Private Equity

Definitions

 Private Equity (PE) refers to a specific type of investment in private

companies in order to help them to develop and expand their activities
or to go through a transformation or restructuring
 The main forms of private equity include:
 Venture Capital: capital is provided at an early stage to companies with high
growth potential. The form of capital is equity with little or no debt
 Growth Capital: capital is provided to mature companies that are looking to
develop or restructure their business
 Mezzanine Capital: Capital is provided in the form of a subordinated debt or
preferred equity. The claim on the firm’s assets is only senior to that of
common shares
 LBO (Leveraged Buy-Out) : acquisition, with borrowed money, of a majority
stake in an existing company
 Private equity is usually an institutional funding, as opposed to individual
financing such as seed funding, angel investing, crowdfunding…
Main participants in PE

 The main participants in a private

equity are: Rank Firm
Capital raised
(US$ m)
 Private Equity fund manager: who
1 The Carlyle Group 30,650.33
manages the pooled money on behalf
of the investors in the private equity 2 Kohlberg Kravis Roberts 27,182.33
fund 3 The Blackstone Group 24,639.84

 The company: both the management 4 Apollo Global Management 22,298.02

and shareholders of the target 5 TPG 18,782.59
company 6 CVC Capital Partners 18,082.35
 The bank: in the case of an LBO 7 General Atlantic 16,600.00
8 Ares Management 14,113.58
 Each of these participants has their
9 Clayton Dubilier & Rice 13,505.00
own perceptions of risks and
10 Advent International 13,228.09
expectations of return
Largest private equity firms by PE capital raised
for the year 2014
(source: Private Equity International)
PE funds vs. quoted equity funds

 Private equity funds differ from quoted equity funds in the sense that PE
fund mangers seek to:
 Control the acquired company, and
 Optimize its capital structure

 Thus PE funds operate with much better information and stronger

influence over the target company than quoted equity funds. As such,
private equity tries to address the principal-agent problem by aligning
the interests of management and shareholders
 This idea of aligning interests to achieve economic efficiencies is central to
private equity

 In return of these advantages, PE funds bear more risks through the use
of debt and forgo liquidity in their investments. PE funds generally hold
on to their investments until they achieve their objectives over a period
of 3 to 8 years
Missions of PE fund managers

 The PE fund managers have four main missions:

 Fund raising: mainly from institutional investors such as pensions funds,
insurance companies and high net worth individuals
 Sourcing investments: prospecting for potential deals. This requires
considerable efforts (some PE funds specialize in a particular sector with
dedicated investment teams)
 Investment management: PE funds managers are actively involved in the
management of their investments, and particularly in setting and
implementing strategies
 Exit strategy: once the objectives are achieved, managers must realize the
capital gains through selling or floating their investments

 To align their interests with the investors’, fund managers quite often
invest alongside other investors on the same terms in the fund. As such,
their rewards come from the fund’s management fees and their share in
capital gains
Investors vs. banks

 For institutional investors, private equity is an asset class that allows

their portfolio to achieve the desired mix of capital gains and income
yield (through higher risk/ higher return investments)

 Private equity offers investors more stable growth opportunities, in

comparison to the volatility of financial markets. Moreover,
commitments to the funds are drawn down gradually as investments are
made (cash not required yet by the fund can be invested meanwhile)

 When debt is used, PE funds may require large loans that can be shared
between several banks through a process of syndication
 By sharing the loan, banks reduce the impacts on their balance sheets
 To further manage risks, banks put a series of financial covenants on the loan
contracts
 Income for banks comes from interest but increasingly from “arranging” the
syndicated loans
Basics of Leveraged Buyout (LBO)

 An LBO is an acquisition of a company financed mainly by debt. It aims

to improve operational performances. Some of the main categories of
LBOs:
 MBO: Management Buyout, the existing management of the company
undertakes the LBO (with the company’s employees)
 MBI: Management Buyin, a new management is put in place
 LBL: Leveraged Build-up, the new group continues to acquire companies in
its sector to create synergies

 Tax consolidation is one of the main drivers of LBOs. The cost of debt is
offset by the pre-tax profits of the target company. These latter must
generate profits sufficient enough and stable over time to meet the
acquiring holding’s interest and debt payments

 The average lifetime of an LBO is short, between 2 and 5 years

Impact of leverage

 Financial buyers in a LBO focus more on ROE than ROA

 The following example illustrates the impact of debt on the ROE of the
buyers as opposed to 100% cash financing:
Type of financing
All Cash 50% Debt 80% Debt
Purchase price 100 100 100
Equity 100 50 20
Debt 0 50 80
EBIT 20 20 20
Interest (at 10%) 0 5 8
Earnings Before Taxes 20 15 12
Taxes (at 35%) 7,0 5,3 4,2
Net Income 13,0 9,8 7,8
After-tax ROE 13,0% 19,5% 39,0%
Exit strategies

 Because of their high gearing, LBOs are risky and, as such, investors
require high returns (above 20% per year)

 Debt financing especially for large transactions can be complex.:

 Senior debt
 Subordinated debt
 Mezzanine debt (between debt and equity)
 securitization

 The main exit strategies for an LBO:

 Sale to a trade buyer
 Initial Public Offer
 Sale to another holding (for a new LBO)
 Leveraged recapitalization (the target company increases its leverage to pay
a large dividend or buy back shares)
Interactions with other business units

 Depending on the size of their activities, Investment banks may

dedicate a business division or an entire subsidiary to PE activities
 PE equity funds may operate in some sectors in which listed companies
exist. As such, these funds may benefit from the analysis that produced
by the “Research & Analysis” division (existing coverage of listed firms)
 PE interactions with the investment bank other business units is
especially important when it comes to financing and implementing exit
strategies. For example:
 If the PE fund decides to issue debt, the asset management business unit of
the investment bank could potentially be an important investor through its
mutual funds (as bondholders)
 If the PE fund opts for a syndicated loan, the investment bank, via the
corporate finance division, could arrange the deal
 If the IPO is the chosen exit strategy, the corporate finance division could be
selected to take in charge the process