus:

¾ Team: How strong/experienced? How will the team gel/work together?

¾ Performance: How to assess Stanton’s track record?

(Sourcing? Execution? Relative to a levered index? Which index?)

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Private Equity
Assessing Stanton Returns

Date of Capital Realized Total Mult of

Company Sector Investment Total EV Invested Proceeds Value Cost Gross IRR

GT Com Telco Apr-96 118 29 130 130 4 49.8%

Paradyne Telco Aug-96 179 52 201 490 9 110.6%

Globespan Telco Aug-96 6 5 28 527 110 311.4%

Zilog Semis Feb-98 405 114 - 325 3 77.2%

ON Semis Aug-99 1,780 338 - 2,000 6 492.6%

Semiconductor

TOTAL 2,488 537 358 3,472 6

Investments

Source: Josh Lerner & David Gallo: HBS No.200-063

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Private Equity
Measuring Performance:

Dave Swenson, famed CIO of Yale Investment Office, suggests

looking at buyout fund performance relative to levered public equity

¾ To do so:
¾ For each TPG investment, take equity position, equal to enterprise value,
in the relevant NASDAW index
¾ Fund the difference between the TPG equity contribution and EV with
debt, borrowed at 12%
¾ In 12/99, cash out the indexed position and pay down debt

¾ How does remaining equity value compare with TPG investments?

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Private Equity
Example: Zilog

How good was the 2.9x return on Zilog?

¾ Invest the original Zilog EV ($405M) and invest in NASDAQ same period
¾ $114M of equity
¾ $292 (remainder) in debt

¾ In Dec 99, sell whole position at current index value, pay off debt

¾ NASDAQ increased by 3.06x from 2/98 to 12/99

¾ Value of EV $405 thus went to 1238
¾ Pay off $292 of debt accruing at 12% = 359.3
¾ Total equity value is 879, a 7.7x increase in equity value!

¾ In fact, a levered NASDAQ returned significantly more than Zilog

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Private Equity
Consider Investment in NASDAQ, same period, same leverage …

Enterprise Value Invested in NASDAQ Total Total

Holding Debt Levered From
Company Period Apr-96 Aug-96 Feb-98 Aug-99 Dec-99 Payback NASDAQ Stanton

GT Com 3.67 118 530 134 397 129.5

Paradyne 3.33 179 871 186 685 490.3

Globespan 3.33 6 29 2 27 526.7

Zilog 1.83 405 1,237 358 879 325

ON Semiconductor 0.33 1,780 2,770 1,498 1,272 2,000

Total leveraged Investments 3,260 3,471.5

– Without Globespan
(VC Deal) 3,233 2,944.8

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Private Equity
Performance Assessment and GP Selection:

¾ Thus, a levered NASDAQ would have produced a higher return than the strategy of
levered tech buyouts (ie. excluding Globespan VC deal)
¾ Much of Stanton in fact “market driven” multiple arbitrage plays
¾ Important for LPs to understand “source” of returns ...
¾ Multiple arbitrage: Sold at higher multiple than bought, on same earnings
¾ Debt paydown: Same earnings, but cash flow paid down debt to create
equity value
¾ Operating earnings improvement: Increased earnings (pays debt, sell at multiple)
¾ And tie that to the stated strategy/team of GP; and objectives of LP
¾ Multiple arbitrage: Market timing play
¾ Debt paydown: Old style LBOs (mostly competed away in today’s market)
¾ Operating earnings improvement: Need “value added” team/experience
¾ Stanton’s ability to “pull the trigger” consistently not to be undersold

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Private Equity
Key Issues for LPs to focus on …

¾ Other risks? What are they?

¾ Worth investigating Francisco further? Would you invest?

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Private Equity
Key Terms of the Fund

¾ Which terms are most critical for LPs to focus on?

¾ How should Francisco consider its terms in light of other funds?

¾ Which are most important for the GP to defend?

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Private Equity
Fund Size

Fund size: strategy and execution

¾ Ability to spend within reasonable time

¾ Desired size of portfolio (to manage/add-value)
¾ Implied deal size implications (market opportunity, sourcing, team size/skills)
¾ Over/under-subscription impact

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Private Equity
GP Coinvest

GP Coinvest Commitment

¾ Relevant benchmarks/LP alternative views

¾ Realistically available from the GP members
¾ Strategic partners’ investments (Sandy R., Sequoia)
¾ Risk/return for the GP – up/downside risk vs carry “optionality”

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Private Equity
Return Economics and Methodology

Return Economics
¾ Fund management fee: base to “pay the bills”
¾ Carry: performance incentive
¾ Deal fees/expenses: deal specific return/risk for work done

Calculation Process
¾ Preferred return LP return before GP sharing
¾ Catch-up mechanism GP catch-up before joint sharing
¾ Clawback mechanism If later deals worse than early

Other

¾ Investment scope restrictions How much freedom in “blind” pool?

¾ Key man provisions How important are key guys?
¾ Placement agent costs Who pays for fund set up?

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Private Equity
Key Take-Aways

Private Equity in General:

¾ Is just a means of providing capital for specific forms of higher risk opportunities

¾ Typically addresses some combination of risks:

¾ Market, Company, Capital Structure illiquidity

¾ PE often addresses greater uncertainty, BUT …

¾ often with greater information (given resources to pursue)
¾ offers higher returns for that risk; BUT
¾ involves greater illiquidity while change is occuring

¾ A difference between PE and hedge funds is illiquidity

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Private Equity
Key Take-Aways

Investors Considering New Private Equity Funds

¾ Seek to optimize the risk/reward curve with PE as higher return opportunity

with “less correlated” risk

¾ Are willing to share fees and profit participation in order to assess, assess and
execute on these opportunities

¾ Have expanded dramatically the PE market: in number and size of funds, in

scope of deals and impacted returns

¾ Given 10 year commitments(!) are increasingly focused on manager selection,

alignment of incentives, and accountibiliity

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Private Equity
Key Take-Aways

Francisco Partners:

¾ Reflects a continuing entrepreneurial dynamic of the industry:

¾ Great people need opportunities to grow, direct compensation results

¾ Is a good example of the future of PE:

¾ Attempt to expand/extend into “untapped” risk/return opportunities

¾ Provides Investors a new means to generate potentially high returns with “less
correlated” risk in portfolio

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Private Equity
What Happened?

¾ Francisco held first closing of $1.3BN in July 2000

¾ Sequoai committed $100mm
¾ 75 current and former CEOs committed a total of $300mm

¾ Second and final closing in December 2001 brought total to $2.5BN

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Private Equity
First Time Fund Issues …IF we have extra time!

First Fund Dilemma …

¾ Investors are most focused on:
¾ track record
¾ proof team can work together effectively
¾ sound strategy with competitive advantage
¾ ….. because they are committing to a “blind fund” for 10 years

¾ But, as new fund without capital, very hard to prove

¾ even harder in todays market where LPs want proven institutions

¾ However, Stanton addressed issues very effectively

¾ differentiated strategy with solid supporting dynamics
¾ scale to compete effectively, with reasonable ability to invest total
¾ key relationships for deal flow and “insider knowledge”
¾ highly aligned incentives with significant coinvest ($40mm + $100mm)

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Private Equity
Francisco Specific Issues:

¾ Would this “extension” have worked within TPG? Unlikely …:

¾ technology was too different; lack of expertise beyond Stanton
¾ limited value added from “outsiders” to tech space
¾ investment decisions likely to regress to mean
¾ TPG founders would require compensation

¾ Desire (from GP and LPs) to extend “brand” an ongoing dilemma

¾ But, some firms have made successful logical extensions of core skills
¾ Carlyle leveraged global fundraising to international network
¾ Bain Capital leveraged business analysis into hedge and debt funds
¾ Blackstone leveraged advisory business into private equity/RE

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